As the world hoped to return to normalcy after a turbulent 2007, 2008 proved to be a worse year for bankers. A credit crunch and housing collapse maintained the downward pressure on stock prices that began in 2007. 2008 saw the closure of 25 banks nationwide, and the overall banking industry has struggled with deteriorating asset quality and liquidity concerns. In order to gauge the impact of the 2008 financial institution market trends on smaller institutions, Mercer Capital conducted a study of two asset size based bank indices: banks with assets between $500 million and $1 billion (referred to hereafter as the “Small Community Bank Group”) and banks with assets between $1 billion and $5 billion (the “Large Community Bank Group”).
The banking industry made headlines throughout the second half of 2008. The struggles of Freddie Mac and Fannie Mae necessitated nationalization of the two government-sponsored enterprises, and the failures of IndyMac Bank and Washington Mutual Bank fueled the erosion of confidence in the banking industry. Furthermore, the acquisitions of Merrill Lynch by Bank of America and Wachovia by Wells Fargo signaled consolidation in the banking industry in order to survive the economic uncertainty.
In an attempt to provide assistance to the banking industry, the government developed several programs to improve banks’ asset quality and capital positions. Under the Emergency Economic Stimulus Act of 2008, the Troubled Asset Relief Program (“TARP”) was developed with the intention of cleaning up the balance sheets of banks by removing troubled assets from the books. Because pricing the troubled assets was difficult given economic uncertainty, the initial structure of the TARP was abandoned shortly after the program was established. Instead, the Capital Purchase Program under the TARP attempted to provide stability for financial institutions by providing capital injections.
Figure One depicts market pricing trends of financial institutions during 2008. As shown, the Large Community Bank Group saw a price decline of 19.5%, outperforming the overall market, as measured by the performance of the S&P 500, as well as the banking industry, as measured by the SNL Bank Index. For comparison purposes, the SNL Bank Index saw a 45.6% decline in price due primarily to the decline in value of a number of large institutions, and the S&P 500 saw a 38.5% decline in 2008. The Small Community Bank Group observed a decline of 37.8%, reflecting their poorest performance in the last decade.
In order to attempt to isolate the driving trends behind the market performance of these institutions in 2008, we stratified the banks in each group based on TARP participation, asset quality metrics, loan portfolio concentrations, and location. Banks with unavailable financial data were excluded from our stratification, and the resulting analysis included 160 banks in the Large Community Bank Group and 84 banks in the Small Community Bank Group. The following discussion summarizes our findings.
Given market volatility and uncertainty about the effects of new regulations and government support, investors have limited confidence in the overall market. The government is continually amending the TARP regulations and has begun performing stress tests on some of the largest financial institutions to examine banks’ ability to cope with various changes in the economy and try to improve capital positions. As the events of 2009 unfold in accordance with government programs and regulations as well as continued consolidation, the banking industry hopes for improved performance in the second half of 2009.
Reprinted from Mercer Capital’s Bank Watch, Special Edition, May 19, 2009.
While most banks and their directors are generally aware of the tax benefits of an S election, there are some potential disadvantages. One disadvantage is the potential for S elections to encounter additional volatility to the equity account and lower capital ratios relative to C corporations when losses are incurred (all else equal).
When banks are profitable, the impact of the tax election on equity for S and C corporation banks is relatively muted as both pay out a portion of earnings to cover taxes either in the form of a direct payment of the federal tax liability as a C corporation or in the form of a cash distribution to shareholders to cover their portion of the tax liability as an S corporation. However, S corporations are typically limited relative to C corporations in their ability to recognize certain tax benefits when losses occur. The equity accounts of most C corporations benefit from the ability to recognize tax loss carrybacks and deferred tax assets following the occurrence of losses, which serve to soften the direct impact of the loss on capital. S corporations are generally precluded from any tax benefit after the recognition of losses and the resulting loss is directly deducted from equity. A few nasty quirks of book and tax income can make the situation even worse for shareholders and the S corporation bank.
To help illustrate the point further, consider the following example which details how losses realized as an S corporation can flow directly through to equity without the tax benefit recognized by a C corporation. As detailed below, the capital account of the S corporation was impacted more adversely following the recognition of losses than the C corporation (all else equal).
In a recent survey of bank transaction activity nationwide conducted by Mercer Capital, we noticed some evidence of this disadvantage surfacing among S corporation banks. Of transactions (whole bank sales) involving target banks with assets between $100 million and $1 billion announced since June 30, 2008, the majority of S corporation banks sold were distressed, defined as either having non-performing assets as a percentage of assets greater than 3.0% (three out of four transactions involving S corporation targets) or reporting a loss in the most recent year-to-date period (two out of four transactions involving S corporation targets). This trend is illustrated more fully in the chart below and is notable especially when compared to transaction activity of C corporations over this period.
We found some additional evidence that S corporation banks may be experiencing the detrimental impact of additional capital volatility in a review of bank failures. Of 8 total S corporation bank failures since 1998, five have occurred since January 1, 2008, with three occurring since December 1, 2008.
While it is too early to tell whether this evidence of increased transaction activity and failures among distressed S corporations is purely a coincidence or early indications of an emerging trend of capital volatility for S corporation banks, this analysis prompted a number of questions:
If your bank is dealing with any of these issues, feel free to give us a call to discuss the situation confidentially.
An S “election” represents a change in a bank’s tax status. When a bank “elects” S corporation status, it opts to become taxed under Subchapter S of the U.S. Tax Code, instead of Subchapter C of the Code. When taxed as a C corporation, the bank pays federal income taxes on its taxable income. By making the S election, the bank no longer pays federal income tax itself. The tax liability does not disappear altogether, though. Instead, the tax liability “passes through” to the shareholders. This means that the bank’s tax liability becomes the obligation of the bank’s shareholders. While no guarantees generally exist, the bank will ordinarily intend to distribute enough cash to the shareholders to enable them to satisfy the tax liability.
The following table shows what happens when a bank makes an S election. In the table, the bank no longer incurs any federal tax liability following the S election. However, the $350 tax obligation simply “passes through” to the shareholders.
In the preceding table, the bank’s pre-tax income generated a $350 tax obligation, regardless of whether the bank was taxed as a C or S corporation. In the C corporation scenario, the bank directly paid the tax obligation to the government; in the S corporation alternative, the shareholders paid the taxes due on the bank’s earnings. Since the taxes due remain constant at $350 regardless of whether the bank elects
S corporation status or not, what incentive exists for banks to elect S corporation status?
The S election creates two primary tax advantages relative to C corporations:
The best way to illustrate tax advantage #1 is with an example.
In the C corporation scenario, the bank pays $200 of dividends to shareholders. After the shareholders pay taxes on these dividends (at a 15% tax rate on dividends), the shareholders will have after-tax cash flow of $170 from their investment. Assume, instead, that the bank elects S corporation status. In this case, the shareholders owe taxes of $350 (35% of the bank’s $1,000 pre-tax income), but the bank makes distributions of $550. This leaves the shareholders with $200 of after-tax cash flow. No further taxes are owed on the $200. In fact, for any amount of distributions between zero and $1,000 (the bank’s pre-tax earnings), the shareholders will generally face tax liability of $350. By electing S corporation status, therefore, shareholders increase their after-tax cash flow from $170 to $200, an 18% increase.
Given the aforementioned tax benefits, why would every bank not elect S corporation status? Several potential disadvantages of the election exist:
To minimize these risks, the board of directors and management may adopt a more conservative management style for the S corporation bank than the C corporation bank. For instance, higher capital ratios may be desirable. In addition, the bank may adopt more strict underwriting requirements or maintain a lower loan/deposit ratio to reduce the risk of losses.
S corporation elections may be an attractive alternative for banks, but a careful examination of the advantages and disadvantages is necessary. Banks with relatively low balance sheet growth and high profitability often make the best candidates for S elections, because these banks have the capacity to distribute a large portion of their earnings. On the other hand, an S election would be less beneficial for other types of banks. For instance, banks that intend to pursue acquisitions or that have potentially volatile earnings may be better served by remaining C corporations.
If your bank does elect to make an S election, it is typically more complicated than simply “checking a box” on a tax filing. Instead, a number of professionals may need to be involved to ensure the bank’s goals are achieved:
Reprinted from Mercer Capital’s Value Matters™ 2008-08, published August 31, 2008
Capital raising efforts among financial institutions began in earnest in late 2007, primarily among money center banks and investment banks suffering under the weight of mark-to-market adjustments on various asset types. Banks with fewer assets marked to fair value through the income statement largely maintained sufficient capital to manage the initial wave of industry problems. However, the capital pressures intensified in 2008 as past-due levels and losses increased across a spectrum of loans tied to real estate, causing a number of banks to reassess their capital positions and, in some cases, to capitulate under the weight of the external environment and seek out additional capital.
This article provides a summary of capital raising transactions that have occurred in 2008 and offers insight into the financial considerations present in evaluating each capital alternative. These considerations are relevant whether a bank is in the position of raising capital to buttress the balance sheet or, alternatively, has an opportunity to make an investment in another bank facing a capital shortfall.
The surest way to shore-up capital ratios is through the issuance of common stock, which places no pressure on the company’s cash flow if no dividends are declared. The primary disadvantage of common stock offerings is the dilution that current shareholders may experience to their ownership positions and future earnings per share.
Figure One indicates recent common stock offerings. Most of the issuances have occurred at discounts to the issuer’s stock price prior to the transaction. In one-half of the issuances, the offering price for the common stock was less than pro forma tangible book value per share (existing tangible book value, plus the equity raised in the offering). One recent article noted that investors were potentially willing to purchase stock at tangible book value per share, as adjusted to reflect the investors’ estimate of expected losses in the loan portfolio.
In considering a common stock issuance, important questions for community banks to consider include:
Depending on its structure, preferred stock can bear a resemblance to either long-term debt or equity. In its simplest form, “straight” preferred stock economically resembles long-term debt with either fixed or floating rate payments. Convertible preferred stock is a hybrid instrument that combines elements of both debt and equity. Generally, convertible preferred stock has a lower dividend rate than straight preferred stock, but a higher yield than common stock. To compensate investors for accepting the lower current return, the investors receive the right to participate in the appreciation of the common stock. Further, preferred stock dividends can be either cumulative (meaning that dividends are accrued in the intent of paying such dividends later) or noncumulative.
From a bank’s perspective the advantages of preferred stock include:
Potential disadvantages from a bank’s perspective include:
From an investor’s perspective, preferred stock can be an attractive alternative to common stock. For convertible preferred stock, the investor may receive a dividend in excess of the common stock’s dividend, plus the right to enjoy appreciation in the underlying common stock. Thus, the higher dividend protects the investor’s downside (to the extent the issuer actually pays the dividend). Further, if the investor is a corporation, the tax deduction for dividends received may be available.
Preferred stocks have been a popular capital raising tool in the present environment, owing to their flexibility and the downside protection afforded to investors. Figure Two indicates issuances announced during 2008.
When structuring a preferred stock issuance, important considerations include:
From an issuer’s perspective, the most unattractive terms include a high dividend rate and a low conversion premium. As an example, consider South Financial Group’s May offering of 10% preferred stock with a 0.3% conversion premium.
Trust preferred securities are a hybrid instrument, combining the tax treatment of debt and the Tier 1 capital treatment of equity. From a bank’s perspective, the favorable after-tax cost of capital represents one of the primary advantages. Prior to late 2007, another significant advantage of trust preferred securities was that community banks could easily access the capital markets by participating in one of the pooled offerings underwritten by investment banks. As conditions in the credit markets deteriorated, this advantage disappeared, as the pooled offerings have largely vanished from the marketplace, although they may eventually return if investor demand improves.
Figure Three indicates data on trust preferred securities offerings announced in 2008 by publicly traded banks. While pooled offerings have not occurred in 2008, several smaller publicly traded banks have placed trust preferred securities with institutional investors. The pricing in these offerings has increased since the last pooled offerings, which often contained spreads in the range of 150 basis points over LIBOR. The variable rate offerings indicated in the table contain spreads in the range of 350 basis points over LIBOR.
While the availability of trust preferred securities through pooled offerings is currently uncertain, other investors may exist. Alternatively, banks can consider issuing trust preferred securities to local investors or shareholders. Although this type of offering may require more time and professional fees than a pooled offering, the bank will still enjoy the significant tax and capital benefits of trust preferred securities. Questions to consider for banks include:
In the event that the bank needs to raise Tier 2 capital, instead of Tier 1 capital, subordinated debentures may be desirable. Subordinated debentures may be included in Tier 2 capital, subject to a limitation equal to 50% of Tier 1 capital. Like trust preferred securities, interest payments on subordinated debentures are tax deductible. Subordinated debentures can be issued at the subsidiary bank level, which may decrease their credit risk for investors, relative to instruments that require the holding company to maintain sufficient liquidity from bank dividends or other sources of funds.
