Valuing Nonpublic Securities for Tax Purposes

The Situation

In the mid-1990s, a taxpayer received warrants for future shares of a private start-up telecom company in settlement of a contract dispute. When the company went public two years later at a huge premium to the warrant strike price, the taxpayer exercised the warrants for shares of the telecom company. The taxpayer and the Internal Revenue Service agreed on the amount of the taxpayer's gain, but they disagreed over whether the gain should be taxed as ordinary income or at the lower capital gains rate. Resolution of this question depended on whether the warrants' value was readily ascertainable when received by the taxpayer. If so, the capital gains rate applied; if not, the higher ordinary income rate applied. The answer was not obvious since there were no other holders of the warrants, no trading of the warrants, and no public market for the firm's shares.

NERA's Role

NERA was retained to determine whether for tax purposes the warrants had an ascertainable value on the date of grant. Using fundamental probability analysis of the expected rate of return on venture capital for similar investments, as well as private transactions in the companies' shares that took place around the time of the grant, NERA determined that the warrants had an ascertainable fair market value on the date of grant. NERA also determined the actual value of the warrants to a reasonable degree of accuracy. NERA worked closely with the taxpayer's counsel to identify weaknesses in the analysis performed by the government's expert. Both the government's expert and NERA's expert testified at trial.

The Result

In deciding the case, Judge Maurice Foley of the United States Tax Court found that the respondent's expert was "not credible." In contrast, Judge Foley found that NERA's expert was "credible, consistent, and highly qualified." On 8 May 2007, Judge Foley ruled that, based on NERA's expert testimony, the warrants had an ascertainable fair market value on the date of grant.