Advanced D P Chapter Five
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CHAPTER FIVE
CURRENT JUDICIAL DEVELOPMENTS AFFECTING CONTROL PREMIUMS AND MINORITY DISCOUNTS Chapter Objective Identify recent court decisions and how these cases influence consideration of discounts and premiums related to control. Caution: The cases presented in this chapter are by no means all-inclusive of recent court cases involving minority and/or lack of control issues. The following is only intended to be a representative sample of the current decisions regarding the subject.
I. INTRODUCTION Discounts for lack of control play an important role in many business valuations. Not surprisingly, in the estate planning arena, these discounts can form the very foundation for a taxpayer’s estate plan if he or she is holding ownership interests in privately held businesses. With Revenue Ruling 93-12 firmly in place, family attribution is no longer a source of Internal Revenue Service scrutiny in planning the transfer of non-control interests in family-owned businesses. Although “swing vote characteristics” still envelop overall discount consideration, most valuators and estate planners agree that minority ownership interest should be valued significantly lower than ownership interest conveying control. Nowhere is more information available for public observation than from the Internal Revenue Service and subsequent judicial follow-up. As the party with the most to lose (via lower gift and estate tax collections), the IRS, through its judicial challenges, continues to be a prime source of valuation theory and interpretation. One of the most significant cases to come out of the Tax Court to date is the Estate of Richard R. Simplot v. Commissioner. The original case and Ninth Circuit’s reversal in favor of the taxpayer was discussed previously in Chapter 2. The remainder of this chapter will present historical cases of interest which provide a better indication of the current Tax Court and IRS thinking with respect to the application of discounts for lack of control.
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The cases presented in this chapter are by no means all inclusive of recent court cases involving minority and/or lack of control issues. The following is only intended to be a sample, representative of the current decisions regarding the subject.
II. CASES INFLUENCING CONSIDERATION OF DISCOUNTS AND PREMIUMS RELATED TO CONTROL A. ESTATE OF JOSEPH CIDULKA—T.C. MEMO 1996-149 1.
This decision was important for two reasons: a) b)
2. 3. 4.
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Cidulka was founder and controlling shareholder (55.04%) of SOAI, a billboard company; his son owned the balance of the outstanding shares Over the years Cidulka gifted shares to his son and family, at question was 4.91% gifted in 1982 SOAI redeemed his remaining shares (47.17%) in exchange for a self-canceling installment note (SCIN) with a face value of $370,000 (equal to book value); IRS held that the value of the SCIN was $307,381 At issue was the gift amount (i.e. should the 4.91% and the 47.17% be valued separately or together—two minority blocks versus a single control block) Court found that the transactions were planned together and obviously executed together Gift value was the difference between fair market value prior to the January 1982 transactions and the fair market value of the note received as consideration—in effect, the minority discount was lost Author’s Interpretation and Analysis: a)
b) c)
B.
Application of minority discount is not automatic and requires careful consideration Provides clarification that even in light of the hypothetical willing buyer, willing seller envisioned in the term “fair market value,” the courts and the IRS will not inevitably close their eyes to multiple steps in an obviously integrated plan
Technical Advice Memorandum 9504004—addressed a transfer styled as a sale rather than a gift, but the IRS insisted that the gift tax analysis consider the pre-planned redemption of the transferor’s remaining shares, which occurred shortly after the sale Step Transaction Doctrine—set forth in corporation taxation in Zena v. Quinlinan, 213 F.2d 914, 45 AFTR 1672, 54-2 USTC 9445 (CA-6, 1954) Estate of Elizabeth B. Murphy v. Commissioner, T.C. Memo 1990-472—deceased gifted small amounts of stock 18 days before death to reduce holdings to just below 50%; estate tried to treat gift and testamentary transfer as separate minority interests; the IRS objected and court held
BONNER V. UNITED STATES—KTC 1996-278 (5TH CIR. 1996) 1.
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Decedent owned, at time of death: fee simple 62.5% undivided interest in real property (ranch) in Texas; fee simple 50% undivided interest in real property (land) in New Mexico; and fee simple 50% undivided interest in a pleasure boat Balance of all assets were owned by a testamentary trust set up by the decedent’s spouse at her death; the trust satisfied the test for ”qualified terminable interest property” (QTIP) and qualified for marital exclusion at wife’s death Interests held directly by husband and interests held by QTIP trust will be included in estate © 2003–2014 Robert J. Grossman and National Association of Certified Valuators and Analysts 2014.v1
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100% of values were stipulated at decedent’s death, however, at issue was whether the estate could take fractional interest discounts on underlying properties Court allowed fractional interest discounts because decedent’s own interests were subject to his powers of testamentary transfer, but those in the QTIP trust were not Conclusion seems a illogical and counter to long-standing IRS views, and decision is inconsistent with at least one Tax Court ruling—Estate of Babbitt, 87 T.C. 1270, 1277 (1986) Author’s Interpretation and Analysis: Could provide an aggressive planning opportunity as Bonner could be deemed to apply any time there is no power to actually dispose of the property at death, for example: a) b) c) d)
“A” is a 75% shareholder in X corporation A places 40% in irrevocable trust, retaining lifetime income interest, and names full vested beneficiary Both blocks can be included in A’s estate under different provisions of the Internal Revenue Code Because A had no power to direct disposition of trust holdings, there may be plausible argument to discount both blocks for lack of control
C. ESTATE OF BARUDIN V. COMMISSIONER—T.C. MEMO 1996-395, 1996 TAX CT. MEMO LEXIS 403 (AUGUST 1996) 1. 2.
Case involved the valuation of 1/95 interest in a general partnership owning real property Both parties agreed on the underlying asset value, but applied different discounts a) b)
3.
Taxpayer’s expert applied a combined discount for lack of control and lack of marketability of 67.5% IRS expert applied a 15% minority discount, based on market studies, and 15% marketability discount
Court ruled that 19% was an appropriate minority discount, based on the average found in the market studies used by the IRS expert
D. ESTATE OF MELLINGER V. COMMISSIONER—112 T.C. 26 (JANUARY 26, 1999) 1.
2.
3. 4.
Decedent owned, at time of death: 50 shares of Frederick’s of Hollywood common stock as well as shares of Frederick’s of Hollywood stock via a revocable trust that she had established; the revocable marital trust met all requirements to be “Qualified Terminable Interest Property” (QTIP); other shares were held for her income benefit via an irrevocable marital trust set up by decedent’s spouse at his death Interests held by the decedent and in the irrevocable trust, as well as interests held by the QTIP trust, will all be included in estate; at issue was whether the estate could take fractional interest discounts on underlying properties Court allowed fractional interest discounts because decedent’s own interests were subject to her powers of testamentary transfer, but those in the QTIP trust were not Author’s Interpretation and Analysis: a) b)
IRS announced its acquiescence in the Mellinger decision (AOD CC-1999-006) The closely held stock held in a QTIP trust does not have to be aggregated, for valuation purposes, with stock in the same corporation held in a revocable trust and includible in decedent’s gross estate
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ESTATE OF SMITH V. COMMISSIONER—T.C. MEMO 1999-368 (NOVEMBER 5, 1999) 1. 2. 3.
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Case involved the valuation of a large-asset, low-return company, a farm corporation IRS was focused on the underlying asset value, not discounts For the S corporation, taxpayer’s expert determined a minority interest discount of 50%, using market price to net asset value ratios for non-distributing REITs to quantify the amount For the bank stock, taxpayer’s expert used control premium data to apply a 32% minority discount Court accepted both percentages as determined by the taxpayer’s expert
ESTATE OF WEINBERG V. COMMISSIONER—T.C. MEMO 2000-51 (FEBRUARY 2000) 1. 2. 3.
4.
5.
Decedent owned, at time of death: a limited partnership interest (25.235%) in a limited partnership that owned and operated an 11-story apartment building in Philadelphia All parties agreed that fair market value of the apartment building was $10,050,000, but disagreed on the applicability and amount of minority and marketability discounts Estate’s expert argued for a 43% minority discount—determined directly through comparison of public interest’s pricing in relation to their pro rata shares of net asset value, and indirectly through the capitalization of the subject partnership interest’s distributions at a market rate and later comparison of the resulting value to the interest’s pro rata share of net asset value; also applied a 35% discount for lack of marketability IRS expert determined a minority discount of 20% and argued that the discount should only be determined indirectly through the capitalization of the subject partnership interest’s distributions; also applied a 15% discount for lack of marketability The Court ultimately applied a discount of 37% for minority status and a 20% discount for lack of marketability—the overall combined discount totaled 50% from net asset value
G. GOW V. COMMISSIONER—T.C. MEMO 2000-93, 79 T.C.M. 1.
2.
3. 4. 5.
