Advanced D P Chapter Eleven
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CHAPTER ELEVEN
INTERNAL REVENUE SERVICE JOB AID Chapter Objectives 1. 2.
Identify the content of “Job Aid for IRS Valuation Professionals,” as published by the Internal Revenue Service. Recognize the factors that influence marketability listed in the Job Aid.
I. INTRODUCTION In the summer of 2011, an internal document titled “Discount for Lack of Marketability—Job Aid for IRS Valuation Professionals” became public. Dated September 25, 2009 and developed by the IRS’ Engineering/Valuation Program DLOM Team, it is obvious that the document was never intended for public release. The document has received a great deal of commentary within the profession since its discovery. At 107 pages, the paper is quite expansive, clearly illustrating that a great deal of IRS resources were committed to the development of this document and its content. A document of such length clearly had purpose in the opinion of the IRS and the first element to fully understanding the Job Aid is to understand its purpose. The conclusion to the Executive Summary states: This Job Aid is meant to provide a background and context for the Discount for Lack of Marketability as such is commonly applied in business valuation analyses and reports. It reviews past and existing practices and attempts to provide insight into the strengths and weaknesses of these practices. It is not meant to provide a cookbook approach to evaluating a marketability discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal…All background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator.
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The Job Aid is intended only as the name suggests, and the Conclusion ends as follows: By bringing the included material together in one document, we are striving to make the job of the IRS valuation analyst easier. We do not mean to provide guidance as to reasonable levels of marketability discounts that would prevail in all situational contexts or to imply the IRS has any policy per se in the evaluation or determination of such discounts. As the concluding narrative suggests, the Job Aid appears to do a very good job at compiling a wide breadth of available studies, resources, and other salient information developed within the business valuation profession and considered by practitioners in the assessment of the need for a DLOM and the determination of that discount. In this important way, the Job Aid will hopefully have served to not only educate IRS business valuation personnel in many of the nuances attendant to the DLOM, but also add a level of efficiency to the Service’s examination and assessment in these matters so as to better administer this process and reduce taxpayer commitments of time and costs to resolution of DLOM challenges. While it does not appear that the Job Aid significantly expands the body of knowledge relating to discounts for lack of marketability, the Job Aid is still a relatively important document in that it sheds some light on the thinking of the IRS in examining these discounts. For this reason, the document should be considered relevant and an understanding of its contents is necessary for practitioners.
II. JOB AID CONTENTS/STRUCTURE The Job Aid is segregated into seven major components or sections intended to facilitate what appears to be an “all inclusive” document to be used as a tool by the IRS Engineering/Valuation Group in their examination of discounts for lack of marketability. The seven sections, as set forth in the Job Aid are as follows:
Executive Summary Introduction General Marketability Discount Information Summary of Approaches to DLOM Evaluation and Recommendations Summary and Conclusions Bibliography
In addition, the final 23 pages feature two tables and three separate exhibits. The tables address the SEC Institutional Investors Restricted Stock Study and the MPI Restricted Stock Study, while the exhibits are attached and titled as follows:
Exhibit A: Review FMV Restricted Stock Model Exhibit B: Pre-IPO Studies
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A. IRS JOB AID—EXECUTIVE SUMMARY The objective of the effort behind the Job Aid is set forth in the Executive Summary; it was the team’s “hope [to] provide a quality, timely analysis [of DLOM] that will assist employees in the field working DLOM issues.” The employees referenced to in the preceding paragraph are IRS valuators. In the initial paragraph of the document, it is noted that the team’s focus: was to define the issues around DLOM and to develop pro forma IDR’s [Information Document Requests] and audit techniques to assist valuators in the field. Under the Approach paragraph of the Executive Summary, the Job Aid notes that, “It is recognized that the DLOM issue is primarily factual in nature.” The statement directly conflicts with the goal of developing pro forma IDR’s and standardized audit techniques. If the DLOM is factual in nature, as the Job Aid suggests, it is imperative that challenges to the DLOM be specific to the facts as well. Attempting to streamline the DLOM assessment with common procedural processes is to circumvent the real care and consideration that the issue deserves and demands. While sufficient language exists within the Job Aid to suggest that standardizing the DLOM review process is not the overriding goal of the document, it is easy to envision an approach by field receivers that leans on procedural assessments. This is a questionable outcome, of course, and valuators should be cautioned to ensure it does not occur in challenges to those DLOMs that they have determined are appropriate. B.
IRS JOB AID—INTRODUCTION The introduction to the Job Aid, Section B simply recognizes DLOM Team members, including Jeff Myers and Susan Kurzweil, two of the IRS’ most knowledgeable valuation specialists. The introduction expands upon the purpose of the document and provides a glimpse of items that follow in the report. The purpose of this Job Aid is to assist IRS valuation analysts in their examination of and their independent determination of DLOM and to help them to better understand the numerous available approaches. First, we will identify the current state of DLOM studies and methods-ranging from the SEC Restricted Stock study prepared in 1971 to the Liquistat database announced in 2007. We will endeavor to explain the intent of the approaches most widely relied upon by practicing valuators as to how each estimates DLOM. We will identify the parameters used in a given approach, the strengths and weaknesses of the approach, the view of the valuation community concerning the approach, and what the courts have had to say about the approach, if anything. The Job Aid also provides initial IDR questions for examination of DLOM and some sample report language for reviewers to consider in situations where it’s clear that the approach being used by the taxpayer is in error.
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C. IRS JOB AID—GENERAL MARKETABILITY DISCOUNT INFORMATION The third section features numerous definitional matters and background information on DLOMs. Marketability is defined as set forth in the “International Glossary of Business Valuation Terms” as, “the ability to quickly convert property into cash at minimal cost”, and, as set forth in Dr. Pratt’s treatises, “with a high degree of certainty of realizing the anticipated amount of proceeds. The Job Aid in this section sets forth four critical items to remember about DLOM: 1. 2. 3. 4.
DLOM is appropriate when the subject interest is non-marketable, yet the prior steps in the valuation process result in a marketable value. DLOM is not appropriate if the prior valuation process has already taken marketability concerns into consideration. DLOM is applied after the minority interest discount or control premium where such is appropriate to a valuation problem. DLOM should be determined on its own factors and not combined with other discounts.
