by Guest Author, John Stockdale, Jr.
The best time to think about what happens if the business or the relationship between the business owners doesn’t work out is when the business is being formed and business owners are happy. While it is difficult to anticipate all the situations that might arise that may necessitate a buy-out, accounting for the situations you can predict such as death, divorce, and disability are necessary. One important component to an effective buy-sell agreement is the valuation clause. And depending on the parties, different situations may result in the use of different valuation mechanisms. Generally, a court will follow the operating agreement’s valuation where the particular situation is clearly addressed and the valuation mechanism is clear and unambiguous.
Often death triggers a buy-out of the decedent’s interest in the business entity. Early buy-sell agreements used book value to calculate the purchase price of the deceased’s interest. Two recent probate cases emphasize problems associated with below market valuation provisions. In both cases the provisions were upheld despite that they provided for a price below the fair market value of the interests and the federal estate tax was levied on the fair market value of the stock.
In the Matter of the Estate of Maurice F. Frink, No. 6-433 (Iowa App. October 25, 2006), the Iowa Court of Appeals considered whether a buy-sell agreement that required the redemption of the decedent’s stock at “book value” was ambiguous. The beneficiaries of the decedent’s estate plan claimed that “book value” actually meant “fair market value,” which would result in greater value for the beneficiaries. The court determined that “book value” was not an ambiguous term. It found that various dictionaries consistently noted the difference between “book value” and “market value.” Furthermore, it noted that the company had consistently utilized “book value,” as defined under generally accepted accounting principles, when it made prior redemptions. Thus, despite the considerable difference between “book value” and “market value,” the court enforced the buy-sell agreement.
Similarly, a California Court of Appeals considered whether a buy-sell agreement between two brothers regarding their businesses should be enforced against a trust holding those businesses and business interests. Etienne v. Miller, No. F049110 (Cal. App. 5 Dist. October 23, 2006), unpublished. The trust documents specifically referenced the obligations under the buy-sell agreement. The beneficiaries contested the enforcement of the buy-sell agreements because they provided for below market value prices and would, thus, create an onerous federal estate tax burden. The court found that the trustee should enforce the agreements, because the trust documents contemplated the purchase of the interests and, therefore, non-enforcement of the buy-sell provision would frustrate the purpose of the trust. In reaching this decision, the court rejected the argument that the trustee would breach his fiduciary duties to the beneficiaries if he complied with the buy-sell provision because it provided for below market values.
Z. Christopher Mercer in his book, Buy-Sell Agreements, addresses the benefits and drawbacks of using a formula buy-sell agreement, such as book value. While formula agreements are easy to use and understand, they have several drawbacks – particularly where the standard is book value. These drawbacks include the exclusion of any goodwill value from the calculation, the accounting method used by the company, which may include certain booked but unpaid liabilities, and the situation of the parties may have changed between the signing of the buy-sell agreement and the triggering event.
Similarly, the withdrawal of a member, partner, or dissention of a shareholder should be considered as an event triggering rights under a buy-sell agreement. Providing for this contingency early in the business’ life may save the parties from costly breach of fiduciary duty or oppression claims by providing the parties with an exit mechanism. A recent Louisiana case illustrated how a formula buy-sell agreement worked well for the company.
In Tynes E. Mixon, III, M.D. v. Iberia Surgical, LLC, No. 06-878 (La. App. 3 Cir. April 18, 2007), the Louisiana Court of Appeals, Third Circuit considered whether a limited liability company (LLC) member was undercompensated when the LLC repurchased his interest upon his expulsion from the LLC. Mixon and other formed an ambulatory, out-patient surgical center in 1998. The operating agreement provided that a member could only be expelled upon a unanimous vote of the membership. In the event of expulsion or withdrawal, the member’s interest would be repurchased at “fair market value” as computed under Exhibit E of the agreement. Exhibit E stated, “‘Book Value’ means the ‘fair market value’ … of the net equity of the company.” The remaining members unanimously expelled Mixon in 2002. The corporation’s regular accountant calculated the book value of Mixon’s interest under Exhibit E at $71,357.