Dealt with the fair market value of two minority blocks of stock of Williamsburg Vacations, Inc. (WVI), which were issued as bonus compensation to a shareholder/officer/director of a C corporation investment holding company At issue was whether the discounted cash flow method resulted in a control or minority value, and are two-tier discounts acceptable at both the operating company joint venture and the investment holding company levels IRS argued that two-tier discounts at both levels are duplicative and should not be taken into account The court agreed with all discounts ascribed at both tiers by the taxpayer as far as minority and lack of marketability discount issues were concerned The only discount (out of nine) that was not accepted verbatim by the court from the taxpayer was a contingency allowance discount of 15% at the WVI holding company level
H. FERRARO V. FERRARO—2000 VA. APP. LEXIS 164 (MARCH 2000) 1.
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Marital dissolution case in which the trial court had previously valued husband’s 34% interest in various sporting goods stores at $1,300,000
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Husband contended that the trial court erred when it disallowed the application of both a minority and marketability discount; upon appeal, argued that the court had abused its discretion with this decision Appellate court affirmed trial court’s decision: a)
b)
I.
Found that no one owned a majority interest in any of the sporting good stores; therefore, the husband’s minority ownership did not diminish the value of his interest in the businesses Felt the evidence indicated that the husband would not be required to sell his shares in the business in order to pay the wife’s distribution award; thus a discount for lack of marketability was not justified
MAGGOS V. COMMISSIONER—T.C. MEMO 2000-129 (APRIL 2000) 1. 2. 3. 4.
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Decedent owned shares of stock in a family-owned company; 567 shares were redeemed by the company from the decedent on May 1, 1987, for a $3,000,000 promissory note As a result of the redemption transaction, decedent’s son became sole owner of the company Primary issue was whether the transaction constituted a charitable gift for purposes of IRC §2512 Court found value of the shares to be worth $4,900,000 on an aggregated minority basis, and applied a 25% control premium, as well as a 25% discount for lack of marketability
ESTATE OF JONES V. COMMISSIONER—116 T.C. NO. 11 (MARCH 6, 2001) 1. 2. 3. 4.
Estate had interests in two limited partnerships holding real property (ranches, livestock, personal property) Estate’s expert used a 45% discount for lack of control based on the latest Partnership Spectrum compilation and a 20% discount for lack of marketability IRS expert used a 38% discount for lack of control based on the following year’s compilations Court applied a 40% minority interest discount, but denied taxpayer’s 20% marketability discount
K. ESTATE OF TRUE V. COMMISSIONER—T.C. MEMO 2001-167 (JULY 6, 2001) 1.
2. 3.
4.
5.
Tax deficiency and associated penalties asserted by the IRS regarding the value of ownership interests in various corporations and partnerships willed and gifted by the decedent to a trust benefiting his heirs Significant debate occurred in regard to whether or not buy-sell agreements (that were based on tax book value) should set the value for the estate and gifts First estate expert’s revised report applied no marketability discount to controlling interests; a second expert applied discounts of 40% and 45% based on restricted stock and pre-IPO studies and considered the existence of the buy-sell agreements in determining both entity values and the marketability discount IRS expert applied no marketability discount to the controlling interests, arguing that the minority interests represented swing votes, and therefore, would not be subject to a minority interest discount Court rejected the estate expert’s use of premium studies, as well as the IRS argument regarding swing votes; instead, the tax court determined a 15% minority interest discount
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Court stated that the buy-sell agreements were testamentary devices and did not consider them in the determination of the marketability adjustment; disagreeing with all appraisals, the court applied a 20% marketability discount for the controlling interest, and a 30% marketability discount for the minority interest
ESTATE OF HECK V. COMMISSIONER—T.C. MEMO 2002-34, U.S. TAX CT. (FEB. 5, 2002) 1. 2.
3. 4.
5.
The estate included a 39.62% interest in a privately held company in which family members held all shares outright or in a trust The company entered into a distribution agreement that gave the other party the exclusive right to distribute the company’s product, as well as the right of first refusal with respect to any stock offered for sale by a family member Estate’s expert applied a discount of 10% for the right of first refusal and a 25% marketability discount IRS expert argued that the discount for right of first refusal was included in the marketability discount; the expert applied marketability discounts of 15% to stock and 25% to land; 10% discount due to S Corporation status; and 25% minority discounts to land and excess cash The court utilized the estate expert’s recommendations, applying a 25% marketability discount and a 10% discount for right of first refusal; no discounts applied for S Corporation status or lack of control
M. MITCHELL V. COMMISSIONER—T.C. MEMO 2002-98 (APRIL 9, 2002) 1. 2. 3.
4. 5.
6.
Decedent owned a 49.04% interest in John Paul Mitchell Systems In the original case (T.C. Memo 1997-461, October 9, 1997) the taxpayer claimed a $720,000 deduction for his interest based partly on a valuation by a consulting firm On appeal, the estate claimed the Tax Court erred by: failing to provide a detailed explanation of the methodology used to recalculate the fair market value of the stock; miscalculating the value of the stock in a manner inconsistent with its own holding; and failing to shift the burden of proof to the commissioner Both estate experts applied 45% discounts for combined lack of marketability and minority interest Tax Court, on remand from the Ninth Circuit Court of Appeals, applied a 35% combined minority and marketability discount (29% to reflect that the interest had some power, but less than control, and an additional 6%, based on the lack of marketability specifically related to decedent’s minority interest) Tax Court also applied a 10% key person discount
N. ESTATE OF GODLEY V. COMMISSIONER—286 F.3D 210 (APRIL 15, 2002) 1.
2. 3.
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Decedent owned a 50% general partnership interest in four partnerships, as well as a 50% interest in a general partnership that managed the other four partnerships; the decedent’s son owned the remaining interests in the five partnerships and was managing partner The estate argued that an option in the partnership agreement was a bona fide business arrangement and should control the determination of fair market value On appeal, the estate questioned whether the decedent’s 50% interest and any associated lack of control is a question of law
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Tax Court decided that the option was a testamentary device; thus, it was not a valid business arrangement that would determine fair market value Court stated, “there was little to be gained by having control of these partnerships and little risk in holding a minority interest,” due to the fact that the partnership had a steady future cash flow from long term contracts with little risk of losing them; partnership agreements spelled out specific requirements for annual distributions; and, neither party alone could, or would likely want to, have the assets liquidated The Fourth Circuit affirmed that, due to the unique circumstances, the Tax Court did not err in NOT applying a minority discount
O. ESTATE OF BAILEY V. COMMISSIONER—T.C. MEMO 2002-152 1. 2. 3. 4. 5.
Decedent owned a 25% interest in a corporation which owned and operated two hotels, and was also the beneficiary of a QTIP Trust which owned 25% of the same corporation The IRS and the estate agreed that the interests should not be aggregated for valuation purposes Estate discounted “liquidation value” by 50% for key person, minority ownership and lack of marketability IRS expert originally used a 25% discount for lack of marketability, but later reversed it to 50%, using the net asset value approach At trial, both experts argued for different discounts than in their original reports: a) b)
6.
P.
IRS expert used a 20% discount for lack of control; 21.44% for built-in gains; 6% for “stock sale costs” Estate’s expert used a 20% discount for lack of control; 40% for lack of marketability
Tax Court applied a 20% discount for lack of control and a 37.5% discount for lack of marketability to the net asset value
IN RE THE MARRIAGE OF FRANZEN—2003 WISC. APP. LEXIS 72 (JANUARY 29, 2003) 1. 2. 3. 4. 5. 6.
Under valuation was a 50% interest in a Piggly Wiggly store under franchise Wife’s expert determined a value of $548,707, with a 20% discount for lack of marketability and no discount for lack of control Husband’s first expert determined that the 50% interest had a negative value Husband’s second expert testified on other two experts’ values, and sided with husband’s first expert Trial Court valued the interest at $324,860, using wife’s expert’s EBITDA approach and applying a 20% discount for lack of control Appeals court affirmed the trial court’s valuation
Q. COLE V. COLE—2003 ARK. APP. LEXIS 348 (APRIL 30, 2003)* 1.
2.
Marital-property case involves the valuation and division of a substantial amount of property owned by the husband; the wife disputed the value determined by a buy-sell agreement ($750,000) In original case, the wife’s expert applied 10% discount for lack of marketability and 10% discount for lack of control, resulting in a value of $1,274,200; the husband’s first expert
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applied a 50% marketability discount and a 31.5% discount for lack of control, resulting in a value of $497,303; his second expert valued the partnership at $297,500 Trial Court valued the interest at $375,000 (50% of the $750,000), based on the buy-sell agreement Appellate court reversed and remanded trial court’s decision, noting that the buy-sell agreement is not binding on the non-shareholder spouse if that spouse did not sign the agreement Upon second appeal, the decision was affirmed in part and reversed and remanded in part; however, no adjustments were made to the original discounts and premiums applied in the case (2005 Ark. App. LEXIS 8, January 2005)
* Note: Chapter 11 also includes a discussion of this case. R. HESS V. COMMISSIONER—T.C. MEMO 2003-251 (AUGUST 20, 2003) 1. 2. 3. 4.
S.
ESTATE OF HILLGREN V. COMMISSIONER—T.C. MEMO 2004-56 (MARCH 3, 2004) 1. 2. 3. 4.
T.