The Job Aid distinguishes marketability from liquidity, defining liquidity in the International Glossary as “the ability to quickly convert property to cash or pay a liability.” This section notes that marketability indicates the fact of “Salability,” while liquidity indicates “how fast that sale can occur at the current price.” This definition is emphasized by a series of three clarifying examples within the Job Aid: 1. 2. 3.
If an asset is liquid, it is marketable If it’s non-marketable— it’s illiquid Being illiquid does not necessarily equate to being nonmarketable - the asset may still be sellable, but not quickly or without a loss of value
The Job Aid moves forward from definitions to an assessment and listing of subject company factors and subject equity interest factors that have been “identified in various studies as impacting marketability.” The discussion set forth in the Job Aid leans heavily on the Mandelbaum decision, as discussed in Chapter 10 of these materials, authored by U.S. Tax Court Judge David Laro. Considered by many as a landmark decision, Mandelbaum has caused much anguish among the business valuation profession by seeming to combine elements of risk commonly considered within the constraints of building a discount rate, as well as other parts of the valuation, with those required to be considered in developing the DLOM. No commentary exists in the Job Aid to address this concern and how best to avoid double-counting of investment risk in different parts of the business valuation process. Exhibit A lists the factors influencing marketability, including subject company factors and subject interest factors.
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D. MANDELBAUM An important aspect of the Mandelbaum decision was Judge Laro’s finding that little consideration was given to the hypothetical “willing seller” contemplated in the definition of fair market value under Revenue Ruling 59-60 in determining the DLOM. Not often encountered as an issue after Mandelbaum, the Job Aid nevertheless reiterates the point that willing sellers “must also be considered.” Care should be taken by the practitioner community, however, to ensure the service does not focus on the willing seller to the detriment of the willing buyer as a way to attack the DLOM. Interestingly, and seeming somewhat out of place, the DLOM team provides, under the subheading “Willing Seller Consideration,” an in-depth commentary on “the market for a subject interest,” stating that “the applicable market in which a hypothetical buyer may be found need not be one that includes the general public.” The Job Aid then lists seven different legal cases as examples supporting this premise. Though the topic of the “hypothetical buyer” could easily be expanded beyond the discussion in the Job Aid, it seems that the point being made by the DLOM team is that the “most likely” hypothetical buyer may present less investment or marketability risk than the more inclusive “entire universe” of hypothetical buyers that has often been used in the determination of DLOMs under a fair market value standard. E.
MINORITY VS. CONTROLLING While the Job Aid adds nothing new to the discussion of marketability for minority versus controlling interests, it does include a synopsis of where that issue stands, and concludes: Among valuators who apply DLOM to controlling interests, it is generally agreed the DLOM of a controlling interest is less than that for a minority interest. No further guidance is provided on DLOM determination methodologies for controlling versus minority interests, nor does the Job Aid elaborate on any measurable means of comparing a controlling-interest DLOM to a minority-interest DLOM. Interestingly, the Job Aid’s “General DLOM Information” section concludes with “Sample Initial IDR (Information Document Request) Items on Marketability.” The listing includes 17 specific items to be requested when a reviewer initiates his or her examination. While most of the requested items would be routine in the case of preparing a business valuation, it is somewhat disturbing to know, first, that IRS valuation professionals are not already aware of these very routine items; and second, that many, if not all, of these items will be included in the business valuation report, if it is prepared in compliance with governing professional standards; and third, that the preparation of such an extensive information document request might add to inefficiencies in the conduct of the examination. Certainly, the bulk of the information, if already addressed in the business valuation report, need not be requested again unless the examiner suspects improprieties or irregularities in the report or specific underlying source documents.
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We suggest that field examiners and reviewers may achieve a better result by first carefully reading the DLOM report sections, discussing methodologies with the valuator if further clarification is required, and then, if still needed, request those specific documents necessary to conduct the examination or review.
Exhibit A: Factors Influencing Marketability Subject Company Factors
Value of subject corporation’s privately traded securities vs. its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock)
Dividend-paying (or distribution) ability and history
Dividend yield
Attractiveness of subject business
Attractiveness of subject industry
Prospects for a sale or public offering of the company
Number of identifiable buyers
Attributes of controlling shareholder, if any
Availability of access to information or reliability of that information
Earnings levels
Revenue levels
Book-to-market-value ratios
Information requirements
Ownership concentration effects
Financial condition
Percent of shares held by insiders
Percent of shares held by institutions
Percent of independent directors
Listing on a major exchange
Active vs. passive investors
Registration costs
Availability of hedging opportunities
Market capitalization rank
Business risk
Management
Subject Interest Factors
Restrictive transfer provisions
Registered vs. unregistered
Length of the restriction period
General economic conditions
Length of expected holding period
Prevailing stock market conditions
Offering size as a percent of total shares outstanding
Volatility of stock
The document states that the evaluation of the appropriateness of a discount for lack of marketability requires the collection and analysis of a substantial amount of information about
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the entity involved and the subject interest in that entity whose marketability is being considered. To that end, the Job Aid then sets forth a detailed list of inquiring areas to address on the IDR. These are set forth in Exhibit B.
