Experience and the Test of Reason
The Tax Court opinion regarding the Estate of Thompson vs. the Internal Revenue Service (T.C. Memo 2004-174) is remarkable in that the full opinion is essentially a business valuation analysis. The 54 page decision report includes approximately 18 pages of background and industry set-up work describing the Company and its industry, and an additional 36 pages of business appraisal analysis. As a review appraisal, the Court’s due diligence is limited to the information provided to it by the respective experts.
The subject company, Thomas Publishing Company (TPC) is a private, closely held corporation located in New York City , and is engaged in the production and sale of industrial and manufacturing business guides and directories, including the Thomas Register. The decedent owned 487,440 shares of TPC voting common stock (20.57%) at the date of her death, May 2, 1998 .
The decision describes the disparity between the parties’ valuation as “startling.” That startling disparity and the analyses presented by the respective experts encouraged the Court to perform its own analysis based on information derived from the testimony, as well as its own valuation perspective. This is summarized in the following table:
The sole testamentary beneficiary of the decedent’s shares was also the Co-Executor of the Estate. In the fall of 1998, the Executors hired an Alaskan lawyer to appraise and to prepare a valuation report for the Estate’s 20.57% interest. The Executors had learned about the Alaskan lawyer from a family contact who had met him on a fishing trip. The acknowledged reason for hiring the Alaskan lawyer was to have the IRS audit conducted not by the IRS New York City office, but by the IRS Alaska office where the lawyer believed he would be able to obtain for the Estate a more favorable valuation of the Estate’s TPC stock. The lawyer in Alaska hired an Alaskan accountant to assist him in the valuation. Specific analytical assumptions and related discounts were equally bizarre in the Estate’s analysis, discussed below.
The IRS expert submitted an initial report and then had to revise it since the centerpiece of his valuation was a discounted cash flow (DCF) model, and his initial model started with net cash flow of $13,069,000, which turned out to be incorrect. The correct net cash flow figure was only $1,398,000, which should have had a major downward impact on his value, but didn’t. When the revised numbers didn’t come close to supporting his initial analysis he substituted something called “liquidation value” for his terminal value, but provided what the Court easily determined to be a predetermined answer.
The Court admitted the experts’ reports into evidence, but found them both “to be deficient and unpersuasive in calculating the fair market value of TPC as an entity and in calculating the fair market value of the estate’s 20-percent interest therein.” The Court stated that the lawyer and accountant from Alaska both had relatively little valuation experience. The lawyer “appears to have attended limited appraisal courses, other than a few courses while working for respondent many years ago.” The Court was also concerned about the lawyer being engaged to handle the anticipated audit, an inherent conflict of interest. The accountant “belongs to no professional organizations or associations relating to his appraisal or valuation work.” With regard to the Estate’s experts, “we regard those reports and testimony of the estate’s experts to be only marginally credible.” Moreover, they “were barely qualified to value a highly successful and well-established New York City-based company with annual income in the millions of dollars.”
The Court rejected the IRS expert’s discounted cash flow analysis, since significant errors were made, and the expert’s numerous recalculations were suspect, not sufficiently explained and not persuasive.
The Court pursued its own analysis, generally following a capitalization of earnings approach, summarized below. Our summary comments follow.
- Specific Company risk related to Internet technology and management risk perceived by the Estate, but was totally discarded by the Court based on their perception of the Company’s ability to handle the new media;
- Neither the Estate nor the Court discussed the concept of the growth rate in developing the capitalization rate. It is unclear if they fully understood that you must subtract the growth rate from the discount rate to derive the capitalization rate;
- Sustainable net income was calculated by the Estate after a pretax adjustment of $10 million per year against historical earnings for new technology expenditures related to the Internet. The Court accepted this, but it appears large in context with historical results (at 43% of historical reported pretax income);
- The Court determined $68 million in non-operating assets (more than half of total value) based on balance sheet information disclosing $68 million in short term liquid investments. This is a substantial oversight on the part of the Estate’s expert.
Minority and Marketability Discounts
The Estate’s experts’ 40% minority interest discount was based primarily on their reading of general valuation texts, and their 45% lack of marketability discount was based on several factors, but the Estate’s experts “provided no credible explanation for why they used 40-percent and 45-percent minority interest and lack of marketability discounts, as distinguished from some other numbers.” In general the Estate “based their discounts on general studies and not on the facts of this case … without any credible substantive discussion of how the facts of this case support such particular discounts.” The discounts taken by experts and the Court are shown below. Our summary comments follow.
- The Court either ignored, or was unaware of, the fact that the “build-up” capitalization rate was developed using data from Ibbotson Associates, which itself is derived from minority interest pricing in the public marketplace. Accordingly, no minority interest discount is called for from this perspective (and none was taken by the IRS expert for that reason).
- The Court disagreed with the 45% marketability discount used by the Estate’s expert, since it was based on “general studies and not on the facts of this case,” but applied a 30% marketability discount without any clear quantification methodology. They highlighted this point by saying, “Indeed, but for the fact that respondent’s expert allowed a 30-percent discount for lack of marketability, we might have been inclined to reduce this discount.”
Both Experts Rejected
The Tax Court believed that the Estate’s experts were too inexperienced, accommodating and biased in favor of the Estate. They demonstrated no experience related to the business of the subject company. There was no credible explanation regarding the selection of discounts and how they fit the facts of the case. They had relatively little valuation experience, attended only limited appraisal courses, and belonged to no professional organizations or associations relating to appraisal or valuation work.
The Tax Court perceived that the IRS expert selected his comparable companies in a “casual manner,” that he made significant errors in his calculations and analysis, and made questionable and inadequately explained adjustments in his discounted cash flow analysis which were inconsistent with the methodology utilized in his original report.
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