Mixon rejected this price and brought suit. He argued that the operating agreement required the repurchase of his interest at fair market value. He retained a CPA with valuation credentials to value his interest. The CPA valued the business using a comparable transaction method. Based on a 1989 sale of surgical center, he determined that the business should be valued at 9.89 times net income. This gave Mixon’s interest a fair market value of $483,100. The trial court granted the company’s motion for summary judgment that dismissed Mixon’s action. It reasoned that the terms of the operating agreement controlled and defined “book value” as “fair market value” of the net equity. Mixon appealed.
On appeal, Mixon argued that the terms “book value” are not synonymous with “fair market value.” The appellate court agreed, but found that the parties agreed to use book value under Exhibit E of the agreement, which stated, “Book Value mean the ‘fair market value’ … of the net equity.” Further, “the book value of a business has a well defined meaning, is unambiguous, and is susceptible of only one construction. It is the value shown on the books of the business, and no other value. [Citation omitted].” Moreover, “good will, actual value or value in the open market, is not considered in determining book value.” Since Mixon does not contend that the book value of his interest was improperly calculated and book value is the standard of value required under the operating agreement, Mixon received all that was due him under the agreement. Thus, the appellate court affirmed the lower court’s grant of summary judgment in favor of the company.
While the above cases adequately illustrate the benefits and detriments of using of a formula valuation provision, such as “book value,” in a buy-sell agreement, failure to address a possible triggering event, such as divorce, has its own repercussions. This is exemplified by In re the Marriage of Barnes, No. 2006AP3020-FT (Wis. App. May 17, 2007). The Wisconsin Court of Appeals considered whether the trial court erred when it valued the parties’ interest in a limited liability partnership (LLP) under the withdrawal provision of the partnership agreement rather than the dissolution provision of the partnership agreement. During the marriage the husband and his parents established a LLP through which the husband operated a farming business. The husband contributed $140,296 for a general partnership interest and his parents contributed $300,000 for the limited partnership interest. The partnership agreement provided that in event a partner withdraws, the parents were entitled to a return of capital of $250,000. However, in the event of dissolution, the parents were entitled to a return of capital of $300,000. The partnership agreement did not provide a contingency for a partner’s divorce.
The parties contested the valuation of the husband’s general partnership interest. Both parties relied upon the partnership agreement as a guide to valuation. They treated the parent’s contribution as a liability. The wife argued that the LLP should be valued under the withdrawal contingency while the husband argued that the LLP should be valued using the dissolution contingency and a liquidation analysis. The trial court adopted the wife’s position and valued the business as if a partner had withdrawn. The husband appealed.
On appeal, the husband argued that the trial court erred when it used a liquidation analysis and did not value the LLP under the dissolution provision. The appellate court disagreed. It found that the trial court did not err when it selected one contingency over the other as a basis for the valuation when the partnership agreement “quite simply did not make any provision for valuation in the event of divorce.” Thus, it affirmed the trial court’s valuation of the LLP under the withdrawal provision.
Another area where the valuation provision needs to be considered is for estate planning purposes. The purchase price called for in a buy-sell agreement may, under certain circumstances, establish the fair market value of the interest for federal estate tax purposes. The factors include the following: (1) the price must be fixed and determinable under the agreement; (2) the agreement must be binding in life and death; (3) the agreement must have a bona fide business purpose; (4) the agreement must not be a testamentary device; and (5) the agreement must be similar to those entered into at arm’s length. Estate of Blount v. CIR. T.C. Memo. 2004-116 (citing Estate of Lauder v. CIR, T.C. Memo. 1992-736; I.R.C. § 2703).
The cases and issues discussed here emphasize the complexity of buy-sell agreement. Many factors should be addressed in the buy-sell agreement: trigger events, purpose, and valuation method just to name a few. Important in this is consideration of what the ultimate purpose of the buy-sell will be, and explaining the importance of this document to the clients at the time it is drafted. For more information on buy-sell agreements in the business appraisal context and teleconferences on this issue, visit Business Valuation Resources’ website: www.bvresources.com. You can also purchase a copy of Mercer’s book, Buy-Sell Agreements, through Business Valuation Resources or on Mercer Capital’s website: www.mercercapital.com.
Permission to publish this guest article by John Stockdale, Jr., Editor, Business Valuation Resources is provided by Business Valuation Resources, Inc. www.bvresources.com.