Figure Four indicates the pricing of subordinated debenture offerings in 2008. While few community banks are included in this group of offerings, subordinated debentures may remain an attractive alternative to curing a Tier 2 capital need. Transactions announced in April and May have occurred at interest rates ranging from 8.75% to 9.50%. All of the issuances have involved either ten or thirty year terms.
For community banks where subordinated debentures may solve a problem, the following questions should be considered:
For community banks needing capital, the alternatives possess substantially different impacts on existing shareholders and the bank’s future returns, not to mention divergent capital treatments. For potential investors in community banks, downside protection is important in the present environment. As a result, recent capital raises have included common stock issued at discounts to the issuer’s market price and convertible preferred stock issuances with relatively high dividend rates and low conversion premiums.
Mercer Capital can assist community banks and investors with considering the advantages and disadvantages of the spectrum of capital instruments available to a particular bank, focusing on their effects on existing shareholders and future shareholder returns, as well as evaluating the pro forma capital impact of different instruments and offering amounts. We can also assist banks and investors in determining an appropriate stock price or interest rate in offerings sold to local investors, analyzing, from an investor’s standpoint, the advantages and disadvantages of different proposed investment structures, and providing fairness opinions that the capital offering is fair to a specified group of shareholders.
Reprinted from Mercer Capital’s Bank Watch 2008-05, published May 28, 2008.
The majority of respondents to a recent survey presented in the January 2008 edition of Mercer Capital’s Bank Watch are expecting a difficult, if not dismal, 2008. Nearly 83% of respondents believe that the American economy will be in a recession at some point during 2008. In keeping with this theme, virtually all of the respondents believe that interest rates will decline in 2008, and none expect them to increase, with approximately two-thirds of respondents expecting a decline of more than 50 basis points. Given the actions taken by the Fed after this survey, this is not surprising. Despite the current industry focus on credit quality, 40% of respondents listed margin performance and the interest rate environment as their primary concern going into 2008.
Opinions were rather mixed concerning when the industry’s earnings will bottom out, with approximately one-third of respondents indicating the first half of 2008, the majority (43%) indicating the second half of 2008, and the remainder stating that it will be 2009 or beyond before earnings recover. One lone dissenter believes earnings reached bottom in 2007.
However, with the credit crisis still in full force and the dominant topic in the industry for months now, the focus of concern continues to be the quality of the loan portfolio, with 66% of respondents listing that as their primary concern for 2008. Responses were mixed, however, with regard to the types of loans that will present the most problems in 2008.
We’d like to thank everyone who took the time to respond to the survey. We hope that you find the results informative.
Reprinted from Mercer Capital’s Bank Watch, February 26, 2008.
As the world celebrated the closing of another year on December 31, many bankers hoped to soon forget one of the worst periods for bank stock performance in recent history. Credit quality concerns, margin pressure, slowing earnings growth, and a declining housing market took a toll on the market for shares of publicly traded banks, which generally underperformed broader market indices such as the S&P 500 for the year. Seemingly, no public bank was left untouched by the effects of the subprime market collapse and subsequent credit market disruptions; Bank of America and Citigroup, the two largest banking institutions in the U.S., saw price declines of 22.7% and 47.2%, respectively, from year-end 2006 to year-end 2007.
But how has the market affected community banks? Mercer Capital observed two asset size-based bank indices – banks with assets between $1 billion and $5 billion, and banks with assets between $500 million and $1 billion – to gauge the impact of the 2007 financial institution market trends on smaller institutions.
As shown in Figure One, the larger group of banks with assets greater than $1 billion and less than $5 billion felt a more severe impact than the banking industry overall (as measured by the performance of the SNL Bank index) with a year-over-year price decline of 28.9%, reflecting the worst performance observed over the past ten years. For comparison purposes, the SNL Bank index exhibited a decline of 25.2%, while the S&P 500 saw a slight increase of 3.5% for the same period. The unfavorable performance of the larger index was fairly widespread, with 97% (158 out of 163) of the banks reporting price declines in 2007. More than half of the group experienced larger declines than the SNL Bank index overall. Of the five banks with an increase in stock price from 2006 to 2007, four were either targets in a merger or acquisition or the subject of strong takeover speculation.
Public banks with assets between $500 million and $1 billion fared somewhat better, with an overall decline of 21.7%; however, the price decline observed for these banks also reflected the most unfavorable performance in the last decade. Of the 102 banks included in the group, 84% saw declining prices in 2007, with 42% reporting price declines greater than that observed for the SNL Bank index.
Figure Two reflects the historical trend in market performance for the two size-based indices with the 2007 performance notably weaker than 1999, the weakest previous year since 1997. One dollar invested in the larger bank index at the beginning of 1997 would have been worth $3.80 at year-end 2006 but declined to $2.97 at year-end 2007.
In order to attempt to isolate the driving trends behind the market performance of these institutions in 2007, we stratified the banks in each group based on location, loan portfolio concentrations, and asset quality metrics. Tables One and Two and subsequent discussion summarize our findings.
For the larger index, 42 banks were located in higher-risk markets where home price appreciation skyrocketed during the housing boom and are now experiencing the most rapid real estate market declines (Florida, California, Nevada, Georgia, or Colorado) or markets with a struggling local economy (Michigan). Of these banks, 100% reported price declines with a median decrease of 44%. Results for banks in the smaller index located in the same markets were similar, with 95% of the 21 banks reporting a price decline and a median decrease of 37% for the entire group.
Twelve of the larger public banks reported construction & development loans accounting for more than 40% of their loan portfolio at September 30, 2007; all of which saw price declines from 2006 and eleven of which underperformed the SNL Bank index. The median price decline for the larger banks with high concentrations of construction and development loans was 48%, substantially above the median for the $1 billion to $5 billion group overall. The remaining banks in the index reporting construction and development credits at less than 40% of total loans experienced a median price decline of 26%.
For the smaller bank index, each of the nine banks reporting C&D loan levels higher than 40% of loans at September 30, 2007 experienced price declines greater than the SNL Bank index and saw a median price decline of 43% for 2007. The median price decline for the remaining banks in the index was 20%.
Of the 163 banks in the larger index, nine reported commercial real estate loans comprising more than 50% of their entire portfolio at September 30, 2007. Of these banks, eight reported price declines more severe than the overall bank index, with price declines ranging from 21% to 62%. The median price decline for the group was 50%. For comparison purposes, the remaining banks in the index with CRE concentrations less than 50% reported a median price decline of 26%.
CRE concentration observations were less conclusive for the smaller bank index, as the median price decline was less than that observed for the banks with low CRE levels. The pricing disparity may reflect the small number of banks in the index with higher CRE levels, three of which reported price increases apparently reflecting other factors, such as strong asset quality and lower concentrations of riskier construction loans.
24 of the banks with assets between $1 billion and $5 billion reported non-performing assets measuring greater than 2.00% of loans plus OREO at third quarter-end. Of these banks, 22 (92%) underperformed the SNL Bank index; the median price decline for the group was 52%. The remaining banks with non-performing asset ratios less than 2.00% experienced a median price decline of 23%, with less than half underperforming the SNL Bank index. Eight banks in the smaller index reported non-performing assets greater than 2.00%, seven of which saw a price decline greater than the SNL Bank index. The median price decline for these banks was 36%, as compared to 20% for the remaining banks in the index with stronger asset quality metrics.
The above observations regarding smaller publicly traded banks are consistent with the performance of many community banks throughout the U.S. Those with a significant portion of loans in areas with a rapidly declining housing market, high levels of construction and development or CRE credits, or unfavorable trends in asset quality have been viewed more negatively in public markets than those without such characteristics. Banks in this situation may be more likely to encounter earnings obstacles in the near future as the real estate market and credit issues are resolved.
At the time of publication, most of the banks observed in these studies had not yet released financial data for the fourth quarter. As such information is released, our observations of the stock market performance and financial characteristics of the banks discussed above will be updated and further examined in a future issue of Bank Watch.
Reprinted from Mercer Capital’s Bank Watch, January 2008.
On March 31, 2010, Diamond Foods, Inc. completed its acquisition of Kettle Foods, a premium potato chip manufacturer. Diamond paid approximately $616 million for Kettle Foods and $235 million, or nearly 40%, of the purchase price was allocated to “brand intangibles”.1 Such a high value leads to the question: How are such valuations determined and what are the drivers?
Whether it’s the name of an entire business or a single product, trade names can represent substantial value in business transactions and are recognized as a marketing-related intangible asset under ASC 805. ASC 805 states:
“Trademarks are words, names, symbols, or other devices used in trade to indicate the source of a product and to distinguish it from the products of others.”2
Generally the relief from royalty method is used to determine the fair value of a trademark or trade name. The relief from royalty method seeks to measure the incremental net profitability generated by the owner of the subject intangible asset through the avoidance of royalty payments that would otherwise be required to enjoy the benefits of ownership of this asset.
Applying the relief from royalty method requires several steps:
So what might the valuation of a trademark like Kettle Foods look like?
The professionals at Mercer Capital are experienced in valuing trademarks and trade names in numerous industries. Please contact us to find out how we can help you measure the fair value of acquired intangibles.
Endnotes
1 Diamond Foods, Inc. Form 10-Q, October 31, 2010.
2 ASC 805-20-55, paragraph 16.
The AICPA released a draft accounting and valuation guide for “Assets Acquired to Be Used in Research and Development Activities” in November 2011. The guide replaces the 2001 practice aid “Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices & Pharmaceutical Products.” The draft guide focuses on the treatment of acquired intangible assets that will be used in research and development efforts subsequent to the transaction (“In-Process R&D” or “IPR&D” assets). IPR&D assets also include assets expected to be used defensively to protect assets related to ongoing R&D projects. Here are five takeaways from the draft guide:
Mercer Capital provides a range of fair value measurement services to financial managers. Please contact us to explore how we can help you measure and document the fair value of IPR&D assets.
On August 10, 2011, the FASB approved a pending exposure draft, "Testing Goodwill for Impairment.” The revision to the accounting standards codification adds an optional qualitative assessment (referred to by some as the “Step Zero” test) to the annual goodwill impairment testing process. If, on the basis of an assessment of various qualitative factors, the reporting entity determines that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, the fair value of the reporting unit need not be measured. In other words, Step 1 of the goodwill impairment test will no longer be required if a reporting unit passes the qualitative Step Zero assessment.
The paragraphs added to Topic 350 (350-20-35-3A through 350-20-35-3G) include examples of events and circumstances that should be evaluated in preparing the qualitative assessment. The examples cited encompass macroeconomic, industry, market, and firm-specific factors.
A few things to keep in mind regarding this new addition to the codification:
The fair value reporting terrain continues to be rugged and uncertain. We are here to help. If you would like to discuss in confidence how the Step Zero test might apply to your company, please give one our experienced professionals a call.
Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to share risk related to uncertainty of future events, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.
ASC 805, the section of the FASB codification that addresses business combinations, requires that:
In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.
The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.
For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as commercialization of a development-stage product) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive regulatory approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.
In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to contact us in confidence.
In December 2010, the FASB issued ASU 2010-28, which updated rules pertaining to the appropriate measure of reporting unit carrying value. Historically, the carrying value of a reporting unit could be measured on an equity or total capital basis, as long as it was compared to the corresponding measure of value for the Step 1 goodwill impairment test. ASU 2010-28 mandates that reporting unit carrying value can only be measured on an equity basis. Under the Step 1 impairment test which compares reporting unit carrying value to fair value, any reporting unit with a zero or negative equity carrying value automatically passes the test (because the fair value of an equity stake generally cannot be less than zero).
To address this issue, ASU 2010-28 introduces the new requirement that any reporting unit with zero or negative carrying value must automatically perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The update provides a list of qualitative factors that should be considered in making this "more likely than not" determination, examples of which include:
For public entities, the update is effective for fiscal years beginning after December 15, 2010. For non-public entities, the update is effective for fiscal years beginning after December 15, 2011, but early adoption is permitted.
The Public Company Accounting Oversight Board (PCAOB) recently released the Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis which identified instances where auditors failed to comply with PCAOB standards. The document specifically references a number of fair value-related items including goodwill impairment, intangible assets, contingencies, complex or illiquid financial assets, and other fair value measurements.