Exhibit B: Sample Initial IDR Items on Marketability
History of dividend payments [cash dividends are a “liquid” return on investment, which might lower lack of marketability risk]
Salaries and bonuses paid to the officers of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, officers’ compensation can provide cash flow to shareholders, which might lower lack of marketability risk]
Compensation and/or fees paid to the directors of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, directors’ fees can provide cash flow to shareholders, which might lower lack of marketability risk]
List of all marketable securities (description, number, cost value) shown on the latest financial statements [cash-equivalent securities might lower liquidity risk on a companywide basis]
List of all non-marketable securities and investments (description, number, cost value) shown on the latest financial statements [can provide information on how long it might take to liquidate non-market- able assets]
Breakdown of adjusted cost basis for each of the marketable and non-marketable assets owned by the company on the valuation date [can provide information on built-in capital gains tax expense to liquidate the company]
Indicate if the adjusted cost basis of any of the company’s marketable or non-marketable assets reflects a carry-over cost basis, pursuant to a Section 1031 (or similar type) taxdeferred exchange [can provide information on whether the company pursues available tax-deferral strategies]
Current list of shareholders/partners showing the name of each shareholder/partner and the class and number of shares owned by each shareholder as of the valuation date [can provide information on relative ownership distribution and total number of shareholders]
Copies of notes receivable (and/or notes payable) between the company and any shareholders, over the five years leading up to the valuation date [loans to/from shareholders might be relevant to evaluating lack of marketability risk]
Company articles of incorporation and amendments, by-laws and amendments or partnership agreements and amendments [by-laws might address restrictions or procedures for transfer of shares]
Copy of all shareholder agreements (such as buy/sell agreements, stock option agreements, stock purchase agreements, etc.) that have been in effect during the five years prior to the valuation date [shareholder agreements might address restrictions or procedures for transfer of shares]
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All documents pertaining to any sale of the company, a division or unit of the company, or shares (interests) in the company during the five years prior to the valuation date [recent sales/transfers might be relevant to evaluating lack of marketability risk]
Board of directors meeting minutes, for five years leading up to valuation date [Board meetings might address shareholder requests for sale/transfer of shares]
Complete financial statements of the company for the five fiscal or calendar years prior to the valuation date, including balance sheets, income statements and cash flow statements [can provide additional information for evaluating lack of marketability risk]
Complete income tax returns for the five fiscal or calendar years prior to the valuation date, including any audit adjustments [tax returns might include details that are not stated within the regular financial statements]
Brief history and/or description of the company or the company’s business (may already be included in an appraisal report) [can provide additional information for evaluating lack of marketability risk]
Brief statement of duties of subject shareholder’s participation in company operations [can provide additional information for evaluating lack of marketability risk]
IRS JOB AID—SUMMARY OF APPROACHES TO DLOM Section D, “Summary of Approaches to DLOM,” spanning 56 pages, is the most substantial portion of the Job Aid. The IRS team classifies the approaches into four categories: benchmark study approaches, security-based approaches, analytical approaches, and other approaches. The Job Aid provides a background/summary areas of focus by the IRS, and perhaps the most interesting topic, strengths and weaknesses of each approach (as viewed by the DLOM team), and finally what the courts have said regarding each approach under the aforementioned categories. Some of the more interesting aspects of this section are as follows. As business valuation has evolved, valuators are no longer applying the average or median discount but are making an effort to drill down into the empirical studies and/or employ other quantitative models. The Job Aid notes, “The analyst must get behind the data used to support a DLOM choice rather than simply using summary statistics and resulting conclusions developed by somebody else.” The Job Aid summarizes both the restricted stock studies and the pre-IPO studies benchmark approaches. The IRS acknowledges the decrease in the discounts associated with the more recent restricted stock studies, noting both the increase in volume of privately placed stock under Sec Rule 144(a), and the reductions in the minimum holding period under Rule 144. Referenced cases include Temple (No. 903-CV-165) and Peracchio (T.C. Memo. 2003-280), where courts rejected the use of average study results in favor of a more detailed analysis. Since the McCord decision (112 T.C. No. 13), pre-IPO studies have not been as prevalent as restricted stock studies, but the Job Aid notes that the decision in Bergquist could revive the use of the pre-IPO studies. The benchmark studies section also includes commentary on restricted stock equivalent analysis and the FMV Restricted Stock Database, which refers users of the Job Aid to IRS engineer Tom Kelley’s analysis of the 475 transactions in the database in 2009. The Job Aid advises a careful look at this analysis before accepting the approach. Kelley’s analysis concluded that the FMV Opinions model is flawed with respect to its explanation of the DLOMs relative to the restricted
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stock transactions in the database, and concludes, as a result, that valuators cannot rely with confidence on the model for deriving discounts for interests in privately held concerns. Commentary regarding the flotation cost approach provides that the IRS will focus on whether the valuator considered separation of “costs of reaching marketability” from other factors (or costs) that might be contributing to the discount. As with the other studies and models used for estimating DLOM, the IRS will inquire as to the existence (and consideration) of other factors that might be contributing to the discount. In the event that the valuator uses a median, average, or adjusted discount from the flotation data it should be sufficiently documented in the valuation report. The Mandelbaum factors are included in the Job Aid as a benchmark method. As should already be expected in applying these factors, the service wants to understand the basis on which the valuator determined the relative importance of each of the factors in deriving the DLOM. Securities-based approaches are based on option pricing models such as Longstaff and Chaffee, and from observing illiquidity demonstrated by stock prices such as the Bid-Ask Spread Method and option prices such as long-term equity anticipation securities (LEAPS). The IRS notes, and we concur, that these methods are not widely used in the valuation of closely held businesses and have not been vetted in any meaningful way by the courts. The analytical approach category includes studies that investigate those circumstances surrounding and the results of a private placement of unregistered or registered (or both) stock in bulk. The studies assume that registered shares have a marketability discount of zero. Therefore, to quantify the DLOM, the studies compare the total discount per share for the private placement of unregistered shares to that of registered shares. The Job Aid does point out that where significant blocks of stock in private placement are involved, in comparison to normal daily trading volumes, an element of blockage as well as marketability may be present. The studies, nearly all prepared by members of academia, include Karen Wruck, Hertzel & Smith, Mukesh, Bajaj, et al., and Ashok Abbott. The Job Aid points out that Bajaj, et al. is the only analytical approach that has been referred to in court cases, including Gross and McCord; that approach has met criticism by members of the valuation community, however. In the conclusion to the analytical approaches, the Job Aid states: As a result of the weaknesses cited related to sample selection, sample point classification, and measurement point concerns, it is unlikely that these approaches can be used to derive a numerical result that will go forth unchallenged. Instead, the raw data collected and the many component factors proposed can be used to make subjective judgments about discount magnitudes that would seem more satisfactory than using the gross averages generated by the benchmark studies… The other approaches to DLOM include Mercer’s Quantitative Marketability Discount Model (QMDM), Frazier’s Nonmarketable Investment Company Evaluation (NICE), Tabak’s CAPMbased approach to calculating illiquidity discounts and Partnership Profiles. Exhibit C (see IRS Job Aid article in the Appendix section of these materials) summarizes the approaches addressed by the Job Aid, their respective strengths and weaknesses and court opinions, if any.
