How Easy It Is For Appraisers to Misinterpret a Case!

Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.

It was interesting to read Estate of Pauline Welch (T.C.M. 1998-167), which was issued in May 1998. Pauline Welch died on March 18, 1993. At the time of her death, Mrs. Welch was a minority shareholder holding voting and nonvoting shares of two privately owned companies, Electric Services, Inc. (ESI) and Industrial Sales, Inc. (ISC). According to the Court’s opinion (with numbered items noted to facilitate further discussion):

1. The estate tax valuation was done on a net asset valuation method.
2. Employed by the estate, Mercer Capital Management, Inc. (Mercer) valued ESI and ISC at $670,000 and $1,809,000, respectively, as of the date of decedent’s death.
3. [Footnote: Mercer did not consider either ESI or ISC to be in liquidation in valuing their respective stock. Neither ESI nor ISC was liquidated, and both corporations remain in existence and continue to operate to date.]
4. In arriving at these values, Mercer did not include the following real property owned by each corporation: ESI owned real property located at 213-215 5th Avenue South and 301-307 5th Avenue South, Nashville, Tennessee; and ISC owned real property located at 305 5th Avenue South and 302 6th Avenue South, Nashville, Tennessee.
5. Mercer excluded these properties from its calculations because it believed that the properties had been targeted for potential sale to the City of Nashville.
6. Further, Mercer did not apply a discount to reflect the corporations’ built-in capital gains tax liability.
7. In determining the value of decedent’s shares of ESI and ISC on the estate tax return, the estate combined the Mercer valuation of the corporations’ value with estimates of the value of the real property owned by both corporations and then applied a 34-percent discount for built-in capital gains on the real property and a 50-percent discount for decedent’s minority interest.

The sole issue before the Court was whether a 34% built-in capital gain on real estate held by ESI and ISC should be allowed. In filing the Form 706, the estate took values provided by Mercer Capital for each of the companies (which, as noted above, excluded the value of the real estate and, further, adjusted the earnings of the businesses for rental income on the excluded real estate), added estimated values for the real estate, and then deducted a 34% capital gains allowance on the value of the real estate (not just on the gains), and took a 50% minority interest discount to yield the value of the estate’s minority interest in each of ESI and ISC.  At this point, we can address the numbered items in the quotation from the Court’s opinion above:

(1) The Court indicated that the appraisals were prepared on a net asset value method. This is not technically correct. Both companies were operating companies with significant non-operating assets in the form of investment securities.  Earnings values were prepared for each of the companies after adjusting for both the rent on the real estate which was excluded and the earnings from the non-operating assets. In each case, indications of value from both a capitalized earnings method and a net asset value method were employed, with the net asset value method being weighted most heavily in the final correlations of value. 100% of the equity of each company, adjusted to exclude the value of real estate, was valued at modest discounts to net asset value.

(2) Mercer Capital WAS NOT EMPLOYED BY THE ESTATE. We were not aware that there was an estate tax issue at the time of the appraisal.  Our report was prepared as of June 30, 1993, with a report date of September 7, 1993. Quoting from the first paragraph of the ESI report (in the “Assignment Definition” section, which received parallel treatment in the ISI report):

“Mercer Capital Management, Inc. (“Mercer Capital”) has been retained by Electric Service, Inc. (“the Company” or “Electric Service”), Nashville, Tennessee, to provide valuation services.  This report represents an appraisal of the fair market value of the 570 issued and outstanding shares of common stock of Electric Service as of June 30, 1993. The appraisal is prepared on a controlling interest basis. It is our understanding that this report will be used by our client for the purpose of evaluating a possible exchange of shares between the controlling shareholders or a possible sale to a third party.”  The court and the estate clearly relied upon the Mercer Capital report for a purpose for which it explicitly was not intended.  No representative of Mercer Capital was asked to testify regarding the reports.  Our first knowledge of the tax litigation came as the result of a friend calling and asking about our position on built-in capital gains.  We were employed to provide valuations of 100% of the stock of each of the companies for purposes of possible transactions between the companies or the parties. We were NOT EMPLOYED to provide valuations of the minority interest blocks of shares of the companies, which included appreciated real estate assets, for estate tax purposes. (The shareholder lists we were provided did not include the estate as a shareholder.)

(3) We did not consider either ESI or ISC to be in liquidation because neither company was in liquidation, nor was liquidation mentioned as a possible outcome for either business.

(4) Mercer Capital DID exclude the book value (and market values) of the underlying real estate. SUCH EXCLUSION WAS REQUIRED BY OUR ASSIGNMENTS. The objective of our appraisals was to determine the value of the companies ON A CONTROLLING INTEREST BASIS WITHOUT THE REAL ESTATE, because the parties knew that those values would be determined in the near future in the anticipated eminent domain proceedings.

(5) The second paragraph of each valuation report reads as follows:

“The Company’s land and buildings are expected to be acquired by the City of Nashville within the foreseeable future via either a negotiated sale or eminent domain proceedings. As of the date of this appraisal, no price for the fixed assets has been discussed. This appraisal was prepared excluding the value of the Company’s real estate assets.”

We were told that the properties had been “targeted for potential sale to the City of Nashville.” And, parenthetically, they were sold to the City.

(6) Since Mercer Capital excluded the real properties from its appraisals, as indicated above, there was no reason to consider the built-in capital gains taxes on the properties.

(7) The estate, the IRS and the Court accepted Mercer Capital’s values of 100% of the common stocks of ESI and ISC without adjustment. Note that this valuation base was at the controlling interest basis. All parties accepted the estate’s suggested 50% minority interest discount (note that Mercer Capital was not consulted by the estate regarding the magnitude of appropriate minority interest discounts or marketability discounts applicable to the estate’s minority interests in the two companies). The sole issue before the Court regarded the applicability of the estate’s suggested 34% capital gains tax on the appreciated real estate in each business. All the arguments were apparently made by counsel for the estate and for the IRS. The record mentions no expert testimony on the issue. For a fact, no representative of Mercer Capital was called upon to testify.

This communication has been written to make several points:

1. Based upon NO EXPERT TESTIMONY, the Court found that consideration of built-in capital gains is “speculative” and therefore, should not be considered. This decision will undoubtedly be cited by some (including the IRS) regarding the trapped-in gains issue, but it is based on no new expert testimony or evidence.
2. Mercer Capital’s role in the litigation appears to have been misunderstood by the Court (we had no role), and the decision implicitly suggests that we concurred with the estate’s treatment of the real estate and the embedded capital gains. We actually believe that hypothetical and real willing buyers and sellers have hypothetical or real negotiations over embedded capital gains, and that ultimate truth often lies somewhere between a fully taxable consideration of the gains and a no tax consideration, but much closer to the fully taxable consideration. Differences in treatment of this question in operating companies versus holding companies is beyond the scope of this communication.
3. MERCER CAPITAL’S APPRAISALS WERE USED BY THE COMPANIES WHICH RETAINED US OUT OF CONTEXT. Had we been retained to provide valuations for the estate’s minority interests of ESI and ISC, we would have excluded a consideration of a control premium on the operating businesses, and would have considered the application of an appropriate MARKETABILITY DISCOUNT applicable to the nonmarketable minority interests of each company held by the estate.
4. The Welch case reinforces a point we have made many times, that business appraisers need to be exceedingly careful in citing Tax Court decisions as support for positions taken in tax-related valuations.

Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.