Here are some tips for reporting entities to keep in mind through 2011 and 2012:
At Mercer Capital, our goal is to minimize the hassle and disruption of the fair value measurement and review process for all parties involved, including company management, the audit team, and the auditor’s valuation review team.
When it comes to portfolio company fair value measurement and reporting, 2011 lacked the drama of 2008 and 2009. New procedures and policies spawned by SFAS 157 (now Topic 820) have hardened into established routines, the FASB did not offer any new crisis-related guidance, and (with the exception on a rather petulant August) financial markets were reasonably well-behaved. Nonetheless, private equity fund managers – and their limited partners – cannot take fair value measurement for granted. To help ensure that the upcoming year-end portfolio fair value measurement process is as uneventful as it should be, we have created the following checklist to help fund managers measure the fair value of portfolio company investments.
Mercer Capital provides a range of fair value measurement services to investment fund managers. We are always happy to discuss your valuation issues in confidence as you plan for the year-end fair value measurement cycle. Give us a call today.
The FASB issued an exposure draft regarding a broad range of proposed amendments to Topic 820 on June 29, 2010, with a comment period extending through September 7, 2010. The exposure draft is part of the ongoing convergence project and is intended to more closely align fair value measurements under U.S. GAAP and IFRS. For the sake of our busy friends and colleagues who may not have reviewed the exposure draft yet, we offer a quick overview of some of the more significant proposed changes.
The pace of change at the FASB and IASB shows no signs of slackening. At Mercer Capital, we continue to monitor these developments so we can help make fair value measurement as painless as possible for our clients and their auditors. Our financial statement reporting professionals are always eager to discuss your fair value reporting issues in confidence. Give us a call today.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, originally published August 30, 2010.
Every valuation assignment begins with a determination of the appropriate definition, or standard, of value. The standard of value provides guidance about how value is determined and from what perspective. The appropriate standard of value for most financial reporting valuation assignments, including impairment testing, is fair value, as defined in ASC 820.
Note that fair value is different than other standards of value such as fair market value or the legally-defined statutory fair value.
Fair value is defined in the glossary of ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value assumes a hypothetical transaction for the subject asset or liability at the measurement date. ASC 820 provides additional clarification related to the nature of this hypothetical transaction, which we summarize below.
ASC 820 explicitly states that fair value assumes exposure to the relevant market for a sufficient period of time for normal marketing activities. The hypothetical transaction is not a forced liquidation or distressed sale. However, it does reflect prevailing market conditions.
Fair value is measured from the perspective of the owner of the asset. In other words, it is measured as the price that would be received to sell an asset (exit price) rather than the price that would be paid to acquire an asset (entry price). In the context of measuring the fair value of a reporting unit, exit and entry prices are often indistinguishable.
According to ASC 820, the hypothetical transaction occurs in the “principal market” for the asset, or if there is no principal market for the asset, the hypothetical transaction occurs in the “most advantageous market” for the asset. The principal market is defined as “the market in which the reporting entity would sell the asset… with the greatest volume and level of activity….” In the context of ASC 350, there is generally no principal market for reporting units (or intangible assets); unlike securities, reporting units are not homogenous assets with active markets. So what is the most advantageous market?
The most advantageous market is defined as “the market in which the reporting entity would sell the asset… with the price that maximizes the amount that would be received for the asset… considering transaction costs in the respective markets.” Depending on the circumstances surrounding a particular situation, the most advantageous market for a reporting unit could be the market made up of strategic buyers or the market made up of financial buyers. In any case, the most advantageous market is ultimately defined by the relevant market participants, as we will discuss later.
While transaction costs should be included in the consideration of the most advantageous market for the given asset, these costs must be excluded from the fair value measurement itself. Transactions are an attribute of a market rather than the subject asset itself, and as such, they are not a component of the “price that would be received”.
Fair value is defined from the perspective of market participants rather than a specific party, such as the reporting entity. A market participant is defined as 1) an unrelated party, 2) knowledgeable of the subject asset, 3) able to transact, and 4) motivated but not compelled to transact. In the context of the most advantageous market, potential market participants could be existing industry players, companies looking to enter the industry, private equity investors, or other parties.
ASC 820 clarifies that it is not necessary to identify specific market participants, but rather the characteristics that distinguish market participants in the given situation should be identified. For example, private equity investors generally rely on different funding sources than large operating companies; this is a distinguishing characteristic that would be relevant in the context of fair value.
Fair value is determined with reference to the assumptions market participants would use in valuing the subject asset or liability; assumptions used by the reporting entity may not be consistent with those made by market participants.
Fair value also assumes that an asset will be employed in its highest and best use by market participants. Highest and best use is defined in ASC 820 as the use that would maximize the value of the asset or group of assets within which the subject asset would be used. Fair value should be determined based on the hypothetical transaction price assuming the asset would be used within the “highest and best use” asset group, and that the other assets in that group would be available to market participants. If an asset is most valuable outside the context of any other assets, the fair value should be measured based on a hypothetical transaction of the asset on a stand-alone basis.
For reporting units, the use of an “in-use” or “in-exchange” valuation premise is not often controversial. The delineation of the likely market participants is often more significant in determining the degree to which synergies with potentially complementary businesses ought to be reflected in the fair value measurement.
Having discussed the definition of value pertinent to goodwill impairment testing, we will introduce some foundational valuation concepts in the following sections.
Generally accepted valuation theory (as well as ASC 820) recognizes three general approaches to valuation. , Within each approach, a variety of valuation methods (or techniques) can be applied to fair value measurement in a given situation. ASC 820 states that valuation techniques consistent with these approaches should be used to measure fair value.
In the context of measuring the fair value of a reporting unit for purposes of the Step 1 goodwill impairment test, valuation techniques under the market and income approaches are generally most appropriate. Business valuation techniques under the cost approach frequently do not capture the value of goodwill and certain other intangible assets; in such cases, the resulting valuation indications would not be consistent with the objective of measuring fair value.
Inputs to the various valuation techniques may be either observable or unobservable. ASC 820 contains a hierarchy which prioritizes inputs into three broad levels:
Fair value measurements should rely on the highest level inputs available. ASC 820 notes that the availability of inputs can impact the selection of valuation techniques, but clarifies that the hierarchy prioritizes valuation inputs, not techniques.
Fair value measurements for impairment testing tend to rely heavily on Level 3 inputs, but can also include Level 2 inputs. Common inputs include:
By their nature, unobservable inputs cannot be derived from external market information. Accordingly, unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1, May 2010
For privately held companies (particularly those sponsored by private equity and venture capital funds), getting the valuation process right the first time for equity compensation grant compliance is always the least expensive route in terms of both direct and indirect cost.
In general, it is safe to expect the level of scrutiny over equity compensation-related valuation to increase with the size of the equity compensation grant – both the absolute magnitude (in terms of dollars) and relative magnitude (as a percentage of total revenue or enterprise value). While complexity of the equity compensation grant or capital structure does not inherently increase scrutiny, it does make it more challenging to demonstrate clear compliance with tax and financial reporting regulations. With appropriate awareness, management can minimize total compliance cost by selecting valuation procedures appropriate to the situation and getting it right the first time.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, April 2010.
With many acquirers spending 2009 on the sidelines, the new accounting treatment for contingent consideration arrangements under SFAS 141R remains largely untested. When markets thaw, however, we expect that acquirers will be anxious to make up for lost time, and a resumption of deal activity will spark new conversations with auditors regarding the appropriate treatment of earnouts and other forms of contingent consideration.
As an expression of our faith in the future of the economy, we offer a few cautionary notes regarding the accounting for contingent consideration.
Reprinted from Mercer Capital's Financial Reporting Flash, published November 6, 2009.
Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.
Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.
While every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:
A purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:
The purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.
Discussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.
The intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.
After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).
The historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.
This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).
Transaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.
The report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.
Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.
At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”
A purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
Reprinted from Mercer Capital’s Value Matters (TM) 2007-10, October 2007.
Reprinted from Mercer Capital’s E-Law Newsletter 00-03 & 2000-04, March 13, 2000.
On February 15, 2000, the Weinberg case was filed in U.S. Tax Court. [Estate of Etta H. Weinberg, et al, v. Commissioner, T.C. Memo. 2000-51.]
Since we had just reported in this year’s first E-LAW that we were unaware of any published opinions in which the QMDM was discussed, I was rather excited to read the case. I received a copy on February 19th and pages 20 and 28 were flagged for my attention. I quickly turned to page 20 and read:
“Dr. Kursh [who was the IRS’ expert] then applied a marketability discount. In order to determine the amount of this discount, he used the Quantitative Marketability Discount Model (QMDM) that is described in a book written by Mr. Z. Christopher Mercer entitled Quantifying Marketability Discounts (1997).”
I then turned to page 28 where I read:
“. . . we did not find the QMDM helpful in this case.”
Wow! My first reactions were irritation, worry, and anxiety, not necessarily in that order. This was the first reported case to my knowledge in which the QMDM has been addressed and things didn’t look so good.
But, like every case, Weinberg is based on a particular set of facts and circumstances. We need to review the case, the treatments of the valuation issues by the two experts and the Court in order to place Judge Whalen’s comments about the QMDM into proper perspective.
Let me say that after reviewing the case, I believe the Court DID find the QMDM helpful, as is proven by the results of the case. In fact, Weinberg is not a case about the marketability discount but about the minority interest discoun.
The conclusions of the experts and the Court are summarized in Table 1 so readers can see where we are headed at the outset.
The experts in the case were:
This E-LAW is based on the facts as presented in the Court’s opinion. We supplemented our review of the opinion by obtaining a copy of Dr. Kursh’s valuation report and talking briefly with him about his report. We have not yet been able to obtain a copy of Mr. Siwicki’s report. We chose to take time for a complete analysis of the case rather than responding quickly. Thanks to all of our readers who have called to let us know about the case or to inquire about our response. Here it is.
Etta H. Weinberg, the decedent, died on December 15, 1992, the valuation date in this case. On the date of her death, the decedent possessed a general power of appointment over the principal of a marital deduction trust that had been created under her late husband’s will referred to as Trust A. Trust A owned a 25.235% interest in Hill House Limited Partnership (“Hill House” or “the FLP”). Hill House owned and operated an 11-story, single building apartment complex that contained 188 apartments, an office suite, an underground parking garage, and a swimming pool. The complex had been built in 1964. Occupancy exceeded 98% as of the valuation date. [Dr. Kursh visited the property in connection his appraisal. He commented that the location of the property resulted in extremely low vacancy rates. He further stated that the property was visually in excellent condition, and that, according to management, there were no significant deferred maintenance issues.]
The apartment had a mortgage with four remaining monthly installments of principal and interest of $18,406. [Other things remaining the same, the FLP’s annual cash flow was going to increase by $220,872 ($18,406 x 12 months) within four months.] The parties stipulated that the fair market value of the apartment complex was $10,050,000. [This was the average value of two real estate appraisals prepared in this matter ($9,600,000 and $10,500,000)]
The Hill House Limited Partnership Agreement provided the general partner “sole discretion to determine when distributions are made” and that “such distributions shall be made pro rata to the Partners in accordance with their respective Percentage Interests.” There was a restriction on transfer in the Agreement giving all the other partners a right of first refusal for any interests any partner hoped to sell on the same terms and conditions offered by a third party. And the agreement provided that the general partner had sole discretion to consent to or to deny the substitution of a limited partner, unless the purchaser of an interest was already a partner. Trust A’s 25.235% interest was the largest limited partnership interest. There were three interests of 14% to 15% each, three more interests on the order of 9%, and a final 3% interest in the FLP. The decedent’s son was the sole general partner with a 1% interest.
The financial statements summarized in the Court’s opinion provided the information found in Table 2 which is supplemented by relevant calculations.
During the period reviewed, Hill House experienced growth in net income and maintained a strong cash position while making substantial distributions of its earnings. Average distributions for the 1990-1992 period totaled $683,333, or 82% of net income.
A market value balance sheet providing a stipulated net asset value is reproduced in Table 3.
The sole issue for the Court’s consideration was the fair market value of the subject 25.235% interest in Hill House Limited Partnership. While the Court summarized the valuations of the experts based on the subject interest, we will discuss the value of the partnership in its entirety in order to maintain visible relationships to net asset value and to distributions as we proceed.
The Court concluded that the fair market value of the subject interest was $1,309,651. Although there is a specific valuation rationale for the Court’s conclusion, we note that the conclusion is approximately a splitting of the difference between the two appraisals presented to the Court.
Mr. Siwicki’s valuation (on behalf of the taxpayer) is summarized in Table 4.