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G. IRS JOB AID—EVALUATION AND RECOMMENDATIONS Section E of the Job Aid, “Evaluation and Recommendations,” appears, first and foremost, to be a directive, albeit informal, from the DLOM team to its valuation professionals. The Job Aid properly instructs the reviewer to consider, in detail, the taxpayer’s or the appraiser’s arguments for the approach or approaches chose and for the numerical result decided upon. At that point, with full understanding and knowledge, the reviewer can judge the merits of those arguments put forth in defense of the DLOM. Preparation and submission of a full valuation report prepared in accordance with professional standards is the best position for any taxpayer to be in, given an IRS challenge. Ultimately, the DLOM is a question of fact and the burden of proof falls to the taxpayer. It is noteworthy, however, that the Job Aid allows that a failure by the taxpayer to produce any real analysis, and without substantial backup, does not automatically make the result wrong or unsustainable. That is good news, leaving taxpayers with the opportunity to provide additional explanatory information to defend their discounts in the event of a challenge. In the alternative position, where the reviewer is faced with determining his or her own DLOM, the Job Aid suggest that the reviewer start with the basic question, “Under the prevailing facts and circumstances and considering the nature of the interest to be valued, why is the DLOM not zero?” The Job Aid suggests that by enumerating the factors that would lead to a conclusion that some DLOM at all is appropriate, the reviewer will be building a framework as to how substantial a DLOM might be reasonable. Further discussion is included in this section of the document addressing the “willing seller” issue. Also in the “Evaluations and Recommendations” section, the Job Aid addresses how the reviewer should “deal with marketability discounts in a report review under certain specific situations,” and offers “typical report language for getting started.” Five specific situations are addressed: 1. 2. 3. 4. 5.
Use of pre-IPO studies to support DLOM Use of simple average or median from restricted stock studies Use of analytical study results without getting behind the data Use of study results not supported by market data. Reliance solely on court decisions
While the language suggested by the DLOM team for reviewers facing these five situations presents no new arguments, and simply sets out earlier commentaries and court case findings, all valuators should avoid these five situations. Valuators adhering to professional standards have steered away from these situations for nearly a decade. We have not seen any of these situations in opposing expert reports or those reports we are asked to review in many years. It is not surprising to see questions about the pre-IPO studies, as the post-McCord era has seen a plethora of commentaries challenging the validity of those studies. Items b) and c) simply reflect the evolution of the profession over the last decade in trying to move to more scientific and specific measures of discounts. Item d), study results not supported by market data, focuses on models like Mercer’s QMDM. As the determination of the need for, and quantification of, a DLOM has always been fact-specific, reliance solely on court cases would seem to be a rare occurrence among high-quality valuation professionals. 10 – Chapter Eleven
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Practitioners should have some concern over “prepackaged” and “canned” responses to the IRS reviewer’s DLOM positions. Such an approach counters the need for the reviewer to make his or her own determinations and assessments, and could result in less than appropriate findings on their part. Through experience, we have found that the quality of IRS valuation professionals will ultimately lead to a fair and balanced resolution. Preconceived conclusions by the reviewer, however, seem to be challenging the idea of open and forthright discussions to get the issue resolved. That being the case, understanding the exact language in the suggested sample report language, so that care might be exercised in crafting the business valuation reports, is likely the best way to address this concern. The final paragraph of Section E, “Sources Available to IRS Valuation Analysts,” includes the FMV Restricted Stock Study database (www.fmv.com/index.php?C=Restricted _Stock_Study) and the Valuation Advisors Pre-IPO databases (www.bvmarketdata.com). The Job Aid concludes with a summary of its criticism (discussed earlier) of the FMV Restricted Stock Database by alleging critical flaws: 1. 2. 3.
FMV Opinions’ model is flawed insofar as explanation of the DLOMs on the restricted stock transactions in their database. Valuators cannot confidently rely on FMV’s model when determining DLOMs on restricted stocks, much less on interests in private equity. Neither FMV’s model nor multivariate regression analysis can be applied to FMV’s database to confidently determine the DLOM on private equity.
Such a challenge will be addressed over time (and already has, in some venues) by FMV Opinions, as well as other commentators. However, knowledge that the IRS has made its position known should prove useful on making future DLOM determinations. H. IRS JOB AID—SUMMARY AND CONCLUSIONS The Summary and Conclusions section of the Job Aid is extremely brief, consuming just a single page of the report. Most importantly, the document reiterates the importance of specific facts and circumstances in the determination of DLOM’s status. As is always the key, facts, and circumstances surrounding the subject interest are what deter- mine the level of DLOM, if any. DLOM studies, methods, and models can be complex, can indicate widely diverse conclusions, and may be appropriate in only certain limited situations. The business valuation profession does not identify acceptable or unacceptable methods for estimating marketability discounts, although some individual practitioners have their own preferences and frequently disagree as to the best approach. This Job Aid does not provide guidance on the best DLOM approaches, but is meant to help the reader understand and make an informed decision about DLOM. It is current as of the date of this writing.
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FACTS AND CIRCUMSTANCES The Job Aid includes an extensive bibliography, as well as a detailed analysis of DLOM team member Tom Kelley’s assessment of FMV Restricted Stock Study in Appendix A. There is no question that significant resources were committed to this project and that the service did a fairly comprehensive job of setting out current thinking, both within the profession and within the federal government as of the date of the report. While we are impressed, generally, with the substance of the Job Aid, it does little more than compile current thinking over a broad number of specific topics into a single document. The Job Aid does not, nor was it intended to, add to the quality or breadth of the body of knowledge available to taxpayers and their valuators in determining appropriate DLOMs. While Job Aid offers substantial criticisms of a number of approaches to the determination of DLOMs, it ultimately yields to this conclusion: As is always the key, facts, and circumstances surrounding the subject interest are what determine the level of DLOM, if any. As time moves forward (the Job Aid was first revealed to the public in July 2011), it is certain that this document will continue to be dissected and critiqued by members of the business valuation community. To that end, every new piece of quality information is important to the advancement of the profession, and the IRS DLOM team should be congratulated for their work and contribution.