Sole issue was the fair market value of the stock in a company that manufactured metal processing machines and automation systems for the auto industry Taxpayer’s expert applied a 15% discount for lack of control, using the DCF method and the guideline public company method IRS expert also applied a 15% discount for lack of control, using four methods—NAV, prior stock transaction, stockholder agreement and guideline public company methods Court accepted the 15% discount for lack of control, but criticized Taxpayer’s expert for applying the discount under the guideline public company method as it results in a minority value
Primary issues were whether the court should disregard an FLP under IRC Section 2036(a) and what was the fair market value of the assets of the partnership Estate’s expert suggested a 50% combined discount for lack of marketability and lack of control, as well as a 5% discount for lack of voting rights IRS experts applied a 35% discount for lack of marketability and a 10% discount for lack of control, using closed-end equity funds and real estate investment trusts Tax Court accepted the estate expert’s values as reasonable
ESTATE OF JELKE V. COMMISSIONER—T.C. MEMO. 2005-131 DOCKET NO. 351203 (MAY 31, 2005)* 1.
2. 3. 4.
8 – Chapter Five
Decedent was beneficiary of a revocable trust that owned 6.44% of common stock in a C corporation closely held by the Jelke family (company’s underlying assets were primarily marketable securities with a market value of approximately $189 million; assets had a built-in gain of approximately $52 million) In addition to contesting the applicability of discounts for built-in gains tax liability, the parties disagreed on the discounts for lack of control and marketability Both experts utilized closed-end fund data to determine discount for lack of control; comparables differed Both experts agreed that there is an inverse relationship between a company’s financial performance and the lack of control discount, but, they disagreed on the strength of the company’s financial performance
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Court determined that a 10% lack of control discount is appropriate—because the company was well diversified and had a long-term record of strong returns in the form of dividends and capital appreciation, investors were less likely to desire control due to the passive nature of their investment in the company Court was not satisfied that the discount applicable to closed-end funds was solely attributable to lack of control, and believed that a portion is due to lack of marketability Court also determined a 15% marketability discount and applied a 13.2% discount for built-in gain tax
* Note: Chapter 12 includes a discussion of the built-in gains aspect of this case; Chapter 13 includes the issues related to marketability. U. ESTATE OF KELLEY V. COMMISSIONER—T.C. MEMO 2005-235, DOCKET NO. 16894-03 (US TAX COURT, OCT 2005)* 1.
2.
Decedent formed a limited liability company (LLC) and a family limited partnership (FLP), and owned 33.33% and 94.83% of the LLC and FLP, respectively, at his date of death Value of the assets (consisting only of cash and CDs) was questioned for estate tax purposes a)
b)
3.
4.
Court found that in this case, where the interest being valued is an interest in a FLP whose assets consist solely of cash and CDs, the income approach should not be afforded more than minor weight (at trial, the estate expert admitted that his income approach calculation was incorrect because it did not compound the earnings each year) Court applied a 12% discount for lack of control as originally determined by the IRS expert, based on the total population of closed-end funds a) b)
5.
The estate expert weighted the net asset value approach at 80% and income approach at 20%, and applied a 53.5% combined discount, which included a control discount based on comparables from the fourth quartile of publicly traded closed-end funds (argued that this data was more comparable to closely held business interests) The IRS expert relied solely on net asset value, and argued for a combined discount of 25.2%; his discount for lack of control was calculated using an arithmetic mean of all closed-end funds (using the entire population data set was an attempt to remove the marketability element of discounts/premiums embedded in the price of closed-end funds)
Court noted that shareholders in all closed-end funds lack control Also noted that funds in the fourth quartile had the lowest demand and, therefore, the highest marketability discount
Court thought that the experts’ approaches to determining the lack of marketability were flawed, and applied a 23% marketability discount based on theories used in the McCord and Lappo Tax Court cases
* Note: Chapter 13 includes a discussion of the issues related to marketability in this case.
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V. ROBERTSON V. UNITED STATES OF AMERICA—3:03-CV-02113 (JANUARY 13, 2006)* 1. 2. 3. 4. 5.
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In December 1996, five trusts contributed assets to a family limited partnership; the majority of the limited partner interests were held by four non-exempt trusts In December 2000, substantially all of the trust’s assets were distributed to the remainder beneficiaries The United States pursued the collection of generation-skipping transfer taxes on the assets The parties agreed regarding the value of the corporate stock distributed, but disagreed on the value of the partnership units distributed to the beneficiaries The IRS contended that the assets should be valued with the market approach, which would result in the partnership’s assets, net of liabilities, without any discounts; the IRS also contended that certain transactions of the partnership interests with its partners occurred at full net asset value without any discounts A secondary IRS position was that partnership interests should be valued in one of two alternative ways: a) b)
7.
Discounted by 14.9% based on the right of first refusal approach A combined discount of 17.925% (6.2% for lack of control and 12.5% for lack of marketability) applied to net asset value
Taxpayers hired two experts who prepared appraisal reports a)
b)
Taxpayers first contended that value of the partnership interests should be discounted by a combined effective discount of 41.5% for lack of control and marketability based upon one report Alternatively, taxpayers argued that a combined discount of 36.0% should be applied to the net asset value based upon the other appraiser’s report
8.
Court disregarded the market approach and rejected the right of first refusal method as too speculative 9. Court relied on the IRS expert and the second taxpayers’ expert, who both considered the makeup of the partnership assets to closed-end funds 10. Court allowed 8% discount for lack of control based on the arguments of the taxpayers’ expert, finding his report to be more thorough, and noting that the government’s expert utilized the mean discount (exaggerates the impact of outliers), instead of the median (more indicative of market factors) 11. Taxpayers’ expert also applied an additional 22% discount based on the legal structure of the Partnership (compared closed-end funds invested in real estate with publicly traded partnerships invested in real estate and “conservatively” estimated half of the 22% as attributable to control); the IRS expert did not perform a similar analysis, and did not provide any strong support why this additional discount would be rejected 12. Court applied a total discount for lack of control of 19% and a 12.5% discount for lack of marketability * Note: Chapter 13 includes a discussion of the issues related to marketability in this case.
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W. ESTATE OF TEMPLE V. UNITED STATES OF AMERICA—CIVIL ACTION NO. 9:03CV-165 (MARCH 2006)* 1.
2. 3.
Case questions fair market value of gifted interests in four entities: Ladera Land (family partnership holding a ranch); Boggy Slough (limited liability company operating a winery); and Temple Interests and Temple Partners (two family partnerships holding publicly traded stock in Temple-Inland and Time Warner) Experts agreed on the net asset value of the entities, but disagreed on the discounts to be applied Ladera Land: a)
b)
c) 4.
Taxpayer’s expert applied a 58.75% combined discount, using Mergerstat to determine a 25% discount for lack of control and the QMDM to derive a 45% discount for lack of marketability IRS expert applied total discount of 38%, which included a combined 33% discount for lack of control and marketability, and an additional 7.5% incremental lack of marketability discount (due to status as private and non-registered interests) Court agreed with the IRS expert’s conclusions, and applied a 38% total discount
Boggy Slough (included two gifted interests—76.6% and 1.6%): a)
For the 76.6% majority interest: (1) IRS expert rejected control discount—partner with at least 51% ownership can dissolve a partnership (2) Taxpayer’s expert applied 60% combined discount, addressing issues of undivided interest (3) Court sided with the taxpayer’s expert, and applied a 60% discount
b)
For the 1.6% minority interest: (1) Court applied a combined discount of 38% (see IRS arguments noted above in Ladera Land)
5.
Temple Partnerships: a)
b) c)
6.
Both experts agreed on methodology utilized in Peracchio, using closed-end funds to quantify the discount for lack of control and restricted stock studies to quantify the marketability discount Court concluded a discount range of approximately 3% to 10% was appropriate for lack of control Court applied a 12.5% discount for lack of marketability, based on the IRS expert’s consideration of restricted stock studies, academic research, the costs of going public, secondary market transactions, asset liquidity, partnership interest transferability, and whether distributions were made
Court determined that no discounts for potential unrealized capital gains were applicable to any of the four entities
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X. EAST PARK LIMITED PARTNERSHIP V. BARBARA A. LARKIN—NO. 289 MD COURT OF SPECIAL APPEALS (MARCH 2006)* 1. 2. 3.
Dissenting shareholder suit focusing on the issue of the fair value standard of value, which was used to determine payment for partnership interests Discounts for lack of control and lack of marketability were not applied in determining fair value Court found that because the withdrawing partners’ interests would not be sold in open market, there was no need for discounts (the majority of states do not apply discounts for lack of control or marketability when determining fair value)
* Note: Chapter 13 also includes a discussion of this case. Y. KOBLICK V. INTERNAL REVENUE SERVICE—2006 TAX CT. MEMO LEXIS 63 (APRIL 3, 2006) 1.
2. 3.