Mr. Siwicki used two methods in arriving at his conclusion, the capitalization of income method, and a “net asset value method.” In reality, we will see that he effectively used a single method. Beginning with Partnership Profiles, Inc.’s May/June 1992 publication (covering 1991 transactions), “The Perspective,” Siwicki narrowed his search from all 85 publicly registered partnerships to seven that invested in residential property, had little or no debt, and made cash distributions to limited partners. In the final analysis, he relied on a single company, IDS/Balcor Income Properties, as the basis for his capitalization rate of 11.0%, and discount to net asset value (NAV) of 51%.
Siwicki capitalized the three-year average distributions of $683,333 using a capitalization rate of 11.0% to reach an indication of value of $6.2 million. Note that Siwicki is capitalizing a measure of distributions expected to be available to the limited partners and not the cash flow of the enterprise.
He did not capitalize the higher level of 1992 distributions ($800,000), nor did he consider that potential annual distributions could soon exceed $1.0 million as result of the mortgage expected pay-off in four months. In other words, it appears that Siwicki capitalized far less cash flow than the cash flow that was currently being distributed or that might reasonably be expected to be distributed in the near future.
Siwicki then applied the discount to NAV from the single comparable of 51% to the net asset value of $10.3 million to reach a “net asset value” of $5.9 million. Note, however, that the discount of 51% to NAV for the comparable was created because the yield on its NAV was not sufficient to induce a buyer to come forth at a higher price. For example, assume that the dividend of IDS/Balcor Income Properties was $1.00 per unit. If that dollar was priced to yield 11.0%, it was priced at $9.09 per unit (i.e., $1.00 / 11%). Correspondingly, the $9.09 per unit price represented a 51% discount to IDS/Balcor’s NAV, so its NAV is $18.55 per unit (i.e., solving for X when $9.09 = (1 – .51X)).
There is no new information in the NAV calculation. It is simply a proxy for a capitalization of income, and not, strictly speaking, a net asset value method. The reason that his capitalized income figure yields a higher indicated value results from Hill House’s higher payout percentage relative to the selected comparable. [Dr. Kursh indicated that he tried to explain this issue during his testimony. Unfortunately, the Court either did not understand or did not agree with his explanation. The fact is, Kursh’s interpretation is correct.]
Siwicki used weights of 75% on his capitalization of income method and 25% on his net asset value method, yielding an indication of value prior to the application of his marketability discount of $5.9 million, or a 43% minority interest discount to net asset value of Hill House of $10.3 million. Note that the yield at this indication of value is 11.5% based on the 3-year average distributions, and 13.5% based on 1992 distributions, before the application of a marketability discount.
At this point, Siwicki “reviewed various market studies on illiquid securities” to arrive at a 35% marketability discount. In particular, he relied upon the 1971 SEC restricted stock study. After applying his 35% marketability discount, Siwicki concluded that the fair market value of the limited partnership was $3.9 million, or 37% of net asset value of $10.3 million (i.e., a 63% discount from NAV).. The value of the subject interest of 25.235% was therefore $972 thousand. The yields implied by his conclusion are 17.7% based on three-year average distributions and 20.8% based on 1992 distributions.
Dr. Kursh’s valuation is summarized in Table 5 and commented on below.
Dr. Kursh used only one method, a capitalization of income method, in valuing the subject interest. He used this method to determine an effective minority interest discount from NAV.
Beginning with the May/June 1993 issue of “The Perspective” published by Partnership Profiles, Inc. (covering 1992 transactions) Kursh selected partnerships that owned residential and/or commercial real estate. These partnerships also had low debt or leverage, had cash flows greater than their distributions and capital expenditures, and had assets that were valued by independent appraisers. Yields on the selected partnerships ranged from 9.3% to 11.6%, and Kursh selected a base rate of return of 10.45% (the median). He adjusted this yield for: a) the lack of diversity of the subject (+0.50%); b) commonality of interests (-1.00%, because the general partner was also a limited partner; and, c) distressed sales in the Partnership Profiles data base (-0.25%). His resulting yield applied for capitalization was 9.7%.
Kursh recognized that the mortgage would soon be paid off and that there would be a substantial increase in cash flow thereafter. He used distributions of $800,476 (after adjusting for his rounding) for 1992 as the “minimum level that a potential buyer would anticipate.” [His reasons for this assumption included the long history of paying dividends, the known increase in cash flow in four months, the excellent condition of the property and the fact that the general partner had substantial interests (direct and indirect) in the distributions to the limited partners.] His resulting marketable minority indication of value was $8.3 million, or a 20% minority interest discount to net asset value of $10.3 million.
Kursh used the QMDM to arrive at a marketability discount of 15%. Now some jaded readers are likely to think that he used a lower than “normal” marketability discount because his client was the IRS. In fact, Kursh used a lower than “normal” marketability discount because a low discount was warranted by the facts! And the Court agreed.
There are five key assumptions to the QMDM. The Court noted four of them used by Kursh.
The expected growth rate of value was estimated at 3% to 4%, based on expected inflation. Note that this is consistent with recent growth in earnings shown above. We will use 3.5% in this analysis. Kursh assumed that the expected growth rate in dividends would be in the same 3% to 4% range. We will use 3.5% in our analysis. [This assumption regarding the expected growth of distributions is clear from Kursh’s report, although not noted by the Court.]
His expected distribution yield was 10% ($800 thousand / $8.3 million, rounded).
He assumed a required holding period return of 16.4%. He used a build-up method beginning with Treasury yields and added a total of 9.2% for a combined large and small stock premium. To his resulting base equity discount rate of 14.4% he added a 1% premium for holding period uncertainty and another 1% premium for lack of diversification. He then bracketed this discount rate and assumed a relevant range of required returns of 16% to 18% in his analysis.
And Kursh assumed that the expected holding period would be between 10 and 15 years.
Kursh presented QMDM tables that, under his assumptions, yielded a marketability discount of 15%. His conclusion of 15% is highlighted for visual reference. The Court’s conclusion of 20% is also shown to be well within the range of judgment indicated by Dr. Kursh’s assumptions! (see Table 6)
A detailed QMDM analysis summarizing Dr. Kursh’s assumptions, and showing his conclusion regarding the marketability discount, that of the Court, and the investment indicated by the Court’s variation on Kursh’s assumptions is provided as Table 7.
Applying the 15% marketability discount to a capitalized income indication of $8.3 million yielded a value of $7.0 million for the FLP, and $1,770,103 for the subject interest. The yield at this conclusion is 9.7% based on 3-year average distributions, and 11.4% based on 1992 distributions.
[It should be clear by now that I believe that Dr. Kursh’s analysis is closer to cosmic truth than Mr. Siwicki’s. Consider another possibility. The limited partners of Hill House do not have to wait for an ultimate sale for substantial liquidity. The general partner could elect to re-mortgage the property and make a special distribution in the near future, which mortgage could be repaid by lowering or eliminating current partnership distributions. There are obviously tax implications to such a strategy, but it is illustrative of the flexibility that existed with Hill House.]
The Court took elements from each of the appraisers in arriving at a value, before marketability discount, of $6.5 million as can be seen in Table 8. Note that this represents an effective minority interest discount of 37%. We will put this aspect of the Court’s analysis into perspective below.
The Court’s conclusion of fair market value of Hill House was $5.2 million, or 50% of NAV. The fair market value of the 25.235% subject interest was therefore $1,309,651. The implied yields based 3-year average distributions and 1992 distributions were 13.2% and 15.4%, respectively.
Mr. Siwicki and the Court (following Siwicki) used Partnership Profiles transaction data to determine a minority interest discount. In doing so, I believe they overstated the effective minority interest discount. Dr. Kursh could be criticized for making the same mistake but to a much lesser degree (because he did not combine his yield capitalization with a “net asset value method”). However, his use of the QMDM allowed him to derive a reasonable conclusion nonetheless.
We need some background regarding Partnership Profiles data to put these comments into perspective. They will assist in understanding the differences between Mr.Siwicki’s 43% minority interest discount, the Court’s 37% minority interest discount, and the 20% minority interest discount applied by Dr. Kursh.
It is generally recognized that, while there is a limited market for the publicly owned limited partnerships, the market is not considered to be overly active or efficient.
Publicly traded limited partnership interests are thinly traded in the secondary market compared to the activity of stocks in the primary markets, such as the New York Stock Exchange (NYSE). When an investor sells shares of a company traded on the NYSE, he or she can receive the cash proceeds in three days. However, it typically takes 60 to 180 days for an investor in publicly traded limited partnership units to complete the transaction and receive the cash proceeds primarily because of the required paperwork with the general partner. Even with this delay, a public limited partnership interest is generally more liquid than a private limited partnership interest, causing the private interest to normally be worth less than a comparable publicly traded interest. [Fishman, Pratt, et al, GUIDE TO BUSINESS VALUATIONS (Fort Worth: Practitioners Publishing Company, 1999), p. 14-18].
In a recent presentation by Charles Elliott, ASA, of Howard, Frazier, Barker and Elliott, several aspects of the secondary market for limited partnership interests were discussed. The paper was presented at the 1998 Annual Business Valuation Conference of the AICPA [Elliott, “An Outline of Valuation Considerations Related to Limited Partnerships,” which is available through SHANNON PRATT’S BUSINESS VALUATION UPDATE website (http://www.bvupdate.com). After subscriber login, click on Whitepapers and search for “Family Limited Partnerships, AICPA 1998 Conference”].
Elliott’s analysis of the secondary market is consistent with theimplications of the QMDM. We highlight certain sections and comment on their relationship to the QMDM factors noted above (these sections are found in Elliott’s paper under the “Valuation’sky hooks’/valuation reference points” heading).
4. Based upon input from the Secondary Market and from Partnership Profiles, Inc., the following conclusions are drawn regarding the basis upon which pricing of limited partnership units in the Secondary Market is determined.
4a. Cash distributions and therefore yield are most important; this is clearly the driver of pricing of partnerships in the Secondary Market. [Therefore, the QMDM’s focus on expected distribution yields and distribution growth.]
4d. Underlying cash flow coverage of yearly distributions made to partners. [This goes to the riskiness of the expected earnings stream and would be considered in the development of the required holding period return of the QMDM.]
4f. Whether or not the assets of the partnership are well diversified. [Again, the mix and diversification of a partnership relate to its riskiness as well as general attractiveness.]
4h3. The time period until liquidation. [A critical focus of the QMDM is in making a realistic estimate of the expected holding period until an opportunity for liquidity may arise. Note that we can almost never know with certainty what the expected holding period will be. However, it is important to make a reasonable estimate based on the facts and circumstances of each case. There is an implicit holding period assumption (or range of assumptions) in every concluded marketability discount. The QMDM asks the appraiser to make reasoned and reasonable judgments regarding this factor and to make those judgments (and the rationales therefore) explicit.]
4h4. The universe of interested buyers. [In the QMDM, we consider the return requirements of relevant universe of buyers of particular interests in the development of the required holding period return. If the universe of buyers is very limited, well-heeled, and sophisticated, the required returns can be substantial (and therefore, the derived marketability discounts may be substantial, depending on the other relevant factors).]
4h6. The presence of rights of first refusal. [Rights of first refusal limit marketability and add to the riskiness of investments in illiquid minority interests. In addition, they can increase the expected holding period for an investment. Both of these aspects are considered in the QMDM.]
We could examine all of Elliott’s observations and discuss each of them in the context of the QMDM. What Elliott is saying, however, is that the secondary market prices limited partnership interests on a rational basis that considers the economics and riskiness of ownership. That is what the QMDM attempts to do.
Now, Elliott goes on further to discuss the secondary market, indicating a flaw with Mr. Siwicki’s analysis regarding the marketability discount.
Because our valuation reference source is the Secondary market, it is inappropriate to utilize traditional lack of marketability discounts in the 30-50 percent range. The reason is that the Secondary market is a “thin market.” As a consequence, there is an element of illiquidity already expressed in the pricing of units in the Secondary Market.
Various sources in the Secondary Market have suggested that additional yield of about 200 basis points may be required than otherwise because of the impaired liquidity of the Secondary Market. This translates into a range of lack of marketability discounts of 15-25%, to be applied to the value of a non- controlling interest in a real estate [distributing] FLP.
Siwicki considered the “illiquidity already expressed” mentioned by Elliott in his capitalization of distributions. He then further discounted by weighting a price/NAV method. Finally, he discounted further by applying a “traditional lack of marketability discount” of 35%. The compounding of discounts resulted in a low value with a very high implied yield on expected distributions. This yield represented a premium to his 11% secondary market pricing base of about 1000 basis points, or far greater than Elliott’s suggestion. The Court achieved a more reasonable result by applying a lower than “traditional” marketability discount.