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CHAPTER ELEVEN
INTERNAL REVENUE SERVICE JOB AID Chapter Objectives 1. 2.
Identify the content of “Job Aid for IRS Valuation Professionals,” as published by the Internal Revenue Service. Recognize the factors that influence marketability listed in the Job Aid.
I. INTRODUCTION In the summer of 2011, an internal document titled “Discount for Lack of Marketability—Job Aid for IRS Valuation Professionals” became public. Dated September 25, 2009 and developed by the IRS’ Engineering/Valuation Program DLOM Team, it is obvious that the document was never intended for public release. The document has received a great deal of commentary within the profession since its discovery. At 107 pages, the paper is quite expansive, clearly illustrating that a great deal of IRS resources were committed to the development of this document and its content. A document of such length clearly had purpose in the opinion of the IRS and the first element to fully understanding the Job Aid is to understand its purpose. The conclusion to the Executive Summary states: This Job Aid is meant to provide a background and context for the Discount for Lack of Marketability as such is commonly applied in business valuation analyses and reports. It reviews past and existing practices and attempts to provide insight into the strengths and weaknesses of these practices. It is not meant to provide a cookbook approach to evaluating a marketability discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal…All background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator.
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The Job Aid is intended only as the name suggests, and the Conclusion ends as follows: By bringing the included material together in one document, we are striving to make the job of the IRS valuation analyst easier. We do not mean to provide guidance as to reasonable levels of marketability discounts that would prevail in all situational contexts or to imply the IRS has any policy per se in the evaluation or determination of such discounts. As the concluding narrative suggests, the Job Aid appears to do a very good job at compiling a wide breadth of available studies, resources, and other salient information developed within the business valuation profession and considered by practitioners in the assessment of the need for a DLOM and the determination of that discount. In this important way, the Job Aid will hopefully have served to not only educate IRS business valuation personnel in many of the nuances attendant to the DLOM, but also add a level of efficiency to the Service’s examination and assessment in these matters so as to better administer this process and reduce taxpayer commitments of time and costs to resolution of DLOM challenges. While it does not appear that the Job Aid significantly expands the body of knowledge relating to discounts for lack of marketability, the Job Aid is still a relatively important document in that it sheds some light on the thinking of the IRS in examining these discounts. For this reason, the document should be considered relevant and an understanding of its contents is necessary for practitioners.
II. JOB AID CONTENTS/STRUCTURE The Job Aid is segregated into seven major components or sections intended to facilitate what appears to be an “all inclusive” document to be used as a tool by the IRS Engineering/Valuation Group in their examination of discounts for lack of marketability. The seven sections, as set forth in the Job Aid are as follows:
Executive Summary Introduction General Marketability Discount Information Summary of Approaches to DLOM Evaluation and Recommendations Summary and Conclusions Bibliography
In addition, the final 23 pages feature two tables and three separate exhibits. The tables address the SEC Institutional Investors Restricted Stock Study and the MPI Restricted Stock Study, while the exhibits are attached and titled as follows:
Exhibit A: Review FMV Restricted Stock Model Exhibit B: Pre-IPO Studies
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A. IRS JOB AID—EXECUTIVE SUMMARY The objective of the effort behind the Job Aid is set forth in the Executive Summary; it was the team’s “hope [to] provide a quality, timely analysis [of DLOM] that will assist employees in the field working DLOM issues.” The employees referenced to in the preceding paragraph are IRS valuators. In the initial paragraph of the document, it is noted that the team’s focus: was to define the issues around DLOM and to develop pro forma IDR’s [Information Document Requests] and audit techniques to assist valuators in the field. Under the Approach paragraph of the Executive Summary, the Job Aid notes that, “It is recognized that the DLOM issue is primarily factual in nature.” The statement directly conflicts with the goal of developing pro forma IDR’s and standardized audit techniques. If the DLOM is factual in nature, as the Job Aid suggests, it is imperative that challenges to the DLOM be specific to the facts as well. Attempting to streamline the DLOM assessment with common procedural processes is to circumvent the real care and consideration that the issue deserves and demands. While sufficient language exists within the Job Aid to suggest that standardizing the DLOM review process is not the overriding goal of the document, it is easy to envision an approach by field receivers that leans on procedural assessments. This is a questionable outcome, of course, and valuators should be cautioned to ensure it does not occur in challenges to those DLOMs that they have determined are appropriate. B.
IRS JOB AID—INTRODUCTION The introduction to the Job Aid, Section B simply recognizes DLOM Team members, including Jeff Myers and Susan Kurzweil, two of the IRS’ most knowledgeable valuation specialists. The introduction expands upon the purpose of the document and provides a glimpse of items that follow in the report. The purpose of this Job Aid is to assist IRS valuation analysts in their examination of and their independent determination of DLOM and to help them to better understand the numerous available approaches. First, we will identify the current state of DLOM studies and methods-ranging from the SEC Restricted Stock study prepared in 1971 to the Liquistat database announced in 2007. We will endeavor to explain the intent of the approaches most widely relied upon by practicing valuators as to how each estimates DLOM. We will identify the parameters used in a given approach, the strengths and weaknesses of the approach, the view of the valuation community concerning the approach, and what the courts have had to say about the approach, if anything. The Job Aid also provides initial IDR questions for examination of DLOM and some sample report language for reviewers to consider in situations where it’s clear that the approach being used by the taxpayer is in error.
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C. IRS JOB AID—GENERAL MARKETABILITY DISCOUNT INFORMATION The third section features numerous definitional matters and background information on DLOMs. Marketability is defined as set forth in the “International Glossary of Business Valuation Terms” as, “the ability to quickly convert property into cash at minimal cost”, and, as set forth in Dr. Pratt’s treatises, “with a high degree of certainty of realizing the anticipated amount of proceeds. The Job Aid in this section sets forth four critical items to remember about DLOM: 1. 2. 3. 4.
DLOM is appropriate when the subject interest is non-marketable, yet the prior steps in the valuation process result in a marketable value. DLOM is not appropriate if the prior valuation process has already taken marketability concerns into consideration. DLOM is applied after the minority interest discount or control premium where such is appropriate to a valuation problem. DLOM should be determined on its own factors and not combined with other discounts.