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Taxpayer was a 45% shareholder in a company that owned a “submersible” lodge, which was donated to a 501(c)(3) charity by transferring his interest simultaneously with those of the other two minority interest shareholders Taxpayer claimed a $720,000 deduction for his interest based partly on a valuation by a consulting engineer; the IRS cut the deduction by half after an audit Taxpayer submitted a report by a marine surveyor who estimated the lodge’s replacement cost at $1.8 million after depreciation; the IRS expert estimated a replacement cost of $1.1 million, which he reduced by depreciation and inflation to a final value between $368,000 and $464,000 IRS proposed a 22% minority discount, but the taxpayer argued the discount should be lower because he had donated his interest as part of a prearranged plan with other shareholders to transfer 100% control Court started with surveyor’s replacement cost and depreciated the value to arrive at $1.06 million Court agreed the discount for lack of control should be lower than the 22% sought by the IRS, citing N. Trust Co. v. Commissioner, 87 T.C. 349 (1986) Court applied a 10% discount for lack of control but with no explanation as to how it arrived at this figure
KOHLER V. COMMISSIONER—T.C. MEMO 2006-152 (JULY 25, 2006) 1. 2.
Case involved valuation of estate’s shares in Kohler, a manufacturer of kitchen and bath products; the shares represented roughly 12.85% of all outstanding capital stock Two taxpayer’s experts and one IRS expert valued the Kohler stock, using different methods: a)
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First taxpayer’s expert used dividend methods, DCF, and capital market methods to value the stock at $47.01 million – he applied a 45% discount for lack of marketability under the DCF and capital market methods, and a 10% discount for lack of marketability to the dividend methods; he also applied a 26% discount for lack of control for the DCF
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c)
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Second taxpayer’s expert used discounted dividend analysis, DCF, and guideline public company analysis to value the stock at $63.385 million—he applied a 35% discount for lack of marketability and a 25% discount for lack of control IRS expert used a guideline company method and the transaction method, applying a 25% discount for lack of marketability
The Court relied upon the taxpayer’s experts’ calculations to determine a value of just over $47 million
AA. DALLAS V. COMMISSIONER—T.C. MEMO 2006-212 (SEPTEMBER 28, 2006) 1. 2. 3. 4.
Father sold 55% of nonvoting stock in S corporation to his sons’ trusts Taxpayer’s appraiser valued the stock, applying a 40% tax affected rate, a 15% lack of control discount, and a 35% discount for lack of marketability IRS expert 20% discount for lack of marketability The court did not allow a discount for lack of voting power; allowed 15% and 20% minority discounts to nonoperating and operating assets, respectively; and a 20% discount for lack of marketability
BB. IN THE MATTER OF THE ESTATE OF NORMAN B. HJERSTED—2008 WL 269013 KANSAS SUPREME COURT (FEBRUARY 1, 2008) 1. 2. 3.
Taxpayer formed a FLP with the intent to disinherit his wife of nearly 20 years to the benefit of a son by a prior marriage The estate’s appraiser applied layered discounts of 32.5%, while the wife’s appraiser applied a 10% marketability discount and a 32.5% discount due to lack of consent The court ruled that discounts for lack of marketability and control did not apply to a FLP
CC. CANNON V. BERTRAND—2008 WL 1734158 LOUISIANA COURT OF APPEALS (APRIL 16, 2008) 1. 2.
Case involved the valuation of a 1/3 interest in a partnership that harvested and sold timber IRS expert believed discount for lack of control was not necessary due to: a) b) c)
3. 4. 5.
A partnership agreement not addressing payments to a withdrawing partner, The controlling statute which entitles a withdrawing partner to “an amount equal to the value that the (former partner) had at the time the membership ceased,” and Unless the partnership was liquidated, there was an automatic market for the existing shares in the remaining partner’s obligation to repurchase the shares.
Taxpayer’s expert applied an 80% combined discount for lack of control and lack of marketability Trial court applied a 35% discount for lack of control Case is currently being appealed by the IRS
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DD. ASTLEFORD V. COMMISSIONER—T.C. MEMO 2008-128, DOCKET NO. 4342-06 (MAY 5, 2008) 1. 2. 3.
Purpose of the valuation was to calculate the fair market value of limited partnership interests transferred as gifts by the petitioner Taxpayer’s expert relied on data from sales of registered real estate limited partnerships (RELPs), while the IRS expert relied upon real estate investment trust (REITs) data Tax Court did not comment on the superiority of RELPs or REITs a) b)
Used RELP data to determine a 30% combined discount for lack of control and lack of marketability for a 50% interest in the general partnership Used REIT data to determine 16.17% and 17.47% liquidity discounts for two gifts of FLP ownership interests and a 21.23% marketability discount for a transfer of FLP limited partnership interests
EE. KAPLAN V. FIRST HARTFORD CORP. 2009 WL 737681 (D.ME.), MARCH 20, 2009 1.
Oppressed minority shareholder in First Hartford Corporation, held investment properties a)
2. 3.
Two component businesses: a portfolio of income-producing properties and a construction/development business
Three experienced valuators differed by a factor of five Plaintiff ’s expert: a)
CEO of private venture capital firm, no valuation credentials or prior expert witness experience (1) Defendants challenged him under Daubert, but the court admitted his testimony
b)
4.
Used an investment approach relying on DCF model to arrive at fair value of $48.3 million
Defendants’ lead expert: a) b)
Credentialed expert with over 20 years of experience Used asset, market and income approaches to conclude fair value of $9.3 million (1) Asset: $13.3 million (2) Income: $7.6 million (3) Market: $10.0 million based on guideline company method; $9.6 million based on guideline transaction analysis; $10.0 million using Pink Sheets
5.
Defendants’ second expert: a) b)
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Professor of Real Estate and Urban Land Economics Used net asset value and investment approaches, as well as Pink Sheets
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(1) Asset: $15.5 million value, then applied 25% minority discount to reach $11.66 million, no DLOM (2) Investment: $9.4 million using public REITs (3) Pink Sheets: $10.0 million w/ implicit minority discount c)
6.
10% weight to NAV and investment methods, 80% weight to market value to conclude $9.8 million value, $13.07 million without the DLOC
Court’s decision—thought discounts were appropriate a) b) c) d)
Started with $3.25/share value used in 100-share trade three days before valuation date Applied 30% total discount Concluded value of $15.0 million Supported by experts’ net asset valuations
FF. KELLER V. UNITED STATES 2009 WL 2601611 (AUGUST 20, 2009) 1. 2. 3. 4.
Widow established FLP to be funded with $250 million in corporate investment bonds After signing papers, before transferring assets she died IRS expert’s value was rejected as hypothetical buyer/seller standards were violated Estate determined a fair market value of partnership assets to be $261 million and the value of the assignee interests was $137 million a)
5.
The trusts held a 99.9% interest in the partnership, reflecting a 47.5% discount
Court sided with estate expert
GG. ESTATE OF GIUSTINA V. COMMISSIONER T.C. MEMO. 2011-141 2011 WL 2516168 (U.S. TAX COURT) (JUNE 22, 2011) 1. 2. 3. 4. 5. 6. 7.
41.1% interest in FLP holding tracts of timberland Estate expert #1 valuation—$12.67 million Estate expert #2 valuation—$13.0 million IRS expert valuation—$33.5 million Court stated only net asset value and discounted cash flow methods were appropriate to use Experts agreed that partnership’s 48,000 acres of timber were worth $143 million Court rejected IRS expert’s DCF and accepted some components of taxpayer’s expert’s DCF 8. Court rejected taxpayer’s experts DLOM of 35% and accepted IRS expert’s DLOM of 25% 9. Court declined to apply a DLOC to NAV calculation, nor did they apply a DLOM 10. Court weighted approaches 75% DCF, 25% NAV—value of $27.45 million for 41.1% interest
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HH. ESTATE OF GALLAGHER V. COMMISSIONER T.C. MEMO. 2011-148 2011 WL 2559847 (U.S. TAX COURT) (JUNE 28, 2011) 1. 2. 3. 4. 5. 6. 7. 8.
Decedent owned 15% in family-founded newspaper publishing company Estate tax return valued 15% share at $34.9 million IRS asserted value of $49.5 million Taxpayer petitioned Tax Court with new appraisal at $26.6 million New appraisers, before trial, found values of $28.2 million and $40.9 million Four categories disputed—date of financial information, adjustments to financial statements, guideline public company method, and income approach Experts agreed DLOM and DLOC were applicable IRS expert—17% DLOC, 30% DLOM a) b)
Taxpayer expert—cash flow was on minority level, 31% DLOM Court applied 23% DLOC and 31% DLOM, valued 15% share at $32.6 million
III. CHAPTER SUMMARY Court cases, while not authoritative beyond each specific case addressed, can provide the business valuator with significant guidance in jurisdictional matters related to the use of control premiums and minority discounts. Moreover, the cases have, over time, provided a window to how these value adjustments can be utilized and what planning implications are necessary to ensure a defendable result.
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CHAPTER FIVE
CURRENT JUDICIAL DEVELOPMENTS AFFECTING CONTROL PREMIUMS AND MINORITY DISCOUNTS Chapter Objective Identify recent court decisions and how these cases influence consideration of discounts and premiums related to control. Caution: The cases presented in this chapter are by no means all-inclusive of recent court cases involving minority and/or lack of control issues. The following is only intended to be a representative sample of the current decisions regarding the subject.