Several other issues related to valuation should appropriately be addressed in your buy-sell agreements. The following discussion is by no means exhaustive, but includes items that are helpful in minimizing problems or uncertainties with the operation of process buy-sell agreements. While some of these items may seem obvious when identified, they are quite often overlooked or are unclear in buy-sell agreements.
It is enormously helpful to specify the financial statements to be used by the appraiser(s). In the absence of specification, the parties must agree on the financial statements to be used, or else the appraiser(s) must decide. Significant differences in valuation conclusions can result from the selection of financial statements of different dates and quality. This confusion should be avoided.
Possible alternatives for specifying financial statements include:
Many buy-sell agreements provide for unrealistic timetables, and therefore, begin with process problems from the outset. The typical buy-sell process contains a number of phases where time is required:
Time to Get Process Started
It takes time to kick off a valuation process. If the trigger event is the death of a shareholder, no one will be focused on the buy sell agreement until the passage of a reasonable time. On the other hand, if the trigger event is a retirement or termination, the parties may be ready to initiate the buy sell agreement process immediately.
Time to Select Appraiser(s)
Most process agreements call for the parties to retain an appraiser. If a company or a shareholder is beginning from scratch to select an appraiser(s), it can easily take 30 to 60 days or more to identify firms, review qualifications, interview appraisers, and select an appraiser(s).
Many process agreements call for two appraisals at the outset. If they are within a designated percentage of each other, no further appraisals are required. If not, however, the two initial appraisers must agree on a third appraiser. This process takes time – often considerable time. Some agreements provide timetables for this process and others do not. In some agreements, the sole role of the first two appraisers is to select the third appraiser. The same time issues relate to this selection. Allow at least 30 to 60 days for this process. (The obvious way to avoid this time lag in getting appraisals started is to select the appraiser at the initiation of the buy-sell agreement using one of the single appraiser processes previously discussed.)
Time to Prepare Appraisal(s)
Once selected, the appraiser(s) must prepare their appraisal(s). Experience has taught that the appraisal process normally takes from 60 to 90 days. Mercer Capital engagement letters typically state that we will use our best efforts to provide a draft valuation report for review within 30 days of an on-site visit with management. We hit that target the great majority of the time, and most often miss it because of client-related issues. Note that the entire process would still take 60 days or more, depending on how quickly the client responds to the information request, schedules the visit, and how long the client takes to review the draft. It takes many companies 30 to 60 days to provide the basic information that we require prior to the on-site visit because the activities of running their businesses preclude prompt action.
If a third appraiser is retained, this appraiser will require time for his or her process. If this is the only appraisal being provided, the process normally takes from 60 to 90 days. If there have been two appraisals already, the third appraiser may be helped by the fact that the company has already developed most of the information that will be required. On the other hand, being the third appraiser can be a fairly dicey situation. In addition to preparing one’s own appraisal as the third appraiser, it is also necessary to review the appraisals of the other two firms. Allow at least 30 to as many as 90 days or more for this process.
Time to Review Draft Appraisals
The procedures of many appraisal firms call for the preparation of draft reports to be reviewed by management, and in the case of some buy-sell agreements, by all sides. This review process will generally take from 15 to 30 days or more, particularly in contentious situations.
Time to Arrange Financing or to Close
Once the appraisal process has been concluded, it normally takes some time to bring the process to closure. The company may be allowed 30 days, or some amount of time to close the transaction.
We can summarize the process timelines to get a picture of how the various types of process agreements might look in operation. You may be surprised at how the various processes actually lay out, regardless of what the written timetables suggest.
The existence of defined timetables in agreements serves to keep the parties focused on the timeline; however, they are seldom binding.
Note that the estimates here assume that there is no litigation and that the parties are generally cooperating to move the process along.
The bottom line is that it is good to agree on realistic timelines in your buy-sell agreements. It is then easier to ask the various appraisers and other parties to stick to them. The operation of process buy-sell agreements can take a long time. This means that the process may be a considerable distraction to management, particularly when significant transactions are involved. It should be obvious, but the prolonged operation of a buy-sell agreement can not only be distracting, but frustrating and confusing to the family of a deceased shareholder, or to a terminated employee.
The interests of shareholders (or former shareholders) and corporations (and remaining shareholders) often diverge when buy-sell agreements are triggered.