The Job Aid distinguishes marketability from liquidity, defining liquidity in the International Glossary as “the ability to quickly convert property to cash or pay a liability.” This section notes that marketability indicates the fact of “Salability,” while liquidity indicates “how fast that sale can occur at the current price.” This definition is emphasized by a series of three clarifying examples within the Job Aid: 1. 2. 3.
If an asset is liquid, it is marketable If it’s non-marketable— it’s illiquid Being illiquid does not necessarily equate to being nonmarketable - the asset may still be sellable, but not quickly or without a loss of value
The Job Aid moves forward from definitions to an assessment and listing of subject company factors and subject equity interest factors that have been “identified in various studies as impacting marketability.” The discussion set forth in the Job Aid leans heavily on the Mandelbaum decision, as discussed in Chapter 10 of these materials, authored by U.S. Tax Court Judge David Laro. Considered by many as a landmark decision, Mandelbaum has caused much anguish among the business valuation profession by seeming to combine elements of risk commonly considered within the constraints of building a discount rate, as well as other parts of the valuation, with those required to be considered in developing the DLOM. No commentary exists in the Job Aid to address this concern and how best to avoid double-counting of investment risk in different parts of the business valuation process. Exhibit A lists the factors influencing marketability, including subject company factors and subject interest factors.
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D. MANDELBAUM An important aspect of the Mandelbaum decision was Judge Laro’s finding that little consideration was given to the hypothetical “willing seller” contemplated in the definition of fair market value under Revenue Ruling 59-60 in determining the DLOM. Not often encountered as an issue after Mandelbaum, the Job Aid nevertheless reiterates the point that willing sellers “must also be considered.” Care should be taken by the practitioner community, however, to ensure the service does not focus on the willing seller to the detriment of the willing buyer as a way to attack the DLOM. Interestingly, and seeming somewhat out of place, the DLOM team provides, under the subheading “Willing Seller Consideration,” an in-depth commentary on “the market for a subject interest,” stating that “the applicable market in which a hypothetical buyer may be found need not be one that includes the general public.” The Job Aid then lists seven different legal cases as examples supporting this premise. Though the topic of the “hypothetical buyer” could easily be expanded beyond the discussion in the Job Aid, it seems that the point being made by the DLOM team is that the “most likely” hypothetical buyer may present less investment or marketability risk than the more inclusive “entire universe” of hypothetical buyers that has often been used in the determination of DLOMs under a fair market value standard. E.
MINORITY VS. CONTROLLING While the Job Aid adds nothing new to the discussion of marketability for minority versus controlling interests, it does include a synopsis of where that issue stands, and concludes: Among valuators who apply DLOM to controlling interests, it is generally agreed the DLOM of a controlling interest is less than that for a minority interest. No further guidance is provided on DLOM determination methodologies for controlling versus minority interests, nor does the Job Aid elaborate on any measurable means of comparing a controlling-interest DLOM to a minority-interest DLOM. Interestingly, the Job Aid’s “General DLOM Information” section concludes with “Sample Initial IDR (Information Document Request) Items on Marketability.” The listing includes 17 specific items to be requested when a reviewer initiates his or her examination. While most of the requested items would be routine in the case of preparing a business valuation, it is somewhat disturbing to know, first, that IRS valuation professionals are not already aware of these very routine items; and second, that many, if not all, of these items will be included in the business valuation report, if it is prepared in compliance with governing professional standards; and third, that the preparation of such an extensive information document request might add to inefficiencies in the conduct of the examination. Certainly, the bulk of the information, if already addressed in the business valuation report, need not be requested again unless the examiner suspects improprieties or irregularities in the report or specific underlying source documents.
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We suggest that field examiners and reviewers may achieve a better result by first carefully reading the DLOM report sections, discussing methodologies with the valuator if further clarification is required, and then, if still needed, request those specific documents necessary to conduct the examination or review.
Exhibit A: Factors Influencing Marketability Subject Company Factors
Value of subject corporation’s privately traded securities vs. its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock)
Dividend-paying (or distribution) ability and history
Dividend yield
Attractiveness of subject business
Attractiveness of subject industry
Prospects for a sale or public offering of the company
Number of identifiable buyers
Attributes of controlling shareholder, if any
Availability of access to information or reliability of that information
Earnings levels
Revenue levels
Book-to-market-value ratios
Information requirements
Ownership concentration effects
Financial condition
Percent of shares held by insiders
Percent of shares held by institutions
Percent of independent directors
Listing on a major exchange
Active vs. passive investors
Registration costs
Availability of hedging opportunities
Market capitalization rank
Business risk
Management
Subject Interest Factors
Restrictive transfer provisions
Registered vs. unregistered
Length of the restriction period
General economic conditions
Length of expected holding period
Prevailing stock market conditions
Offering size as a percent of total shares outstanding
Volatility of stock
The document states that the evaluation of the appropriateness of a discount for lack of marketability requires the collection and analysis of a substantial amount of information about
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the entity involved and the subject interest in that entity whose marketability is being considered. To that end, the Job Aid then sets forth a detailed list of inquiring areas to address on the IDR. These are set forth in Exhibit B.
