Fraud can paralyze a business, large or small. In some cases, a business that falls victim to employee theft can never fully recover. Fraud scams often take years to detect, so they may not have an immediate impact on stock price.
When valuing a business, professionals must put themselves in the shoes of hypothetical buyers and sellers and consider only what was “known or knowable” on the valuation date. In a recent U.S. District Court case, the estate filed a tax return based on the exchange price of bank stock before the company disclosed a devastating fraud scam. After the public disclosure of the incident, the stock became worthless. Here’s why the estate filed a refund claim — and the court denied its claim.
Background
For estate and gift tax purposes, fair market value is defined in IRS Revenue Ruling 59-60 as: “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
The fair market value of a decedent’s property may be calculated on either:
- The date of death, or
- An “alternative valuation date,” occurring six months from the decedent’s death.
In general, the most reliable evidence of fair market value of corporate stock is the price paid on an active exchange, such as the New York Stock Exchange. The price reflects what public investors knew on that specific date.
Refund Claim
In Carter, the estate chose the alternative valuation date (March 21, 2008) to value its interest in Colonial BancGroup. The estate argued that the stock was worthless on the valuation date due to a multimillion-dollar “sham mortgage” scheme perpetrated by one of its customers.
In 2013 and 2016, a representative for the estate filed an amended return and sought a refund of allegedly overpaid estate tax. The court denied her claim for various reasons.
Timeline of Events
The following three relevant dates in this case:
- September 21, 2007, the date of death.
- March 21, 2008, the six-month alternative valuation date.
- August 3, 2009, the date that Colonial BancGroup publicly disclosed the fraud incident, causing the stock value to plummet.
The market for Colonial BancGroup didn’t collapse until more than a year after the six-month alternative valuation date. Until the fraud announcement affected the exchange price, the shareholders were unaware of the scam, and it exhibited no effect upon the stock’s fair market value.
Court Decision
When valuing a business, it’s important to differentiate between events that affect value and those that provide an indication of the company’s value.
A third-party buyout that happens a year after the valuation date is an example of an event that provides an indication of what the business is worth. These types of subsequent events might be used to provide evidence of fair market value, assuming that market conditions remain consistent with conditions on the valuation date and the transaction occurs at arm’s length.
However, in general, when a subsequent event affects the stock price, a valuation expert can factor it into his or her analysis only if it was “known or knowable” as of the valuation date. In Carter, the fraud scam adversely affected Colonial BancGroup’s stock price — but not until more than a year after the valuation date. The company’s shareholders were unaware of the fraud and, therefore, didn’t factor it into their investment decisions.
The U.S. District Court for the Northern District of Alabama reasoned that, if the estate had sold the stock on the valuation date, it would have received the market rate for the stock as of that date. Therefore, the stock’s value was correctly reported on the original estate tax return, and the estate wasn’t entitled to a refund.
In Carter, the court concluded that “the fair market valuation method does not include an exception for fraudulent or criminal actions not known to the public, even if those actions lower or destroy the stock’s value.” The court also noted that, while it was “sympathetic” to the estate’s circumstances, it was unwilling invoke its equitable powers to provide relief.
We Can Help
It’s important to disclose to your business valuation expert any subsequent event that may affect value or provide an indication of value. They can determine whether it’s appropriate to factor the event into the valuation analysis. Contact your Yeo & Yeo business valuation advisor for more information.
Carter v. United States, No. 18-cv-01380-HNJ, N.D. Ala. Aug. 9, 2019