I. INTRODUCTION Discounts for lack of control play an important role in many business valuations. Not surprisingly, in the estate planning arena, these discounts can form the very foundation for a taxpayer’s estate plan if he or she is holding ownership interests in privately held businesses. With Revenue Ruling 93-12 firmly in place, family attribution is no longer a source of Internal Revenue Service scrutiny in planning the transfer of non-control interests in family-owned businesses. Although “swing vote characteristics” still envelop overall discount consideration, most valuators and estate planners agree that minority ownership interest should be valued significantly lower than ownership interest conveying control. Nowhere is more information available for public observation than from the Internal Revenue Service and subsequent judicial follow-up. As the party with the most to lose (via lower gift and estate tax collections), the IRS, through its judicial challenges, continues to be a prime source of valuation theory and interpretation. One of the most significant cases to come out of the Tax Court to date is the Estate of Richard R. Simplot v. Commissioner. The original case and Ninth Circuit’s reversal in favor of the taxpayer was discussed previously in Chapter 2. The remainder of this chapter will present historical cases of interest which provide a better indication of the current Tax Court and IRS thinking with respect to the application of discounts for lack of control.
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The cases presented in this chapter are by no means all inclusive of recent court cases involving minority and/or lack of control issues. The following is only intended to be a sample, representative of the current decisions regarding the subject.
II. CASES INFLUENCING CONSIDERATION OF DISCOUNTS AND PREMIUMS RELATED TO CONTROL A. ESTATE OF JOSEPH CIDULKA—T.C. MEMO 1996-149 1.
This decision was important for two reasons: a) b)
2. 3. 4.
5. 6. 7.
8.
Cidulka was founder and controlling shareholder (55.04%) of SOAI, a billboard company; his son owned the balance of the outstanding shares Over the years Cidulka gifted shares to his son and family, at question was 4.91% gifted in 1982 SOAI redeemed his remaining shares (47.17%) in exchange for a self-canceling installment note (SCIN) with a face value of $370,000 (equal to book value); IRS held that the value of the SCIN was $307,381 At issue was the gift amount (i.e. should the 4.91% and the 47.17% be valued separately or together—two minority blocks versus a single control block) Court found that the transactions were planned together and obviously executed together Gift value was the difference between fair market value prior to the January 1982 transactions and the fair market value of the note received as consideration—in effect, the minority discount was lost Author’s Interpretation and Analysis: a)
b) c)
B.
Application of minority discount is not automatic and requires careful consideration Provides clarification that even in light of the hypothetical willing buyer, willing seller envisioned in the term “fair market value,” the courts and the IRS will not inevitably close their eyes to multiple steps in an obviously integrated plan
Technical Advice Memorandum 9504004—addressed a transfer styled as a sale rather than a gift, but the IRS insisted that the gift tax analysis consider the pre-planned redemption of the transferor’s remaining shares, which occurred shortly after the sale Step Transaction Doctrine—set forth in corporation taxation in Zena v. Quinlinan, 213 F.2d 914, 45 AFTR 1672, 54-2 USTC 9445 (CA-6, 1954) Estate of Elizabeth B. Murphy v. Commissioner, T.C. Memo 1990-472—deceased gifted small amounts of stock 18 days before death to reduce holdings to just below 50%; estate tried to treat gift and testamentary transfer as separate minority interests; the IRS objected and court held
BONNER V. UNITED STATES—KTC 1996-278 (5TH CIR. 1996) 1.
2.
3.
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Decedent owned, at time of death: fee simple 62.5% undivided interest in real property (ranch) in Texas; fee simple 50% undivided interest in real property (land) in New Mexico; and fee simple 50% undivided interest in a pleasure boat Balance of all assets were owned by a testamentary trust set up by the decedent’s spouse at her death; the trust satisfied the test for ”qualified terminable interest property” (QTIP) and qualified for marital exclusion at wife’s death Interests held directly by husband and interests held by QTIP trust will be included in estate © 2003–2014 Robert J. Grossman and National Association of Certified Valuators and Analysts 2014.v1
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7.
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100% of values were stipulated at decedent’s death, however, at issue was whether the estate could take fractional interest discounts on underlying properties Court allowed fractional interest discounts because decedent’s own interests were subject to his powers of testamentary transfer, but those in the QTIP trust were not Conclusion seems a illogical and counter to long-standing IRS views, and decision is inconsistent with at least one Tax Court ruling—Estate of Babbitt, 87 T.C. 1270, 1277 (1986) Author’s Interpretation and Analysis: Could provide an aggressive planning opportunity as Bonner could be deemed to apply any time there is no power to actually dispose of the property at death, for example: a) b) c) d)
“A” is a 75% shareholder in X corporation A places 40% in irrevocable trust, retaining lifetime income interest, and names full vested beneficiary Both blocks can be included in A’s estate under different provisions of the Internal Revenue Code Because A had no power to direct disposition of trust holdings, there may be plausible argument to discount both blocks for lack of control
C. ESTATE OF BARUDIN V. COMMISSIONER—T.C. MEMO 1996-395, 1996 TAX CT. MEMO LEXIS 403 (AUGUST 1996) 1. 2.
Case involved the valuation of 1/95 interest in a general partnership owning real property Both parties agreed on the underlying asset value, but applied different discounts a) b)
3.
Taxpayer’s expert applied a combined discount for lack of control and lack of marketability of 67.5% IRS expert applied a 15% minority discount, based on market studies, and 15% marketability discount
Court ruled that 19% was an appropriate minority discount, based on the average found in the market studies used by the IRS expert
D. ESTATE OF MELLINGER V. COMMISSIONER—112 T.C. 26 (JANUARY 26, 1999) 1.
2.
3. 4.
Decedent owned, at time of death: 50 shares of Frederick’s of Hollywood common stock as well as shares of Frederick’s of Hollywood stock via a revocable trust that she had established; the revocable marital trust met all requirements to be “Qualified Terminable Interest Property” (QTIP); other shares were held for her income benefit via an irrevocable marital trust set up by decedent’s spouse at his death Interests held by the decedent and in the irrevocable trust, as well as interests held by the QTIP trust, will all be included in estate; at issue was whether the estate could take fractional interest discounts on underlying properties Court allowed fractional interest discounts because decedent’s own interests were subject to her powers of testamentary transfer, but those in the QTIP trust were not Author’s Interpretation and Analysis: a) b)
IRS announced its acquiescence in the Mellinger decision (AOD CC-1999-006) The closely held stock held in a QTIP trust does not have to be aggregated, for valuation purposes, with stock in the same corporation held in a revocable trust and includible in decedent’s gross estate
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ESTATE OF SMITH V. COMMISSIONER—T.C. MEMO 1999-368 (NOVEMBER 5, 1999) 1. 2. 3.
4. 5. F.
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Case involved the valuation of a large-asset, low-return company, a farm corporation IRS was focused on the underlying asset value, not discounts For the S corporation, taxpayer’s expert determined a minority interest discount of 50%, using market price to net asset value ratios for non-distributing REITs to quantify the amount For the bank stock, taxpayer’s expert used control premium data to apply a 32% minority discount Court accepted both percentages as determined by the taxpayer’s expert
ESTATE OF WEINBERG V. COMMISSIONER—T.C. MEMO 2000-51 (FEBRUARY 2000) 1. 2. 3.
4.
5.
Decedent owned, at time of death: a limited partnership interest (25.235%) in a limited partnership that owned and operated an 11-story apartment building in Philadelphia All parties agreed that fair market value of the apartment building was $10,050,000, but disagreed on the applicability and amount of minority and marketability discounts Estate’s expert argued for a 43% minority discount—determined directly through comparison of public interest’s pricing in relation to their pro rata shares of net asset value, and indirectly through the capitalization of the subject partnership interest’s distributions at a market rate and later comparison of the resulting value to the interest’s pro rata share of net asset value; also applied a 35% discount for lack of marketability IRS expert determined a minority discount of 20% and argued that the discount should only be determined indirectly through the capitalization of the subject partnership interest’s distributions; also applied a 15% discount for lack of marketability The Court ultimately applied a discount of 37% for minority status and a 20% discount for lack of marketability—the overall combined discount totaled 50% from net asset value
G. GOW V. COMMISSIONER—T.C. MEMO 2000-93, 79 T.C.M. 1.
2.
3. 4. 5.
Dealt with the fair market value of two minority blocks of stock of Williamsburg Vacations, Inc. (WVI), which were issued as bonus compensation to a shareholder/officer/director of a C corporation investment holding company At issue was whether the discounted cash flow method resulted in a control or minority value, and are two-tier discounts acceptable at both the operating company joint venture and the investment holding company levels IRS argued that two-tier discounts at both levels are duplicative and should not be taken into account The court agreed with all discounts ascribed at both tiers by the taxpayer as far as minority and lack of marketability discount issues were concerned The only discount (out of nine) that was not accepted verbatim by the court from the taxpayer was a contingency allowance discount of 15% at the WVI holding company level
H. FERRARO V. FERRARO—2000 VA. APP. LEXIS 164 (MARCH 2000) 1.
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Marital dissolution case in which the trial court had previously valued husband’s 34% interest in various sporting goods stores at $1,300,000
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2.