By using market returns from Partnership Profiles applied to the expected distributions of Hill House, Dr. Kursh developed a value indication reflecting approximately a 20% minority interest discount from NAV. His minority interest discount may be overstated somewhat due to the thinness of the secondary market. However, by basing his expected yield on this value, the QMDM mitigated any overstatement of the marketability discount. Unfortunately, these relationships are not necessarily intuitive and are somewhat difficult to explain. [The calculations referenced in the “Alternative Calculations” section below provide support for this observation.]
The Court “did not find the QMDM helpful in this case” because certain assumptions made by Dr. Kursh were “not based on hard data.” So let’s look at Dr. Kursh’s QMDM assumptions and see where they came from [based on information reported in the decision and the Kursh report].
Referring back to the discussion from Fishman above, shortly following the passage cited, Fishman indicates:
“Understanding how publicly traded limited partnership are priced is essential to determining the fair market value of FLP interests. The total expected return for publicly traded limited partnerships generally ranges from 16% to 22%.”
Examining Dr. Kursh’s assumptions in this light, we see he has assumed a total rate of return in the range of 19% (16% lower range return plus 3% inflation) to 22% (18% higher range of return plus 4% inflation). While we sometimes see total returns somewhat higher than this, Dr. Kursh’s results seem clearly within the range of known market data (and the same market data relied upon by the Court).
Based on our review of the case and Dr. Kursh’s report, it appears that Dr. Kursh used information that was factually based and within the range of reasonable comparisons with market data in his application of the QMDM. It is unfortunate, but the Court was apparently not convinced of the reasonableness of Dr. Kursh’s assumptions and their consistency with “hard data” that was in his report and otherwise readily available.
Dr. Kursh used an effective 20% minority interest discount, with Mr. Siwicki and the Court advancing even higher minority interest discounts of 43% and 37%, respectively. I’ve suggested that the higher minority interest discounts are too high. In fact, many appraisers reference studies of closed-end funds and other market data to suggest minority discounts on the order of 10% to 15%. We developed a series of alternative calculations using this lower range of assumptions to show how the QMDM interrelates with differing minority interest discounts to develop appropriate marketability discounts. These calculations are in the context of the assumptions used in the case regarding distributions (either that a 3-year average was appropriate or that the 1992 level was appropriate).
They are further made in the context of Dr. Kursh’s QMDM assumptions. While in an independent analysis, we might have made somewhat different assumptions, Kursh’s assumptions appear generally reasonable and supported by the facts and circumstances of the case. See Table 9.
Since the relevant distribution yield in the QMDM is the yield at the marketable minority level, we might have used somewhat different distribution yields than Dr. Kursh. [We suggest performing a more detailed distribution analysis to convert the yield to a C Corporation equivalent yield.] So the distribution yields vary based on the indicated distributions (3-year and 1992) and minority interest discounts (10% and 15%), relative to the higher minority interest discounts and lower marketable minority indications used by the appraisers in WEINBERG.
We can now make several observations regarding the alternative calculations.
This is not surprising. Hypothetical and real investors pay a price for an investment in the hope of achieving a target expected return. They do not care what the minority interest or marketability discounts might be. These discounts are tools used by appraisers to simulate the thinking of investors. As mentioned previously, all three calculations value the same expected cash flows and should yield similar results. In this regard, the QMDM is a forgiving tool. Mis-estimates in the minority interest discount tend to be offset by yield adjustments relative to the concluded marketable minority indications (for high distribution entities in particular).
Recall that I believe the Court, following Siwicki’s methodology, overstated the minority interest discount. Because the Court’s effective 37% minority interest discount includes significant elements of a marketability discount (see the Fishman and Elliott discussions above), the application of a 20% marketability discount (larger than Kursh’s calculated discount of 15%) overstates the effective marketability discount relative to the alternate calculations with similar assumptions (and yields a lower conclusion).
[Readers should not infer that I am faulting the Court’s conclusion. Judge Whalen relied on economic evidence that was presented by one expert (Siwicki). Dr. Kursh’s report did not address the logical problems and theoretical issues with the use of Partnership Profiles data raised above by way of rebuttal. He did attempt to explain the problem in Court. However, as is seen by this E-LAW, whose length exceeds that of the Court’s entire decision or Dr. Kursh’s report, there is room for confusion. I do hope this E-LAW will help clarify the issues. We encourage all readers to review the cited sections of Fishman, Pratt and to access Elliott’s analysis.]
I do believe that Dr. Kursh’s analysis using the QMDM was helpful to the Court. It kept a clear focus on the impact of distribution yield on value. It allowed the Court for the first time (at least in a published decision) to focus on all the critical QMDM factors. It also gave the Court a basis to reach a conclusion of fair market value that was far more reasonable than that advanced by the taxpayer’s expert. As should be clear from the analysis above, it appears that Dr. Kursh “won” the battle over the appropriate marketability discount. He “lost” the battle over the appropriate minority interest discount. It is unfortunate that the Court’s comments seem critical of the QMDM, because the Court’s conclusion is entirely consistent with its application by Dr. Kursh.
Two final notes. First, I approach case reviews with caution and considerable trepidation. As an appraiser and a writer, I know that I am subject to review and analysis by other appraisers and courts. I always try to treat the work of other appraisers with respect and hope to receive similar treatment.
Second, it is possible that a case review of mine could be interpreted as critical of a Court or a particular trier of fact.
Again, I approach each case review with the utmost respect for the Court. In valuation cases, the trier of fact has a difficult job. He or she must deal with complex valuation issues, often presented in multiple valuation reports of varying quality, listen to and make judgments about expert testimony and factual issues, as well as deal with other relevant aspects of each case – and the judge has to write a decision that will be reviewed by multiple parties. I hope all readers of these case reviews will consider them in the context they are offered – as constructive and, hopefully, objective analyses to offer valuation insights to our readers.
Reprinted from Mercer Capital’s E-Law Newsletter 2000-03 & 2000-04, March 13, 2000.
In Davis v. Commissioner (Estate of Artemus D. Davis v. Commissioner, 110 T.C. 35 (1998)), the Tax Court ruled favorably for an economic consideration of the embedded capital gains tax inside an asset holding company for the first time since the repeal of The General Utilities doctrine in 1986.
In November 1992, Taxpayer made two minority gifts of approximately 26% each of an asset holding company, the primary asset of which was a 1.3% interest in Winn-Dixie, a large, publicly traded grocery chain. The market value of the interest was some $70 million, which approximated the embedded capital gain. The blocks of shares represented founders’ shares, and were subject to restrictions under Rule 144 of the SEC Act of 1934.
The Tax Court heard from two experts for the taxpayer and one for the IRS. All three were experienced business appraisers who held senior member designations (ASA or FASA) from the American Society of Appraisers. All three experts submitted appraisal reports to the Court.
Upon review of the appraisal reports and the testimony of the experts, and of a stipulation of the net asset value of the holding entity (before consideration of embedded capital gains), the Court dealt with four issues.
Based on a review of the case, it appears that the Court was presented with an array of valuation evidence that it considered, in the main, to be credible. There is nothing unusual about the Court’s treatment of the minority interest discount, or the marketability discount (excluding the embedded gains issue). The restricted stock/blockage issue was unusual in that no discount was allowed.
Davis v. Commissioner will be remembered as an embedded capital gains tax liability case because it is the first post-1986 Tax Court case that has allowed explicit consideration of this liability.
Neither of the experts advancing the “incremental marketability discount” treatment of the embedded gains liability offered any evidence or rationale for their selected increment. The Court provided no further insight. Appraisers relying on the “Davis methodology” are likely to find themselves using unreliable evidence, absent a compelling rationale or explanation of their own.
The Court should have allowed a deduction from net asset value for the entire amount of the embedded capital gains tax liability. The rationale for this conclusion is developed in a forthcoming article that will appear in the November/December 1998 issue of Valuation Strategies. The article’s working title is “Embedded Capital Gains in Post-1986 C Corporation Asset Holding Companies.” The arguments and analyses presented in this article can help solve the problem of the “Not So Good News” noted above.
The article also comments on the Second Circuit Court of Appeals decision {Eisenberg v. Commissioner [1998 WL 480814] (2nd Cir.)} regarding Eisenberg v. Commissioner [T.C.M. 1997-483, October 27, 1997], which effectively eliminates (at least from our valuation-oriented reading) the ability of the IRS to cite pre-1986 cases to support an argument for not considering embedded capital gains liabilities in a post-General Utilities world.
Embedded capital gains tax liabilities are now recognized as real liabilities by the Tax Court. Appraisers must begin to provide economic arguments to support their positions regarding economic consideration.
Reprinted from Mercer Capital’s E-Law Newsletter 98-02, October 29, 1998.
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):
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:
Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
A 1997 case illustrates the complexities that can evolve in the valuation of debt securities and the weight the Tax Court applies to an appraiser’s effort to obtain and verify information on a particular interest to be valued. Of special interest in Evelyn T. Smith, Executrix of the Estate of Verna Mae Crosby v. Internal Revenue Service, No. 1:94-CV-460RR, U.S. District Court for the Southern District of Mississippi Southern Division, filed in February 1996, is the Court’s acknowledgment of the “willing buyer/willing seller” concept in its proper context. In this case, the appraiser was held to the same level of due diligence that a prospective buyer would put forth in obtaining information on a debt instrument at the original valuation date.
The case involved a note from St. Regis Paper Company (“St. Regis”) which was held by the Estate of Verna Mae Crosby (“the Estate”) following her death. When the estate tax return was filed, the Estate retained Mercer Capital to value the note. The valuation issue was heard in Federal District Court when the Executrix sought a refund of estate taxes paid to the IRS.
The original note was issued by St. Regis on May 17, 1977 to Mr. L. O. Crosby, husband of Verna Mae Crosby (the decedent). The note had a principal balance of $10,312,000, and was payable in twenty annual, equal installments of principal of $515,600. Six percent simple interest, computed from the inception of the note to the date of redemption, was added to each principal payment, resulting in annual payments successively larger due to the increasing amount of interest added to each installment.
The annual principal payments were made in a timely manner by St. Regis to Mr. Crosby until his death. Upon his death he bequeathed a two-thirds interest in the note to Mrs. Crosby and a one-third interest to a charitable foundation. Some years later (1981), exchange promissory notes were issued to Mrs. Crosby and the charitable foundation, thus eliminating the two-thirds ownership interest in the original note held by Mrs. Crosby. This fact, however, was not known by the Estate until later. The face amount of the exchange promissory note for Mrs. Crosby (now a 100% ownership interest) was $5,499,733 at the date of issuance and provided for yearly principal payments of $343,733. The terms of the exchange notes were structured identically to the original note, and total interest payments increased each year. The last payment was to be made in May 1997.
In January 1985, St. Regis was merged into Champion International Corporation (“Champion”), which assumed responsibility for the note. Mrs. Crosby died in April 1988. At that time, the unpaid principal on the note was $3,437,733 and the remaining (nominal) interest totaled $4,124,800. An estate tax return was filed on behalf of the Estate which concluded the correct value of the decedent’s interest was $3,348,500 for purposes of computing the estate tax liability. The value was based on an appraisal prepared by Mercer Capital. An IRS audit concluded the value of the interest in the note to be $4,400,000, which implied a deficiency in tax payment by the Estate of $410,838 plus interest to the present or a total payment of $714,195. Contemporaneously with the payment, the Estate filed a claim for a full refund of the estate taxes and interest paid.
The Mercer Capital appraisal and the IRS appraisal (which was prepared by another valuation firm) were both based on Mrs. Crosby’s original two-thirds interest in the note.
Z. Christopher Mercer, ASA, CFA prepared the valuation for the Estate and testified at trial. Shortly prior to trial, it was discovered that the original promissory note had, in fact, been reissued by St. Regis as two exchange promissory notes. Upon learning this fact, the Estate’s expert, Mr. Mercer, prepared an addendum to his valuation since the original note was discounted because of the undivided two-thirds interest. The Mercer Capital valuation was revised upward to $3,553,222. The IRS’ expert testified that this fact had no impact on his valuation.
The experts were generally in agreement on the methodology used to value the note and used similar approaches. They differed substantially on the adjustment necessary to account for the differences between the Estate’s promissory note and the publicly traded debt of Champion. Both experts discounted the cash flows that would be derived from the note using base rates determined from Champion’s publicly traded debt.
The IRS’ expert added 0.5% to his base discount rate determined from Champion’s publicly traded debt. Mercer made a series of adjustments and set forth the rationales which are summarized in Figure 1. Mercer acknowledged that the adjustments were based on experience and reason, rather than market data, but compared his final discount rate to alternative, risky investments.