Exhibit B: Sample Initial IDR Items on Marketability
History of dividend payments [cash dividends are a “liquid” return on investment, which might lower lack of marketability risk]
Salaries and bonuses paid to the officers of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, officers’ compensation can provide cash flow to shareholders, which might lower lack of marketability risk]
Compensation and/or fees paid to the directors of the company, over the five years leading up to the valuation date [especially in companies that don’t pay dividends, directors’ fees can provide cash flow to shareholders, which might lower lack of marketability risk]
List of all marketable securities (description, number, cost value) shown on the latest financial statements [cash-equivalent securities might lower liquidity risk on a companywide basis]
List of all non-marketable securities and investments (description, number, cost value) shown on the latest financial statements [can provide information on how long it might take to liquidate non-market- able assets]
Breakdown of adjusted cost basis for each of the marketable and non-marketable assets owned by the company on the valuation date [can provide information on built-in capital gains tax expense to liquidate the company]
Indicate if the adjusted cost basis of any of the company’s marketable or non-marketable assets reflects a carry-over cost basis, pursuant to a Section 1031 (or similar type) taxdeferred exchange [can provide information on whether the company pursues available tax-deferral strategies]
Current list of shareholders/partners showing the name of each shareholder/partner and the class and number of shares owned by each shareholder as of the valuation date [can provide information on relative ownership distribution and total number of shareholders]
Copies of notes receivable (and/or notes payable) between the company and any shareholders, over the five years leading up to the valuation date [loans to/from shareholders might be relevant to evaluating lack of marketability risk]
Company articles of incorporation and amendments, by-laws and amendments or partnership agreements and amendments [by-laws might address restrictions or procedures for transfer of shares]
Copy of all shareholder agreements (such as buy/sell agreements, stock option agreements, stock purchase agreements, etc.) that have been in effect during the five years prior to the valuation date [shareholder agreements might address restrictions or procedures for transfer of shares]
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All documents pertaining to any sale of the company, a division or unit of the company, or shares (interests) in the company during the five years prior to the valuation date [recent sales/transfers might be relevant to evaluating lack of marketability risk]
Board of directors meeting minutes, for five years leading up to valuation date [Board meetings might address shareholder requests for sale/transfer of shares]
Complete financial statements of the company for the five fiscal or calendar years prior to the valuation date, including balance sheets, income statements and cash flow statements [can provide additional information for evaluating lack of marketability risk]
Complete income tax returns for the five fiscal or calendar years prior to the valuation date, including any audit adjustments [tax returns might include details that are not stated within the regular financial statements]
Brief history and/or description of the company or the company’s business (may already be included in an appraisal report) [can provide additional information for evaluating lack of marketability risk]
Brief statement of duties of subject shareholder’s participation in company operations [can provide additional information for evaluating lack of marketability risk]
IRS JOB AID—SUMMARY OF APPROACHES TO DLOM Section D, “Summary of Approaches to DLOM,” spanning 56 pages, is the most substantial portion of the Job Aid. The IRS team classifies the approaches into four categories: benchmark study approaches, security-based approaches, analytical approaches, and other approaches. The Job Aid provides a background/summary areas of focus by the IRS, and perhaps the most interesting topic, strengths and weaknesses of each approach (as viewed by the DLOM team), and finally what the courts have said regarding each approach under the aforementioned categories. Some of the more interesting aspects of this section are as follows. As business valuation has evolved, valuators are no longer applying the average or median discount but are making an effort to drill down into the empirical studies and/or employ other quantitative models. The Job Aid notes, “The analyst must get behind the data used to support a DLOM choice rather than simply using summary statistics and resulting conclusions developed by somebody else.” The Job Aid summarizes both the restricted stock studies and the pre-IPO studies benchmark approaches. The IRS acknowledges the decrease in the discounts associated with the more recent restricted stock studies, noting both the increase in volume of privately placed stock under Sec Rule 144(a), and the reductions in the minimum holding period under Rule 144. Referenced cases include Temple (No. 903-CV-165) and Peracchio (T.C. Memo. 2003-280), where courts rejected the use of average study results in favor of a more detailed analysis. Since the McCord decision (112 T.C. No. 13), pre-IPO studies have not been as prevalent as restricted stock studies, but the Job Aid notes that the decision in Bergquist could revive the use of the pre-IPO studies. The benchmark studies section also includes commentary on restricted stock equivalent analysis and the FMV Restricted Stock Database, which refers users of the Job Aid to IRS engineer Tom Kelley’s analysis of the 475 transactions in the database in 2009. The Job Aid advises a careful look at this analysis before accepting the approach. Kelley’s analysis concluded that the FMV Opinions model is flawed with respect to its explanation of the DLOMs relative to the restricted
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stock transactions in the database, and concludes, as a result, that valuators cannot rely with confidence on the model for deriving discounts for interests in privately held concerns. Commentary regarding the flotation cost approach provides that the IRS will focus on whether the valuator considered separation of “costs of reaching marketability” from other factors (or costs) that might be contributing to the discount. As with the other studies and models used for estimating DLOM, the IRS will inquire as to the existence (and consideration) of other factors that might be contributing to the discount. In the event that the valuator uses a median, average, or adjusted discount from the flotation data it should be sufficiently documented in the valuation report. The Mandelbaum factors are included in the Job Aid as a benchmark method. As should already be expected in applying these factors, the service wants to understand the basis on which the valuator determined the relative importance of each of the factors in deriving the DLOM. Securities-based approaches are based on option pricing models such as Longstaff and Chaffee, and from observing illiquidity demonstrated by stock prices such as the Bid-Ask Spread Method and option prices such as long-term equity anticipation securities (LEAPS). The IRS notes, and we concur, that these methods are not widely used in the valuation of closely held businesses and have not been vetted in any meaningful way by the courts. The analytical approach category includes studies that investigate those circumstances surrounding and the results of a private placement of unregistered or registered (or both) stock in bulk. The studies assume that registered shares have a marketability discount of zero. Therefore, to quantify the DLOM, the studies compare the total discount per share for the private placement of unregistered shares to that of registered shares. The Job Aid does point out that where significant blocks of stock in private placement are involved, in comparison to normal daily trading volumes, an element of blockage as well as marketability may be present. The studies, nearly all prepared by members of academia, include Karen Wruck, Hertzel & Smith, Mukesh, Bajaj, et al., and Ashok Abbott. The Job Aid points out that Bajaj, et al. is the only analytical approach that has been referred to in court cases, including Gross and McCord; that approach has met criticism by members of the valuation community, however. In the conclusion to the analytical approaches, the Job Aid states: As a result of the weaknesses cited related to sample selection, sample point classification, and measurement point concerns, it is unlikely that these approaches can be used to derive a numerical result that will go forth unchallenged. Instead, the raw data collected and the many component factors proposed can be used to make subjective judgments about discount magnitudes that would seem more satisfactory than using the gross averages generated by the benchmark studies… The other approaches to DLOM include Mercer’s Quantitative Marketability Discount Model (QMDM), Frazier’s Nonmarketable Investment Company Evaluation (NICE), Tabak’s CAPMbased approach to calculating illiquidity discounts and Partnership Profiles. Exhibit C (see IRS Job Aid article in the Appendix section of these materials) summarizes the approaches addressed by the Job Aid, their respective strengths and weaknesses and court opinions, if any.