3.
Husband contended that the trial court erred when it disallowed the application of both a minority and marketability discount; upon appeal, argued that the court had abused its discretion with this decision Appellate court affirmed trial court’s decision: a)
b)
I.
Found that no one owned a majority interest in any of the sporting good stores; therefore, the husband’s minority ownership did not diminish the value of his interest in the businesses Felt the evidence indicated that the husband would not be required to sell his shares in the business in order to pay the wife’s distribution award; thus a discount for lack of marketability was not justified
MAGGOS V. COMMISSIONER—T.C. MEMO 2000-129 (APRIL 2000) 1. 2. 3. 4.
J.
CURRENT JUDICIAL DEVELOPMENTS
Decedent owned shares of stock in a family-owned company; 567 shares were redeemed by the company from the decedent on May 1, 1987, for a $3,000,000 promissory note As a result of the redemption transaction, decedent’s son became sole owner of the company Primary issue was whether the transaction constituted a charitable gift for purposes of IRC §2512 Court found value of the shares to be worth $4,900,000 on an aggregated minority basis, and applied a 25% control premium, as well as a 25% discount for lack of marketability
ESTATE OF JONES V. COMMISSIONER—116 T.C. NO. 11 (MARCH 6, 2001) 1. 2. 3. 4.
Estate had interests in two limited partnerships holding real property (ranches, livestock, personal property) Estate’s expert used a 45% discount for lack of control based on the latest Partnership Spectrum compilation and a 20% discount for lack of marketability IRS expert used a 38% discount for lack of control based on the following year’s compilations Court applied a 40% minority interest discount, but denied taxpayer’s 20% marketability discount
K. ESTATE OF TRUE V. COMMISSIONER—T.C. MEMO 2001-167 (JULY 6, 2001) 1.
2. 3.
4.
5.
Tax deficiency and associated penalties asserted by the IRS regarding the value of ownership interests in various corporations and partnerships willed and gifted by the decedent to a trust benefiting his heirs Significant debate occurred in regard to whether or not buy-sell agreements (that were based on tax book value) should set the value for the estate and gifts First estate expert’s revised report applied no marketability discount to controlling interests; a second expert applied discounts of 40% and 45% based on restricted stock and pre-IPO studies and considered the existence of the buy-sell agreements in determining both entity values and the marketability discount IRS expert applied no marketability discount to the controlling interests, arguing that the minority interests represented swing votes, and therefore, would not be subject to a minority interest discount Court rejected the estate expert’s use of premium studies, as well as the IRS argument regarding swing votes; instead, the tax court determined a 15% minority interest discount
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L.
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Court stated that the buy-sell agreements were testamentary devices and did not consider them in the determination of the marketability adjustment; disagreeing with all appraisals, the court applied a 20% marketability discount for the controlling interest, and a 30% marketability discount for the minority interest
ESTATE OF HECK V. COMMISSIONER—T.C. MEMO 2002-34, U.S. TAX CT. (FEB. 5, 2002) 1. 2.
3. 4.
5.
The estate included a 39.62% interest in a privately held company in which family members held all shares outright or in a trust The company entered into a distribution agreement that gave the other party the exclusive right to distribute the company’s product, as well as the right of first refusal with respect to any stock offered for sale by a family member Estate’s expert applied a discount of 10% for the right of first refusal and a 25% marketability discount IRS expert argued that the discount for right of first refusal was included in the marketability discount; the expert applied marketability discounts of 15% to stock and 25% to land; 10% discount due to S Corporation status; and 25% minority discounts to land and excess cash The court utilized the estate expert’s recommendations, applying a 25% marketability discount and a 10% discount for right of first refusal; no discounts applied for S Corporation status or lack of control
M. MITCHELL V. COMMISSIONER—T.C. MEMO 2002-98 (APRIL 9, 2002) 1. 2. 3.
4. 5.
6.
Decedent owned a 49.04% interest in John Paul Mitchell Systems In the original case (T.C. Memo 1997-461, October 9, 1997) the taxpayer claimed a $720,000 deduction for his interest based partly on a valuation by a consulting firm On appeal, the estate claimed the Tax Court erred by: failing to provide a detailed explanation of the methodology used to recalculate the fair market value of the stock; miscalculating the value of the stock in a manner inconsistent with its own holding; and failing to shift the burden of proof to the commissioner Both estate experts applied 45% discounts for combined lack of marketability and minority interest Tax Court, on remand from the Ninth Circuit Court of Appeals, applied a 35% combined minority and marketability discount (29% to reflect that the interest had some power, but less than control, and an additional 6%, based on the lack of marketability specifically related to decedent’s minority interest) Tax Court also applied a 10% key person discount
N. ESTATE OF GODLEY V. COMMISSIONER—286 F.3D 210 (APRIL 15, 2002) 1.
2. 3.
6 – Chapter Five
Decedent owned a 50% general partnership interest in four partnerships, as well as a 50% interest in a general partnership that managed the other four partnerships; the decedent’s son owned the remaining interests in the five partnerships and was managing partner The estate argued that an option in the partnership agreement was a bona fide business arrangement and should control the determination of fair market value On appeal, the estate questioned whether the decedent’s 50% interest and any associated lack of control is a question of law
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6.
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Tax Court decided that the option was a testamentary device; thus, it was not a valid business arrangement that would determine fair market value Court stated, “there was little to be gained by having control of these partnerships and little risk in holding a minority interest,” due to the fact that the partnership had a steady future cash flow from long term contracts with little risk of losing them; partnership agreements spelled out specific requirements for annual distributions; and, neither party alone could, or would likely want to, have the assets liquidated The Fourth Circuit affirmed that, due to the unique circumstances, the Tax Court did not err in NOT applying a minority discount
O. ESTATE OF BAILEY V. COMMISSIONER—T.C. MEMO 2002-152 1. 2. 3. 4. 5.
Decedent owned a 25% interest in a corporation which owned and operated two hotels, and was also the beneficiary of a QTIP Trust which owned 25% of the same corporation The IRS and the estate agreed that the interests should not be aggregated for valuation purposes Estate discounted “liquidation value” by 50% for key person, minority ownership and lack of marketability IRS expert originally used a 25% discount for lack of marketability, but later reversed it to 50%, using the net asset value approach At trial, both experts argued for different discounts than in their original reports: a) b)
6.
P.
IRS expert used a 20% discount for lack of control; 21.44% for built-in gains; 6% for “stock sale costs” Estate’s expert used a 20% discount for lack of control; 40% for lack of marketability
Tax Court applied a 20% discount for lack of control and a 37.5% discount for lack of marketability to the net asset value
IN RE THE MARRIAGE OF FRANZEN—2003 WISC. APP. LEXIS 72 (JANUARY 29, 2003) 1. 2. 3. 4. 5. 6.
Under valuation was a 50% interest in a Piggly Wiggly store under franchise Wife’s expert determined a value of $548,707, with a 20% discount for lack of marketability and no discount for lack of control Husband’s first expert determined that the 50% interest had a negative value Husband’s second expert testified on other two experts’ values, and sided with husband’s first expert Trial Court valued the interest at $324,860, using wife’s expert’s EBITDA approach and applying a 20% discount for lack of control Appeals court affirmed the trial court’s valuation
Q. COLE V. COLE—2003 ARK. APP. LEXIS 348 (APRIL 30, 2003)* 1.
2.
Marital-property case involves the valuation and division of a substantial amount of property owned by the husband; the wife disputed the value determined by a buy-sell agreement ($750,000) In original case, the wife’s expert applied 10% discount for lack of marketability and 10% discount for lack of control, resulting in a value of $1,274,200; the husband’s first expert
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3. 4.
5.
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applied a 50% marketability discount and a 31.5% discount for lack of control, resulting in a value of $497,303; his second expert valued the partnership at $297,500 Trial Court valued the interest at $375,000 (50% of the $750,000), based on the buy-sell agreement Appellate court reversed and remanded trial court’s decision, noting that the buy-sell agreement is not binding on the non-shareholder spouse if that spouse did not sign the agreement Upon second appeal, the decision was affirmed in part and reversed and remanded in part; however, no adjustments were made to the original discounts and premiums applied in the case (2005 Ark. App. LEXIS 8, January 2005)
* Note: Chapter 11 also includes a discussion of this case. R. HESS V. COMMISSIONER—T.C. MEMO 2003-251 (AUGUST 20, 2003) 1. 2. 3. 4.
S.
ESTATE OF HILLGREN V. COMMISSIONER—T.C. MEMO 2004-56 (MARCH 3, 2004) 1. 2. 3. 4.
T.