It was evident to the Court, as it would be to a lay person, that there were significant differences in the publicly traded debt of Champion and the one page note held by the Estate, including:
The Court agreed that none of these factors were present in the Estate’s note. Mercer testified that the absence of these factors was an important consideration for hypothetical potential buyers for the note. He then went on to explain why a number of categories of potential investors would be precluded from acquiring the note.
Of major concern to Mercer Capital, and apparently the Court, was Mercer Capital’s inability to obtain necessary information from Champion to value the note in 1988. Efforts to obtain information about the note were ultimately acknowledged with a one-page letter indicating that Champion was the successor of St. Regis and was “responsible” for the promissory note. (This letter did not reference the later- discovered exchange promissory notes.) The IRS’ expert did not make an independent attempt to contact Champion. One month prior to trial, however, the trial lawyer for the IRS deposed a representative of Champion.
While the representative was able to acknowledge and confirm Champion’s responsibility for the note, as well as a number of factors for which Mercer Capital applied discounts (or premiums to the required rate of return), it is important to note that the IRS’ expert did not have this information in hand at the time of his appraisal. This information only became available prior to the trial, and only upon subpoena by the Department of Justice.
The Court’s conclusion, after careful review of the facts, swung heavily on the fact that both experts, in their reports, referred to their appraisals as fair market value appraisals, which is defined as the price that would be agreed upon by a good faith purchaser and a good faith seller, both being aware of all relevant facts and neither being under any duress.
The “relevant facts” were those that existed in 1988 when Mercer originally valued the note. The Court agreed that the information that was obtained, or unable to be obtained, by Mercer Capital at that time, was the only information relevant to the valuation of the note issue. The IRS’ deposition of a Champion representative which was obtained prior to trial was deemed to be irrelevant when attempting to determine the value as of April 1988. In addition, the Court noted that the deposition did not refute the factors considered in the Mercer Capital valuation.
The Estate was awarded a full refund of the deficiency, along with statutory interest from the date of payment in 1993.
This case covers a number of general concepts that are important in the valuation of any debt instrument or, more generally, in the valuation of closely held business interests. Not all the factors have been discussed in this article because of space limitations:
If you would like a copy of this case or to discuss a valuation issue in confidence, please give one of our professionals a call.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
There has been a substantial controversy regarding the appropriate treatment of embedded capital gains in determining the fair market value of interests of C corporations since the repeal of the so-called General Utilities doctrine by the Tax Reform Act of 1986 (“TRA”). The Internal Revenue Service has long held the position that embedded capital gains, or “trapped-in gains”, are speculative in nature. According to this argument, in the absence of a specific plan for the liquidation of a C corporation’s assets, it is inappropriate to consider the embedded capital gains tax liability that will be incurred upon liquidation of that corporation’s assets. We refer to this argument as the IRS Position.
Many business appraisers, on the other hand, have suggested that embedded capital gains must somehow be considered in valuations of post-1986 C Corporation asset holding companies. The crux of their argument is that rational investors would consider the risks and realities of acquiring interests in corporations with significant embedded gains in their overall investment decision-making processes, regardless of whether a liquidation is imminent, or even reasonably foreseeable, over a relevant investment time horizon. Some appraisers have called for a complete recognition of embedded tax liabilities in the valuation of C corporation asset holding companies. We refer to this argument as the Business Appraisers’ Position.
This article will test both positions and examine whether no consideration, a partial consideration, or full consideration of embedded tax liabilities makes sense in the context of the definition of fair market value.
In this article, we will:
The financial statements of most corporations are maintained on the historical cost basis of accounting. Assets are recorded at their original costs, and then, their bases are adjusted over time by depreciation, amortization, capital improvements, and disposals or other transactions that impact carrying value (basis). In the case of asset holding corporations, where assets subject to appreciation are likely to be found (e.g., land, buildings, investment securities, etc.), there can be a growing divergence between the historical “book values” of assets and their current market values with the passage of time.
To postulate a simple example, assume that ABC, Inc., a C corporation, owns a parcel of land with an original cost basis of $100 thousand. Currently, this land has an appraised fair market value of $1.0 million. Under current tax law (see below), the difference between the historical cost basis and the current market value, or $900 thousand (i.e., $1.0 million of fair market value less the $100 thousand cost basis), represents a capital gain that is “trapped-in” at the C corporation level. The gain is said to be a trapped-in (or “built-in”) gain because it will be incurred if the parcel of land is sold inside the corporation. Such embedded gains are also referred to as “inside gains,” indicating that the gain occurs inside the corporation, and must be dealt with before funds are available for shareholders, either via distribution or in liquidation.
Assume further that the corporation’s tax accountant has told us that the tax rate on the embedded capital gain is 40%. We can now quantify the embedded capital gain tax liability at $360 thousand (i.e., the $900 thousand embedded gain times the tax rate of 40%). The fundamental questions raised by the controversy outlined above are:
During the period from about 1935 until the Tax Reform Act of 1986, corporations generally did not recognize gains on certain distributions of appreciated assets to their shareholders or on certain liquidating sales of property. The policy was based on a doctrine established in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). Under the so-called General Utilities doctrine, assets were allowed to leave corporate ownership and to take a stepped-up basis in the hands of shareholders without imposition of a corporate-level tax. Under the General Utilities rule, it was usually feasible to avoid paying tax on otherwise trapped-in capital gains by effecting appropriate distributions of the underlying assets. This doctrine was the law of the realm for some fifty years.
In the Tax Reform Act of 1986, the Congress repealed the General Utilities doctrine under the theory that it undermined the corporate income tax. C corporations and their shareholders have been dealing with the reality of the repeal of the General Utilities doctrine ever since.
Prior to 1986, business appraisers and investors were not overly concerned with the issue of embedded capital gains. The reason was straightforward: significant embedded capital gains tax liabilities were avoidable through generally available elections under the General Utilities doctrine (26 U.S.C. x 337(a)(1958)).
Since 1986, the Internal Revenue Service has cited numerous Tax Court cases that disallowed consideration of embedded capital gains tax liabilities in fair market value determinations.2 Virtually all the cases frequently cited by the IRS deal with pre-1986 valuation dates. To jump ahead a little, we quote the very recent Court of Appeals case of Eisenberg, which is discussed in more depth below:
Now that the TRA [Tax Reform Act of 1986] has effectively closed the option to avoid capital gains tax at the corporate level, reliance on these cases in the post-TRA environment should, in our view, no longer continue.3
So, things are different economically since 1986 with respect to the embedded capital gains issue. However, until recently, the IRS and the Tax Court have consistently argued (at least in substance) that they are not.
The basic arguments by the IRS for not considering the valuation impact of embedded capital gains have been consistent and simple:
Unless a liquidation of the underlying assets is imminently contemplated, the consideration of embedded capital gains is “speculative.” If the gain is speculative, it should not be considered today.
The economic argument is that the gain might never be realized and the tax might never be paid because no liquidation is presently contemplated. Further, if the tax is ultimately paid, it might happen at such a distance in the future that its present value would be minimal. Therefore, according to the IRS Position, embedded capital gains should not be considered in fair market value determinations.4
Embedded capital gains can be avoided by having a C corporation make an S election. Under transition rules, if the gains are realized ten years or more following the S election, they are subject to only the pass-through, shareholder level personal tax.5
The arguments of the IRS Position are simple. Unfortunately, they do not follow the basic definition of fair market value (see below) and have incorrectly focused the attention of appraisers and the Tax Court on irrelevant issues.
The basic argument for considering the embedded tax liability related to an embedded gain in a C corporation flows from common sense: If the tax cannot reasonably be avoided, it must be considered in valuation. After all, the components of a fair market value transaction include:
A willing buyer and a willing seller, both of whom are fully (or at least, reasonably) informed of the facts surrounding the subject investment, neither of whom is under compulsion to engage in a transaction, and both of whom have the financial capacity to engage in a transaction. Based on these components, the hypothetical willing buyer and seller engage in a (hypothetical) transaction.
Following the passage of the TRA of 1986, the analysts at Mercer Capital, like those at many other appraisal firms, made calculations and judgments that led to the inevitable conclusion that if a substantial embedded gain existed in a C corporation asset holding company, it should be considered explicitly in the valuation of interests in that company. After all, how could a rational investor ignore the reality of embedded capital gains? Unfortunately, appraisers have been, collectively, as guilty of failing to formalize their valuation logic as has the Internal Revenue Service (with the exceptions noted below).
What has followed since 1986 has been a cat-and-mouse game over the issue. Many appraisers have routinely considered embedded capital gains taxes as liabilities in the determination of net asset value of C corporation holding entities since 1986. Given the frequency of occurrence of the issue of embedded gains at our firm and with other appraisal firms, we can only assume that most cases (ours and others) are either ignored or resolved prior to disputes rising to the level of Tax Court litigation. Unfortunately, the common element of the various embedded tax cases that have previously been heard by the Tax Court is the paucity of economic evidence from appraisers mentioned in the decisions.
Very little has been written on the issue of embedded gains. A recent search found only a limited treatment of the issue in the valuation literature. The various valuation texts are virtually silent with respect to hard positions on the issue.
Responding to TAM 9150001, John Gasiorowski wrote an article in Business Valuation Review in 1993 which concluded:
Investors have access to alternatives. Under the economic principles of anticipation and substitution, investors will pay less to acquire an interest in a real estate holding company organized as a C corporation than for an equivalent interest in an identical entity organized differently. Because corporate level taxes affect strategic outcomes, the impact of corporate taxes must be considered in the valuation.6
In Shannon Pratt’s Business Valuation Update, we find this brief position:7
In most (if not all) cases, I believe that the liability for trapped-in capital gains taxes should be reflected in the value of the stock or partnership that owns the assets. However, the IRS, the U.S. Tax Court and many family law courts have not, at least as yet, fully shared this view.
and….
Consensus is building among appraisers that the built-in capital gains tax should be recognized one way or another, either in the form of a balance sheet adjustment or some type of a discount.
In a 1996 article in Estate Planning, William Frazier advanced the position that the built-in capital gains taxes should be considered as a liability in the valuation of closely held corporations. In the context of a thoughtful article on the subject, which examined the issue in the context of the definition of fair market value, Frazier concluded:
Courts uniformly should abandon the ill-founded notion that the built-in corporate capital gains tax not be allowed as a reduction in the value of the equity of a closely held company when liquidation is only speculative. The premise for this policy has been undermined with the repeal of General Utilities. Observations from the marketplace, which should be the primary source of value determination, clearly show that the application of outdated legal precedents and the IRS viewpoint espoused in TAM 91500001 is out of step with economic reality, resulting in tax valuations that are unjustly burdensome. Failing to take into account capital gains taxes will result in the continuation of an ambiguous policy of determining value by a standard different from fair market value.8
And Steven Bolten wrote a brief article noting that at the first sign in early 1997 that the capital gains tax might be cut by up to half its then current rate, the financial markets reacted by lowering the discount to net asset values for closed end investment companies. Bolten concluded:
This observed decline in the discount to net asset value for the closed end investment companies, concomitant with the likely enactment of a capital gains tax cut, surely is evidence that the financial markets are, indeed, incorporating the trapped-in capital gains tax liability in valuations.9
The bottom line is that the IRS has argued loudly and consistently that embedded capital gains should be ignored in fair market value determinations. Appraisers, on the other hand have argued, albeit less loudly and less consistently, that embedded capital gains should be considered. And the Tax Court, at least until the issuance of Davis v. Commissioner, has either sided with the IRS or has avoided taking a clear stand on the issue.
Davis followed shortly on the heels of Estate of Pauline Welch, (T.C.M. 1998-167), which was issued in May 1998. In Welch, the Tax Court’s opinion followed the historical line of cases noted above, and disallowed consideration of the embedded capital gains liability in two closely held companies.11 In Davis, we find a case in which the Court specifically allowed consideration of the embedded capital gains tax in a C corporation asset holding company.
Davis will be reviewed extensively in many other forums. For our purposes, we can summarize the basic facts as follows:
Artemus D. Davis made two gifts of 25 shares of A.D.D. Investment and Cattle Company (“ADDI&C”), representing 25.8% (each) of the 97 shares outstanding as of November 1992, a distinctly post-General Utilities doctrine valuation date. The gift tax return was supported by an appraisal prepared by Alex W. Howard of Howard Frazier Barker Elliott, Inc.