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G. IRS JOB AID—EVALUATION AND RECOMMENDATIONS Section E of the Job Aid, “Evaluation and Recommendations,” appears, first and foremost, to be a directive, albeit informal, from the DLOM team to its valuation professionals. The Job Aid properly instructs the reviewer to consider, in detail, the taxpayer’s or the appraiser’s arguments for the approach or approaches chose and for the numerical result decided upon. At that point, with full understanding and knowledge, the reviewer can judge the merits of those arguments put forth in defense of the DLOM. Preparation and submission of a full valuation report prepared in accordance with professional standards is the best position for any taxpayer to be in, given an IRS challenge. Ultimately, the DLOM is a question of fact and the burden of proof falls to the taxpayer. It is noteworthy, however, that the Job Aid allows that a failure by the taxpayer to produce any real analysis, and without substantial backup, does not automatically make the result wrong or unsustainable. That is good news, leaving taxpayers with the opportunity to provide additional explanatory information to defend their discounts in the event of a challenge. In the alternative position, where the reviewer is faced with determining his or her own DLOM, the Job Aid suggest that the reviewer start with the basic question, “Under the prevailing facts and circumstances and considering the nature of the interest to be valued, why is the DLOM not zero?” The Job Aid suggests that by enumerating the factors that would lead to a conclusion that some DLOM at all is appropriate, the reviewer will be building a framework as to how substantial a DLOM might be reasonable. Further discussion is included in this section of the document addressing the “willing seller” issue. Also in the “Evaluations and Recommendations” section, the Job Aid addresses how the reviewer should “deal with marketability discounts in a report review under certain specific situations,” and offers “typical report language for getting started.” Five specific situations are addressed: 1. 2. 3. 4. 5.
Use of pre-IPO studies to support DLOM Use of simple average or median from restricted stock studies Use of analytical study results without getting behind the data Use of study results not supported by market data. Reliance solely on court decisions
While the language suggested by the DLOM team for reviewers facing these five situations presents no new arguments, and simply sets out earlier commentaries and court case findings, all valuators should avoid these five situations. Valuators adhering to professional standards have steered away from these situations for nearly a decade. We have not seen any of these situations in opposing expert reports or those reports we are asked to review in many years. It is not surprising to see questions about the pre-IPO studies, as the post-McCord era has seen a plethora of commentaries challenging the validity of those studies. Items b) and c) simply reflect the evolution of the profession over the last decade in trying to move to more scientific and specific measures of discounts. Item d), study results not supported by market data, focuses on models like Mercer’s QMDM. As the determination of the need for, and quantification of, a DLOM has always been fact-specific, reliance solely on court cases would seem to be a rare occurrence among high-quality valuation professionals. 10 – Chapter Eleven
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Practitioners should have some concern over “prepackaged” and “canned” responses to the IRS reviewer’s DLOM positions. Such an approach counters the need for the reviewer to make his or her own determinations and assessments, and could result in less than appropriate findings on their part. Through experience, we have found that the quality of IRS valuation professionals will ultimately lead to a fair and balanced resolution. Preconceived conclusions by the reviewer, however, seem to be challenging the idea of open and forthright discussions to get the issue resolved. That being the case, understanding the exact language in the suggested sample report language, so that care might be exercised in crafting the business valuation reports, is likely the best way to address this concern. The final paragraph of Section E, “Sources Available to IRS Valuation Analysts,” includes the FMV Restricted Stock Study database (www.fmv.com/index.php?C=Restricted _Stock_Study) and the Valuation Advisors Pre-IPO databases (www.bvmarketdata.com). The Job Aid concludes with a summary of its criticism (discussed earlier) of the FMV Restricted Stock Database by alleging critical flaws: 1. 2. 3.
FMV Opinions’ model is flawed insofar as explanation of the DLOMs on the restricted stock transactions in their database. Valuators cannot confidently rely on FMV’s model when determining DLOMs on restricted stocks, much less on interests in private equity. Neither FMV’s model nor multivariate regression analysis can be applied to FMV’s database to confidently determine the DLOM on private equity.
Such a challenge will be addressed over time (and already has, in some venues) by FMV Opinions, as well as other commentators. However, knowledge that the IRS has made its position known should prove useful on making future DLOM determinations. H. IRS JOB AID—SUMMARY AND CONCLUSIONS The Summary and Conclusions section of the Job Aid is extremely brief, consuming just a single page of the report. Most importantly, the document reiterates the importance of specific facts and circumstances in the determination of DLOM’s status. As is always the key, facts, and circumstances surrounding the subject interest are what deter- mine the level of DLOM, if any. DLOM studies, methods, and models can be complex, can indicate widely diverse conclusions, and may be appropriate in only certain limited situations. The business valuation profession does not identify acceptable or unacceptable methods for estimating marketability discounts, although some individual practitioners have their own preferences and frequently disagree as to the best approach. This Job Aid does not provide guidance on the best DLOM approaches, but is meant to help the reader understand and make an informed decision about DLOM. It is current as of the date of this writing.
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FACTS AND CIRCUMSTANCES The Job Aid includes an extensive bibliography, as well as a detailed analysis of DLOM team member Tom Kelley’s assessment of FMV Restricted Stock Study in Appendix A. There is no question that significant resources were committed to this project and that the service did a fairly comprehensive job of setting out current thinking, both within the profession and within the federal government as of the date of the report. While we are impressed, generally, with the substance of the Job Aid, it does little more than compile current thinking over a broad number of specific topics into a single document. The Job Aid does not, nor was it intended to, add to the quality or breadth of the body of knowledge available to taxpayers and their valuators in determining appropriate DLOMs. While Job Aid offers substantial criticisms of a number of approaches to the determination of DLOMs, it ultimately yields to this conclusion: As is always the key, facts, and circumstances surrounding the subject interest are what determine the level of DLOM, if any. As time moves forward (the Job Aid was first revealed to the public in July 2011), it is certain that this document will continue to be dissected and critiqued by members of the business valuation community. To that end, every new piece of quality information is important to the advancement of the profession, and the IRS DLOM team should be congratulated for their work and contribution.
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