Sole issue was the fair market value of the stock in a company that manufactured metal processing machines and automation systems for the auto industry Taxpayer’s expert applied a 15% discount for lack of control, using the DCF method and the guideline public company method IRS expert also applied a 15% discount for lack of control, using four methods—NAV, prior stock transaction, stockholder agreement and guideline public company methods Court accepted the 15% discount for lack of control, but criticized Taxpayer’s expert for applying the discount under the guideline public company method as it results in a minority value
Primary issues were whether the court should disregard an FLP under IRC Section 2036(a) and what was the fair market value of the assets of the partnership Estate’s expert suggested a 50% combined discount for lack of marketability and lack of control, as well as a 5% discount for lack of voting rights IRS experts applied a 35% discount for lack of marketability and a 10% discount for lack of control, using closed-end equity funds and real estate investment trusts Tax Court accepted the estate expert’s values as reasonable
ESTATE OF JELKE V. COMMISSIONER—T.C. MEMO. 2005-131 DOCKET NO. 351203 (MAY 31, 2005)* 1.
2. 3. 4.
8 – Chapter Five
Decedent was beneficiary of a revocable trust that owned 6.44% of common stock in a C corporation closely held by the Jelke family (company’s underlying assets were primarily marketable securities with a market value of approximately $189 million; assets had a built-in gain of approximately $52 million) In addition to contesting the applicability of discounts for built-in gains tax liability, the parties disagreed on the discounts for lack of control and marketability Both experts utilized closed-end fund data to determine discount for lack of control; comparables differed Both experts agreed that there is an inverse relationship between a company’s financial performance and the lack of control discount, but, they disagreed on the strength of the company’s financial performance
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5.
6. 7.
CURRENT JUDICIAL DEVELOPMENTS
Court determined that a 10% lack of control discount is appropriate—because the company was well diversified and had a long-term record of strong returns in the form of dividends and capital appreciation, investors were less likely to desire control due to the passive nature of their investment in the company Court was not satisfied that the discount applicable to closed-end funds was solely attributable to lack of control, and believed that a portion is due to lack of marketability Court also determined a 15% marketability discount and applied a 13.2% discount for built-in gain tax
* Note: Chapter 12 includes a discussion of the built-in gains aspect of this case; Chapter 13 includes the issues related to marketability. U. ESTATE OF KELLEY V. COMMISSIONER—T.C. MEMO 2005-235, DOCKET NO. 16894-03 (US TAX COURT, OCT 2005)* 1.
2.
Decedent formed a limited liability company (LLC) and a family limited partnership (FLP), and owned 33.33% and 94.83% of the LLC and FLP, respectively, at his date of death Value of the assets (consisting only of cash and CDs) was questioned for estate tax purposes a)
b)
3.
4.
Court found that in this case, where the interest being valued is an interest in a FLP whose assets consist solely of cash and CDs, the income approach should not be afforded more than minor weight (at trial, the estate expert admitted that his income approach calculation was incorrect because it did not compound the earnings each year) Court applied a 12% discount for lack of control as originally determined by the IRS expert, based on the total population of closed-end funds a) b)
5.
The estate expert weighted the net asset value approach at 80% and income approach at 20%, and applied a 53.5% combined discount, which included a control discount based on comparables from the fourth quartile of publicly traded closed-end funds (argued that this data was more comparable to closely held business interests) The IRS expert relied solely on net asset value, and argued for a combined discount of 25.2%; his discount for lack of control was calculated using an arithmetic mean of all closed-end funds (using the entire population data set was an attempt to remove the marketability element of discounts/premiums embedded in the price of closed-end funds)
Court noted that shareholders in all closed-end funds lack control Also noted that funds in the fourth quartile had the lowest demand and, therefore, the highest marketability discount
Court thought that the experts’ approaches to determining the lack of marketability were flawed, and applied a 23% marketability discount based on theories used in the McCord and Lappo Tax Court cases
* Note: Chapter 13 includes a discussion of the issues related to marketability in this case.
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V. ROBERTSON V. UNITED STATES OF AMERICA—3:03-CV-02113 (JANUARY 13, 2006)* 1. 2. 3. 4. 5.
6.
In December 1996, five trusts contributed assets to a family limited partnership; the majority of the limited partner interests were held by four non-exempt trusts In December 2000, substantially all of the trust’s assets were distributed to the remainder beneficiaries The United States pursued the collection of generation-skipping transfer taxes on the assets The parties agreed regarding the value of the corporate stock distributed, but disagreed on the value of the partnership units distributed to the beneficiaries The IRS contended that the assets should be valued with the market approach, which would result in the partnership’s assets, net of liabilities, without any discounts; the IRS also contended that certain transactions of the partnership interests with its partners occurred at full net asset value without any discounts A secondary IRS position was that partnership interests should be valued in one of two alternative ways: a) b)
7.
Discounted by 14.9% based on the right of first refusal approach A combined discount of 17.925% (6.2% for lack of control and 12.5% for lack of marketability) applied to net asset value
Taxpayers hired two experts who prepared appraisal reports a)
b)
Taxpayers first contended that value of the partnership interests should be discounted by a combined effective discount of 41.5% for lack of control and marketability based upon one report Alternatively, taxpayers argued that a combined discount of 36.0% should be applied to the net asset value based upon the other appraiser’s report
8.
Court disregarded the market approach and rejected the right of first refusal method as too speculative 9. Court relied on the IRS expert and the second taxpayers’ expert, who both considered the makeup of the partnership assets to closed-end funds 10. Court allowed 8% discount for lack of control based on the arguments of the taxpayers’ expert, finding his report to be more thorough, and noting that the government’s expert utilized the mean discount (exaggerates the impact of outliers), instead of the median (more indicative of market factors) 11. Taxpayers’ expert also applied an additional 22% discount based on the legal structure of the Partnership (compared closed-end funds invested in real estate with publicly traded partnerships invested in real estate and “conservatively” estimated half of the 22% as attributable to control); the IRS expert did not perform a similar analysis, and did not provide any strong support why this additional discount would be rejected 12. Court applied a total discount for lack of control of 19% and a 12.5% discount for lack of marketability * Note: Chapter 13 includes a discussion of the issues related to marketability in this case.
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CURRENT JUDICIAL DEVELOPMENTS
W. ESTATE OF TEMPLE V. UNITED STATES OF AMERICA—CIVIL ACTION NO. 9:03CV-165 (MARCH 2006)* 1.
2. 3.
Case questions fair market value of gifted interests in four entities: Ladera Land (family partnership holding a ranch); Boggy Slough (limited liability company operating a winery); and Temple Interests and Temple Partners (two family partnerships holding publicly traded stock in Temple-Inland and Time Warner) Experts agreed on the net asset value of the entities, but disagreed on the discounts to be applied Ladera Land: a)
b)
c) 4.
Taxpayer’s expert applied a 58.75% combined discount, using Mergerstat to determine a 25% discount for lack of control and the QMDM to derive a 45% discount for lack of marketability IRS expert applied total discount of 38%, which included a combined 33% discount for lack of control and marketability, and an additional 7.5% incremental lack of marketability discount (due to status as private and non-registered interests) Court agreed with the IRS expert’s conclusions, and applied a 38% total discount
Boggy Slough (included two gifted interests—76.6% and 1.6%): a)
For the 76.6% majority interest: (1) IRS expert rejected control discount—partner with at least 51% ownership can dissolve a partnership (2) Taxpayer’s expert applied 60% combined discount, addressing issues of undivided interest (3) Court sided with the taxpayer’s expert, and applied a 60% discount
b)
For the 1.6% minority interest: (1) Court applied a combined discount of 38% (see IRS arguments noted above in Ladera Land)
5.
Temple Partnerships: a)
b) c)
6.
Both experts agreed on methodology utilized in Peracchio, using closed-end funds to quantify the discount for lack of control and restricted stock studies to quantify the marketability discount Court concluded a discount range of approximately 3% to 10% was appropriate for lack of control Court applied a 12.5% discount for lack of marketability, based on the IRS expert’s consideration of restricted stock studies, academic research, the costs of going public, secondary market transactions, asset liquidity, partnership interest transferability, and whether distributions were made
Court determined that no discounts for potential unrealized capital gains were applicable to any of the four entities
* Note: Chapter 13 includes a discussion of the issues related to marketability in this case. © 2003–2014 Robert J. Grossman and National Association of Certified Valuators and Analysts 2014.v1
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X. EAST PARK LIMITED PARTNERSHIP V. BARBARA A. LARKIN—NO. 289 MD COURT OF SPECIAL APPEALS (MARCH 2006)* 1. 2. 3.
Dissenting shareholder suit focusing on the issue of the fair value standard of value, which was used to determine payment for partnership interests Discounts for lack of control and lack of marketability were not applied in determining fair value Court found that because the withdrawing partners’ interests would not be sold in open market, there was no need for discounts (the majority of states do not apply discounts for lack of control or marketability when determining fair value)
* Note: Chapter 13 also includes a discussion of this case. Y. KOBLICK V. INTERNAL REVENUE SERVICE—2006 TAX CT. MEMO LEXIS 63 (APRIL 3, 2006) 1.
2. 3.
4.
5. 6. 7.
Z.