ADDI&C owned a block of stock comprising approximately 1.3% of Winn-Dixie Stores, Inc., a large grocery chain whose shares trade on the New York Stock Exchange. The block had a market value of $70.0 million at the valuation date, and a cost basis of $338 thousand. Mr. Davis was a founder of Winn-Dixie, and ADDI&C was incorporated in 1947.
ADDI&C had a net asset value of $80.1 million at the valuation date. The total trapped-in capital gain in the company was $70.9 million, of which $69.7 million resulted from the Winn-Dixie block of stock. The embedded capital gains liability totaled $26.7 million (at the stipulated applicable rate of 37.63%), or about one-third of the net asset value.
In addition to the appraisal prepared by Mr. Howard, that was filed with the gift tax return, the taxpayer obtained a second appraisal prepared by Dr. Shannon P. Pratt of Willamette Management Associates. The Internal Revenue Service obtained an appraisal from Mr. John A. Thomson of Klaris, Thomson & Schroeder, Inc. All three appraisers are Accredited Senior Appraisers, having earned the ASA designation from the American Society of Appraisers (Mr. Pratt holds the FASA designation, Fellow of the American Society of Appraisers). All three appraisers prepared valuation reports and rebuttal reports that were reviewed by the Court.
While Davis will always be remembered as an embedded capital gains case, there were actually four distinct valuation issues dealt with by the appraisers and the Court, each of which had considerable economic impact. Unlike many other Tax Court cases, and particularly those dealing with embedded gains, the Court had credible valuation evidence from three qualified appraisers on each point. Without editorializing, the issues are summarized below.
Restricted Stock Issue. The Winn-Dixie shares were restricted under Rule 144 of the Securities and Exchange Act of 1934. Restrictions on the marketability of the block based on its size and trading restrictions needed to be considered. The taxpayer’s appraisers (Howard and Pratt) recommended discounts of 4.9% and 10%. Mr. Howard’s discount was based on the use of the Black-Scholes option pricing model, and Dr. Pratt’s was based on unquantified judgment. Mr. Thomson said that no restricted stock or blockage discount was appropriate because of the rising trend in Winn-Dixie’s shares. Based on its review of the record and the testimony of the experts, the Court did not allow any restricted stock or blockage discount for the Winn-Dixie shares.
Minority Interest Discount. There was little discussion in the case of the issue the minority interest discount. The recommendations of the appraisers were 15% (Howard), 20% (Pratt), and 12% (Thomson). The Court’s concluded minority interest discount was 15%.
Marketability Discount. All three appraisers recommended marketability discounts to the Court. Two of the appraisers, Dr. Pratt and Mr. Thomson, incorporated their consideration of the next issue, the embedded capital gains question, into their overall marketability discount analysis. Their reasoning was that such a large trapped-in liability would certainly impede the marketability of the subject shares. Excluding the specific consideration of embedded capital gains, Mr. Howard and Dr. Pratt relied on various restricted stock studies and pre-IPO studies, as well as their analysis of the various factors of the case. Mr. Thomson relied only on restricted stock studies and his analysis.12 The marketability discounts suggested by the experts were 35% (by Howard and Pratt) and 23% (by Thomson). The Court concluded that the appropriate marketability discount was $19.0 million, which translated into a marketability discount of 27.9%.
The Embedded Capital Gains Issue. The Court was presented with three different views of the treatment of embedded capital gains in Davis. Mr. Howard took the position that the tax on the embedded gain represented a present, economic liability. He therefore tax-effected the gain at estimated statutory rates and reduced net asset value by the full amount of the embedded liability.13 The IRS broke ranks with its appraiser and declared to the Court that there should be no consideration of embedded gains in the determination of fair market value as a matter of law. Dr. Pratt (for the taxpayer) and Mr. Thompson (for the IRS) advocated a middleground position (the IRS position). As noted earlier, they considered that the embedded tax liability would be an additional impediment to the marketability of the subject interests. And both suggested that the “extra” factor should add 15% to their otherwise determined marketability discounts, resulting in partial considerations of the embedded tax liability.
The Court was unconvinced by the IRS argument for no consideration of embedded gains liabilities as a matter of law. Mr. Howard was no less convincing to the Court with his argument that a full consideration of the embedded gain should be deducted from net asset value. Quoting from the decision on this point:
Petitioner adopts the view of petitioner’s expert Mr. Howard and argues that the full amount of such tax should reduce ADDI&C’s net asset value in making that determination. On the record before us, we reject petitioner’s position and Mr. Howard’s opinion. On that record, we find that, where no liquidation of ADDI&C or sale of its assets was planned or contemplated on the valuation date, the full amount of ADDI&C’s built-in capital gains tax may not be taken as a discount or adjustment in determining the fair market value on that date….even though we have found that as of that date it was unlikely that ADDI&C could have avoided all of ADDI&C’s built-in capital gains tax, and the record does not show that there was any other way as of that date by which ADDI&C could have avoided all of such tax. [emphasis added, citations omitted]
The Court apparently agreed with the manner in which Mr. Thomson and Dr. Pratt considered a partial treatment of the embedded gain as an incremental impediment to marketability. Both added 15% to their marketability discounts, which provided a range of dollar liabilities of $8.8 million (Pratt) to $10.6 million (Thomson).14 Within this range, the Court held that the appropriate consideration of the embedded gains tax liability was $9.0 million. Given that the total embedded gain was $26.7 million, the Court allowed a deduction to net asset value of some 34% of the embedded liability. The effective tax rate used by the Court on the embedded gain was therefore 12.7% (i.e., $9.0 million divided by the $70.9 million taxable gain inside ADDI&C).
Based on the record in Davis, the Court rejected both positions outlined at the beginning of this article, the full consideration of embedded capital gains liabilities advocated by many business appraisers (The Business Appraisers’ Position), and the absence of consideration advocated by the IRS (The IRS Position). It is not clear from the case as to how Pratt and Thomson arrived at their partial considerations of the embedded gain in ADDI&C. It is clear, however, that the Court was amenable to the consideration of economic arguments that attempted to simulate the thinking of hypothetical buyers of subject minority interests in ADDI&C common stock.
Davis stands, in our opinion, as a mandate by the Tax Court to appraisers to articulate their economic and valuation rationales for the consideration of the impact of embedded gains on hypothetical negotiations between hypothetical willing buyers and sellers.
As this article was being finalized, we received a Second Circuit Court of Appeals decision regarding the appeal of the October 1997 Eisenberg decision of the Tax Court. Without going into details of the earlier case, we can summarize that Irene Eisenberg owned all the outstanding common stock of a C corporation that held a building in Brooklyn, New York. After stipulations of the fair market values of the building on three gifting dates and of a 25% minority interest discount, the sole issue for determination by the Tax Court was whether to consider a valuation adjustment for the embedded capital gains tax liability inside the corporation. The taxpayer argued for full consideration of the embedded liability, and the IRS argued for no consideration. The Tax Court held for no consideration citing the cases outlined above and the rationale regarding the speculative nature of any liquidation of the company.
After stating the issue of the appeal, the Court reviewed background cases on the embedded tax issue, as well as a brief history of the General Utilities doctrine and of its repeal by the Tax Reform Act of 1986. Brief quotes from the appellate decision trace the Court’s conclusion that rational purchasers of shares of post-1986 C corporations would consider the impact of embedded tax liabilities on the price they are willing to pay for interests in such corporations.
We quoted the Court’s position earlier disfavoring the consistent citing of pre-1986 valuation date cases by the IRS to support post-1986 valuation economics.
Regarding the recurring theme that embedded capital gains should not be considered because there is no plan of liquidation in place, and the resulting implications for hypothetical willing buyers, the Court indicated:
Fair market value is based on a hypothetical buyer and a willing seller, and in applying this willing buyer-willing seller rule, ‘the potential transaction is to be analyzed from the viewpoint of a hypothetical buyer whose only goal is to maximize his advantage…[C]ourts may not permit the positing of transactions which are unlikely and plainly contrary to the economic interest of a hypothetical buyer…’ [citing Estate of Curry v. United States, 706 F.2d 1424. Emphasis added]
In elaborating on this position:
Our concern in this case is not whether or when the donees will sell, distribute or liquidate the property at issue, but what a hypothetical buyer would take into account in computing fair market value of the stock. We believe it is common business practice and not mere speculation to conclude a hypothetical willing buyer, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains on the sole asset of the Corporation at issue in making a sound valuation of the property. [emphasis added]
And reiterating the view of hypothetical buyers:
The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying.
In the concluding paragraph of its discussion, the Court stated:
We believe that an adjustment for potential capital gains tax liabilities should be taken into account in valuing the stock at issue in the closely held C corporation even though no liquidation or sale of the Corporation or its assets was planned at the time of the gift of the stock.16 [emphasis added]
If Davis stands as a mandate to business appraisers to become specific in their development of valuation adjustments relating to the embedded capital gains issue, Eisenberg is our clarion call.
Buyers of appreciating properties, broadly defined, whether stocks, land, investment properties or other, generally have the option of acquiring desired investments in the normal markets for the properties. Negotiations occur between buyers and sellers for the properties and transactions are effected.
In the present article, we are discussing situations where appreciating properties are, for whatever historical reasons, residing inside C corporation holding companies. Post-1986, appreciation inside such corporations is subject to income taxation. Sellers desiring to obtain the market value of appreciated properties inside C corporation have two basic options:
Liquidate the asset(s) inside the corporation, pay any corporate tax on the appreciation of the assets upon their sale, and then either make substantial distributions of the net assets or engage in a liquidation of the corporation.
From the universe of potential buyers of the asset(s) inside the corporation, find a buyer who will purchase the C corporation’s stock as a vehicle to access the asset(s) who either has reasons to own the asset(s) inside a C corporation, or who will liquidate the corporation to gain access.
When analyzing the impact of embedded capital gains in C corporation holding entities, we must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities. We must also consider the realistic option that potential buyers of the stock of those entities must be assumed to have – that of acquiring similar assets directly, without incurring the problems and issues involved with embedded capital gains inside a C corporation.
In Figure 2, we have attempted to analyze the impact of embedded capital gains in C corporation holding entities from the vantage point of hypothetical willing buyers and sellers. Through this analysis, we are seeking to reach conclusions regarding whether or how the issue of such embedded gains, and their associated embedded tax liabilities, would reasonably influence the negotiating positions of buyers and sellers of the stock.
In developing Figure 2, we prepared a series of spreadsheet models that attempt to simulate a series of transactions involving both buyers and sellers of C corporation holding entities containing appreciating property in the context of current tax law. Summary results of the modeling are found in Figure 2. The property involved has an assumed fair market value of $1.0 million, the corporate tax rate on embedded gains is assumed to be 40%, and the personal marginal tax rate is assumed to be 20%. In the example, the asset is assumed to be growing in value at a rate of 6% per year, and pays no dividends.17 A further assumption is that there are no costs involved in liquidating the C corporations other than the necessity to pay embedded capital gains taxes.18
Essentially, Figure 2 analyzed five alternative purchase options available to a buyer of appreciating assets, which relate to acquiring those assets through C corporation holding entities. The alternatives shown include:
The buyer acquires the property outright in the normal market for such property at its market value.
The buyer acquires C corporation stock where the basis of the property inside the corporation is equal to the property’s fair market value in its normal market.
The buyer acquires C corporation stock with a large embedded gain and embedded tax liability (i.e., with virtually a zero basis inside the corporation) and pays the seller a price for the shares that reflects no reduction for the embedded tax liability.
The buyer acquires C corporation stock with the basis of the property inside the corporation equal to 50% of the fair market value of the property (called a mid-range embedded gain in Figure 2). In this case, the buyer reduces the price paid for the stock by the amount of the embedded tax liability on a dollar-for-dollar basis.
The buyer acquires C corporation stock with a large embedded gain and embedded tax liability (as in Alternative III), and the price paid for the stock is again reduced by the full amount of the embedded tax liability.
Analysis of Figure 2 leads to the conclusion that rational buyers of C corporation holding entities with appreciated assets will negotiate to reduce the purchase price paid for the stock by the full amount of any embedded capital gains tax liabilities. The rationale for this conclusion can be summarized by the following points:
The buyer always has the presumed opportunity to acquire similar property in the open market. The rate of return from an investment in the property from this alternative should reasonably be used to evaluate options involving the acquisition of the same or similar property through the purchase of C corporation stock.