Taxpayer was a 45% shareholder in a company that owned a “submersible” lodge, which was donated to a 501(c)(3) charity by transferring his interest simultaneously with those of the other two minority interest shareholders Taxpayer claimed a $720,000 deduction for his interest based partly on a valuation by a consulting engineer; the IRS cut the deduction by half after an audit Taxpayer submitted a report by a marine surveyor who estimated the lodge’s replacement cost at $1.8 million after depreciation; the IRS expert estimated a replacement cost of $1.1 million, which he reduced by depreciation and inflation to a final value between $368,000 and $464,000 IRS proposed a 22% minority discount, but the taxpayer argued the discount should be lower because he had donated his interest as part of a prearranged plan with other shareholders to transfer 100% control Court started with surveyor’s replacement cost and depreciated the value to arrive at $1.06 million Court agreed the discount for lack of control should be lower than the 22% sought by the IRS, citing N. Trust Co. v. Commissioner, 87 T.C. 349 (1986) Court applied a 10% discount for lack of control but with no explanation as to how it arrived at this figure
KOHLER V. COMMISSIONER—T.C. MEMO 2006-152 (JULY 25, 2006) 1. 2.
Case involved valuation of estate’s shares in Kohler, a manufacturer of kitchen and bath products; the shares represented roughly 12.85% of all outstanding capital stock Two taxpayer’s experts and one IRS expert valued the Kohler stock, using different methods: a)
12 – Chapter Five
First taxpayer’s expert used dividend methods, DCF, and capital market methods to value the stock at $47.01 million – he applied a 45% discount for lack of marketability under the DCF and capital market methods, and a 10% discount for lack of marketability to the dividend methods; he also applied a 26% discount for lack of control for the DCF
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b)
c)
3.
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Second taxpayer’s expert used discounted dividend analysis, DCF, and guideline public company analysis to value the stock at $63.385 million—he applied a 35% discount for lack of marketability and a 25% discount for lack of control IRS expert used a guideline company method and the transaction method, applying a 25% discount for lack of marketability
The Court relied upon the taxpayer’s experts’ calculations to determine a value of just over $47 million
AA. DALLAS V. COMMISSIONER—T.C. MEMO 2006-212 (SEPTEMBER 28, 2006) 1. 2. 3. 4.
Father sold 55% of nonvoting stock in S corporation to his sons’ trusts Taxpayer’s appraiser valued the stock, applying a 40% tax affected rate, a 15% lack of control discount, and a 35% discount for lack of marketability IRS expert 20% discount for lack of marketability The court did not allow a discount for lack of voting power; allowed 15% and 20% minority discounts to nonoperating and operating assets, respectively; and a 20% discount for lack of marketability
BB. IN THE MATTER OF THE ESTATE OF NORMAN B. HJERSTED—2008 WL 269013 KANSAS SUPREME COURT (FEBRUARY 1, 2008) 1. 2. 3.
Taxpayer formed a FLP with the intent to disinherit his wife of nearly 20 years to the benefit of a son by a prior marriage The estate’s appraiser applied layered discounts of 32.5%, while the wife’s appraiser applied a 10% marketability discount and a 32.5% discount due to lack of consent The court ruled that discounts for lack of marketability and control did not apply to a FLP
CC. CANNON V. BERTRAND—2008 WL 1734158 LOUISIANA COURT OF APPEALS (APRIL 16, 2008) 1. 2.
Case involved the valuation of a 1/3 interest in a partnership that harvested and sold timber IRS expert believed discount for lack of control was not necessary due to: a) b) c)
3. 4. 5.
A partnership agreement not addressing payments to a withdrawing partner, The controlling statute which entitles a withdrawing partner to “an amount equal to the value that the (former partner) had at the time the membership ceased,” and Unless the partnership was liquidated, there was an automatic market for the existing shares in the remaining partner’s obligation to repurchase the shares.
Taxpayer’s expert applied an 80% combined discount for lack of control and lack of marketability Trial court applied a 35% discount for lack of control Case is currently being appealed by the IRS
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DD. ASTLEFORD V. COMMISSIONER—T.C. MEMO 2008-128, DOCKET NO. 4342-06 (MAY 5, 2008) 1. 2. 3.
Purpose of the valuation was to calculate the fair market value of limited partnership interests transferred as gifts by the petitioner Taxpayer’s expert relied on data from sales of registered real estate limited partnerships (RELPs), while the IRS expert relied upon real estate investment trust (REITs) data Tax Court did not comment on the superiority of RELPs or REITs a) b)
Used RELP data to determine a 30% combined discount for lack of control and lack of marketability for a 50% interest in the general partnership Used REIT data to determine 16.17% and 17.47% liquidity discounts for two gifts of FLP ownership interests and a 21.23% marketability discount for a transfer of FLP limited partnership interests
EE. KAPLAN V. FIRST HARTFORD CORP. 2009 WL 737681 (D.ME.), MARCH 20, 2009 1.
Oppressed minority shareholder in First Hartford Corporation, held investment properties a)
2. 3.
Two component businesses: a portfolio of income-producing properties and a construction/development business
Three experienced valuators differed by a factor of five Plaintiff ’s expert: a)
CEO of private venture capital firm, no valuation credentials or prior expert witness experience (1) Defendants challenged him under Daubert, but the court admitted his testimony
b)
4.
Used an investment approach relying on DCF model to arrive at fair value of $48.3 million
Defendants’ lead expert: a) b)
Credentialed expert with over 20 years of experience Used asset, market and income approaches to conclude fair value of $9.3 million (1) Asset: $13.3 million (2) Income: $7.6 million (3) Market: $10.0 million based on guideline company method; $9.6 million based on guideline transaction analysis; $10.0 million using Pink Sheets
5.
Defendants’ second expert: a) b)
14 – Chapter Five
Professor of Real Estate and Urban Land Economics Used net asset value and investment approaches, as well as Pink Sheets
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(1) Asset: $15.5 million value, then applied 25% minority discount to reach $11.66 million, no DLOM (2) Investment: $9.4 million using public REITs (3) Pink Sheets: $10.0 million w/ implicit minority discount c)
6.
10% weight to NAV and investment methods, 80% weight to market value to conclude $9.8 million value, $13.07 million without the DLOC
Court’s decision—thought discounts were appropriate a) b) c) d)
Started with $3.25/share value used in 100-share trade three days before valuation date Applied 30% total discount Concluded value of $15.0 million Supported by experts’ net asset valuations
FF. KELLER V. UNITED STATES 2009 WL 2601611 (AUGUST 20, 2009) 1. 2. 3. 4.
Widow established FLP to be funded with $250 million in corporate investment bonds After signing papers, before transferring assets she died IRS expert’s value was rejected as hypothetical buyer/seller standards were violated Estate determined a fair market value of partnership assets to be $261 million and the value of the assignee interests was $137 million a)
5.
The trusts held a 99.9% interest in the partnership, reflecting a 47.5% discount
Court sided with estate expert
GG. ESTATE OF GIUSTINA V. COMMISSIONER T.C. MEMO. 2011-141 2011 WL 2516168 (U.S. TAX COURT) (JUNE 22, 2011) 1. 2. 3. 4. 5. 6. 7.
41.1% interest in FLP holding tracts of timberland Estate expert #1 valuation—$12.67 million Estate expert #2 valuation—$13.0 million IRS expert valuation—$33.5 million Court stated only net asset value and discounted cash flow methods were appropriate to use Experts agreed that partnership’s 48,000 acres of timber were worth $143 million Court rejected IRS expert’s DCF and accepted some components of taxpayer’s expert’s DCF 8. Court rejected taxpayer’s experts DLOM of 35% and accepted IRS expert’s DLOM of 25% 9. Court declined to apply a DLOC to NAV calculation, nor did they apply a DLOM 10. Court weighted approaches 75% DCF, 25% NAV—value of $27.45 million for 41.1% interest
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HH. ESTATE OF GALLAGHER V. COMMISSIONER T.C. MEMO. 2011-148 2011 WL 2559847 (U.S. TAX COURT) (JUNE 28, 2011) 1. 2. 3. 4. 5. 6. 7. 8.
Decedent owned 15% in family-founded newspaper publishing company Estate tax return valued 15% share at $34.9 million IRS asserted value of $49.5 million Taxpayer petitioned Tax Court with new appraisal at $26.6 million New appraisers, before trial, found values of $28.2 million and $40.9 million Four categories disputed—date of financial information, adjustments to financial statements, guideline public company method, and income approach Experts agreed DLOM and DLOC were applicable IRS expert—17% DLOC, 30% DLOM a) b)
Taxpayer expert—cash flow was on minority level, 31% DLOM Court applied 23% DLOC and 31% DLOM, valued 15% share at $32.6 million
III. CHAPTER SUMMARY Court cases, while not authoritative beyond each specific case addressed, can provide the business valuator with significant guidance in jurisdictional matters related to the use of control premiums and minority discounts. Moreover, the cases have, over time, provided a window to how these value adjustments can be utilized and what planning implications are necessary to ensure a defendable result.
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