Under Alternative II, where there is no present embedded gain, there is an argument that the buyer should discount the price for the stock because the anticipated future capital gains and capital gains taxes at the corporate level will lower the expected holding period return for any reasonable holding period. The seller of the corporation, however, has the capability of liquidating the corporation and therefore will not likely negotiate a reduction for the future liabilities of the buyer. Further, the buyer, once having purchased the stock, has the option of liquidating the corporation to gain direct access to the asset without incurring future capital gains associated with the C corporation status.19
Alternative III is the analytical equivalent of the IRS Position (pre-Davis and pre-Eisenberg) with respect to embedded capital gains. In this alternative, there is a large embedded capital gain in the corporation (very much like that of the gain in ADDI&C in Davis discussed above). By ignoring the embedded capital gain and embedded tax liability in Alternative III, the buyer is placed at risk of loss of substantial principal if there is a necessary liquidation in the early years, or an unanticipated liquidation of the underlying property. For example, assume the property in Alternative III is Winn-Dixie stock. Assume further that the buyer pays $1.0 million for the stock, making no adjustment for the $400 thousand embedded tax liability in the C corporation. Finally, assume that the day after closing of the transaction, Safeway agrees to purchase 100% of Winn-Dixie’s stock for cash. The buyer has just turned a $1.0 million investment into $600 thousand, and would recognize a $400 thousand loss. The economic effect of Alternative III is that the buyer has made a gift of the amount of the embedded tax liability ($400 thousand) to the seller. This gift can be recognized in an early loss on liquidation or in the form of a permanently impaired rate of return in relationship to Alternative I, the outright purchase alternative. Rational buyers are not in the business of making gifts to sellers of properties.20
With Alternative IV, with a mid-range embedded gain of $500 thousand, the buyer of the C corporation’s stock encounters a permanent impairment of return in relationship to Alternative I, even though the stock’s purchase price is lowered by the full amount of the embedded tax liability. As in Alternative II, there is an argument for the buyer to negotiate for a further discount to account for capital gains on future appreciation; however, as in that alternative, the buyer has remedies, and the seller has the alternative of liquidating the corporation to avoid additional discounting.
Only in Alternative V, in which the corporation has a virtually zero basis in the property, is the buyer indifferent, from a rate of return perspective, with the outright purchase alternative of Alternative I. In this case, the buyer reduces the stock’s purchase price by the full amount of the embedded tax liability, and the discount from fair market value is sufficient to offset the combined impact of future corporate and personal taxes. As is visually apparent, the compound returns available from Alternative I, the outright purchase of the property, are identical with those from Alternative V.
The end result of this analysis is that there is not a single alternative in which rational buyers (i.e., hypothetical willing buyers) of appreciated properties in C corporations can reasonably be expected to negotiate for anything less than a full recognition of any embedded tax liability associated with the properties in the purchase price of the shares of those corporations. And rational sellers (i.e., hypothetical willing sellers) cannot reasonably expect to negotiate a more favorable treatment, because any non-recognition of embedded tax liabilities by a buyer translates directly into an avoidable cost or into lower expected returns than are otherwise available. Valuation and negotiating symmetry call for a full recognition of embedded tax liabilities by both buyers and sellers.
We can close with a few concluding observations:
The Tax Court (in Davis) and the Second Circuit Court of Appeals (in Eisenberg) have recognized the economic reality of embedded capital gains tax liabilities and that such liabilities are appropriately considered in the determination of the fair market value of C corporation asset holding entities. However, appraisers who attempt to argue for a partial discount by citing Davis stand a good chance of losing their arguments based on differing facts or circumstances, or on the lack of economic justification for their positions. Appraisers are responsible for providing valuation and economic evidence to the Courts. The door is clearly open for the admission of such evidence regarding embedded capital gains tax liabilities in C corporation asset holding entities.
Endnotes
1 The treatment of embedded capital gains in operating companies or in tax pass-through entities is beyond the scope of this article, although many of the issues discussed are obviously applicable to C corporation operating companies that hold significant appreciated non-operating (or perhaps operating) assets. While the issue of embedded gains arises in valuations for many purposes, the following discussion is framed in the general context of gift and estate tax appraisals.
2 See Estate of Andrews v. Commissioner 79 T.C. 938, 942, 1982 WL 11197 (1982); Estate of Piper 72 T.C. 1062; Estate of Cruikshank , 9 T.C. 162 (1947); Estate of Luton v. Commissioner, T.C.M. 1994-539; Estate of Bennett v. Commissioner, T.C.M. 1993-34; Gallun v. Commissioner, 33 T.C.M. (CCH) 1316 (1974), and other cases often cited by the Internal Revenue Service in Tax Court cases, as well as argued in various settlement negotiations with taxpayers and their professional representatives.
3 Eisenberg v. Commissioner, 1998 WL 480814 (2nd Cir.).
4 Has anyone advocating the IRS Position ever made any pro forma present value of future tax liability calculations under reasonable assumptions regarding expected holding periods until liquidation, the growth rate in value of the assets in the interim, the tax consequences of liquidation and with the virtual certainty that the tax will ultimately be recognized reflected in the discount rate?
5 What rational buyer would subject himself to such exposure and pay hard dollars today against the chance of mitigating, for such a long period of time, the gain via an S election? This argument has nothing to do with fair market value or rational investment.
6 Gasiorowski, John R., “Is a Discount for Built-in Capital Gain Tax Justified?”, Business Valuation Review, June 1993, pp. 35-39.
7 Pratt, Shannon P., “Trapped-in capital gains affects real-world value,” Shannon Pratt’s Business Valuation Update, February 1996, pp. 33-34. Dr. Pratt is one of the experts in the Davis case which is discussed below.
8 Frazier, William H., “How Corporate-Level Capital Gains Taxes Affect Fair Market,” Estate Planning, June 1996, pp. 198-203. Mr. Frazier is a partner of Alex W. Howard, another of the experts in Davis.
9 Bolten, Steven E., “Financial Market Valuations Include Trapped-In Capital Gains Liabilities,” Business Valuation Review, June 1997, pp. 23-24.
10 Davis v. Commissioner, (T.C. June 30, 1998).
11 Interestingly, the taxpayer in Welch submitted valuation reports on the two companies prepared by Mercer Capital for another purpose entirely and as of a different valuation date without the knowledge of Mercer Capital. A discussion of Welch can be found in Mercer Capital’s newly initiated E-Law Newsletter, Volume 1, Issue #1, “How Easy it is for Appraisers to Misinterpret a Case!”
12 The restricted stock studies and pre-IPO studies cited by the experts in Davis are summarized in a recent book. See Mercer, Z. Christopher, Quantifying Marketability Discounts: Developing and Supporting Marketability Discounts in the Appraisal of Closely Held Business Interests (Peabody Publishing, LP: Memphis, Tennessee, 1997). Chapters 2, 3 and 12 deal with these studies at length.
13 The reasonableness of his position is affirmed below. This is the Business Appraisers’ Position stated at the outset of this article.
14 It is almost impossible not to editorialize. Both Pratt and Thomson agree that the embedded capital gain should be considered in the valuation of post-1986 C corporations. Thomson, to his credit, stuck to his valuation guns in the face of a client that undoubtedly pressured him not to consider any liability for embedded gains taxes. He gave partial treatment of the liability in the guise of a larger marketability discount. Given that the Tax Court had been so negative on opinions like that of Howard in the past, Pratt undoubtedly believed that a consideration as an incremental marketability discount was a way to introduce a legitimate valuation adjustment that the Court has disfavored as part of one that the Court has favored. Neither Pratt nor Thomson, however, provided any economic rationale for their selected 15% increases to their marketability discounts. As a result, there is no basis for using this case to justify a treatment of embedded gains tax liabilities in any other matter.
14 Eisenberg v. Commissioner of Internal Revenue, [(1998 WL 480814 (2nd Cir))]. This case represented an appeal to the United States Court of Appeals, Second Circuit, of a 1997 memorandum decision of the Tax Court: Irene Eisenberg v. Commissioner, T.C.M. 1997-483, October 27, 1997.
15 The Court did, in footnote 15, indicate that a full deduction of the tax liability from net asset value might not be considered, but concluded in footnote 16: “In any event, all of these circumstances should be determined as a matter of valuation for tax purposes.”
16 The results of the modeling are not sensitive to either the tax rates assumed or to the growth rate in value of the property.
17 This analysis could easily be adjusted for estimated costs of liquidation.
18 In this example, it might be useful to examine the specific costs of liquidation. This is also a case in point where consideration of embedded gains in operating companies with significant non-operating assets could depart from this argument. If it is not feasible to liquidate the corporation, a buyer might negotiate strongly for a further adjustment for future capital gains liabilities.
19 To carry this analysis a bit further, adoption of the IRS Position regarding the non-recognition of embedded capital gains tax liabilities is tantamount to asking a taxpayer to make a gift, in the form of higher gift or estate taxes today, to the U.S. Treasury. A rational taxpayer is just as unlikely to desire to make such a gift to the Treasury as a rational buyer is to making the gift to a seller facing the embedded obligation in a C corporation. This is particularly burdensome when the taxpayer will ultimately have to deal with the embedded capital gains tax in the corporation. In effect, the IRS position would require the taxpayer to pay an additional tax. While that might be good for revenues for the U.S. Treasury, the IRS Position has nothing to do with the concept of the fair market value of C corporation stocks.
First appeared in the 1998 November/December issue of Valuation Strategies.
The 2010 year is a unique time to be making important business decisions, be they operating, financial, or ownership related. We are living in an uncertain world. Business owners must carefully consider the current uncertainties in order to position their companies (and themselves) optimally for the future. In this article, we focus on the current economic, transaction, and tax environments that business owners should consider in their decision-making.
With very few exceptions, the operating environment across industries continues to be very challenging. The overall economy shrank around 2.5% during 2009 as measured by the change in GDP. While our economy appears to have avoided a doomsday scenario of continued, accelerated declines (at least to date), and GDP actually increased during the third and fourth quarter of 2009 (5.7% during quarter four based on the most recent official data available), we continue to see high levels of uncertainty regarding any recovery.
Through discussions with business owners and executives across all sorts of industries, we continue to hear the same two questions:
For many industries, pre-2008 performance levels will likely not be achieved again in the short-term. Those management teams that understand the realities of the current economic environment will be the ones that will position their companies for both short-term and long-term success.
In line with the general economic environment, merger and acquisition (“M&A”) activity during 2009 decreased substantially compared to the last several years. Based on broad market data published by MergerStat, total M&A transactions for 2009 measured 6,751, compared to totals of 10,559 and 8,048 for 2007 and 2008, respectively.
From an anecdotal perspective, our experience at Mercer Capital during 2009 suggests that the middle and lower ends of the M&A market were similarly diminished in 2009. Some deals did get done, but the overall quality of the companies being transacted was generally lower. As with the general economic activity, transaction activity did appear to show some signs of life, however meager, during the last quarter of 2009.
The reason for the reduced transaction activity is obvious. With the weak economic conditions (and general lack of capital availability), valuations have continued to decline relative to what might have been a reasonable valuation expectation just a few years ago. At these lower valuations, there are fewer sellers, especially sellers of quality companies.
As ownership groups make decisions regarding business transactions (either the sale of their business or the possible acquisition of other businesses), they must understand the market from just a few years ago is no longer directly relevant. The price that could have been gotten three years ago is not the appropriate benchmark from which to make investment decisions. Such a backward view of the market could result in a business owner missing a viable opportunity for liquidity; an opportunity that may be very attractive relative to what will be available in the future.
Usually, the one part of the financial environment that is certain is taxes. While there is no question that there will continue to be a tax burden, the level and form of taxes is currently in flux. Consider the following:
As of January 1, 2010, there is no estate tax. The 2001 tax bill which set a schedule to phase-out the estate tax has reached its final year. While expectations were that the estate tax issue would have been resolved for the long-term before this year, that did not happen. Currently, at least three scenarios seem possible:
In 2011, dividends, which are currently taxed at a federal rate of 15%, will revert to being taxed as ordinary income at an individual’s highest marginal tax rate. At the same time, the tax rate applicable to capital gains will increase from 15% to 20%.
Government expenditures currently far exceed government revenues and this is likely to continue well into the future. While a political discussion of spending and tax policy is not our intent, this is an important fact in considering what future tax burdens might be.
What will happen with the specific tax issues outlined above (not to mention the broader question of regular income tax rates) is not clear. There is likely to be an estate tax by 2011 (at the latest) and the rate on dividend and capital gains is likely to increase in the future.
Business owners must have flexibility in their ownership and liquidity plans to deal with the different possibilities.
We face several uncertainties in 2010. However, as the legendary coach John Wooden once said, “Do not let what you cannot do interfere with what you can do.” We cannot predict the future, but we can look for opportunities amid the uncertainties in the current economic, transaction, and tax environments. If Mercer Capital can assist you, please contact us at 901.685.2120.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1 (2010)