In the real world, motivations, whether actual or perceived, are embedded in many process agreements. These motivations are clear for buyers and sellers whose interests are obviously different. The motivations for the appraisers are less clear. Appraisers are supposed to be independent of the parties. Nevertheless, based on our experience, it is rare for the appraiser retained to represent a seller to reach a valuation conclusion that is lower than that reached by the appraiser for the buyer. This does not at all imply that both appraisers are biased. Consider the following possibilities:
Legal counsel for each side desires to protect the interests their clients. As such, in the context of buy-sell agreements, the thinking may occur as follows:
“If my client is the seller, we need to be able to select ‘our’ appraiser, because the company will select its appraiser. Since I am concerned that the company will try to influence its appraiser on the downside, I want to be able to try to influence our appraiser on the upside. Since we are selling and they are buying, this is only natural.”
For purposes of this discussion, if the two appraisals are not sufficiently close together, they can be viewed as advocating the positions of the seller and buyer, respectively. All the parties and their legal counsel may begin to think:
“What is needed now is a ‘truly’ independent appraiser to finalize the process.”
Many process agreements call for the two appraisers to select a third appraiser who is mutually acceptable to them because:
“Surely, ‘our’ appraiser and ‘their’ appraiser, working together, can select a truly independent appraiser to break the log jam since neither side has been successful in influencing the outcome of the process. But, now that we have a third appraiser, what should his or her role be?”
The role of the third appraiser will be determined by the agreement reached by the parties. Consider the following:
We speak here from personal experience. Professionals at Mercer Capital have been the first, second, and third appraisers in numerous buy-sell agreement processes. Clients sometimes do attempt to influence the appraisers, either in blatant or subtle fashion. This is to be expected and is not nefarious. Clients are naturally influenced by their desire for a conclusion favorable to them.3 The purpose of process buy-sell agreements, however, regardless of their limitations, is to reach reasonable conclusions.
Multiple appraiser buy-sell agreements have advantages.
There are several disadvantages to multiple appraiser buy-sell agreements:
Based on our experience, multiple appraiser process agreements seem to be the norm for substantial private companies and in joint venture agreements among corporate venture partners. The standard forms or templates found for process agreements at many law firms include variations of multiple appraiser processes similar to those described previously.
As business appraisers, we participate in multiple appraiser buy-sell agreement processes with some frequency. Because of the reputation of our senior professionals and our firm, we are called into valuation processes around the country. Chris Mercer has been the appraiser working on behalf of selling shareholders and companies, and has been the third appraiser selected by the other two on other occasions. As the third appraiser, he has been required to provide opinions where the process called for the averaging of my conclusion with the other two as well as averaging with the conclusion nearest mine. He has also been asked to pick the better appraisal, in his opinion, given the definition of value in agreements. He has also been the third appraiser who provided the only appraisal. Others at Mercer Capital have also performed similar roles.
This experience is mentioned to emphasize that the disadvantages of multiple appraiser appraisal processes outlined here are quite real. We have seen or experienced first hand every disadvantage in the list above. We hope to provide alternatives with more advantages and fewer disadvantages based on our collective experience at Mercer Capital.
Many buy-sell agreements are funded, in whole or in part, by life insurance on the lives of individual shareholders, who may be key managers, as well. Life insurance is a tidy solution for funding when it is available and affordable. It is important, however, to think through the implications of life insurance from a valuation perspective whether you are a valuation expert, a business owner or both.
The proceeds of a life insurance policy owned by a company naturally flow to the company. Should life insurance proceeds resulting from the death of a shareholder be considered as a corporate asset solely for the purposes of funding the repurchase liability created by a buy-sell agreement? Alternatively, should the life insurance proceeds could be considered as a separate corporate asset, i.e., as a non-operating asset, to be included in the calculation of value for the deceased shareholder’s shares?
This decision as to the treatment for any particular buy-sell agreement is one that warrants discussion and agreement. Absent specific instructions in a buy-sell agreement, appraiser(s) may have to decide how life insurance proceeds are to be considered in their determination(s) of value. What they decide will almost certainly disappoint at least one side and may surprise both.
Two potential treatments of life insurance proceeds are noted above. Let’s consider them specifically, and then look at examples of their treatment and the differing impacts that the treatments have on all parties to a buy-sell agreement, including the selling shareholder, the remaining shareholder(s), and the company.
This first treatment would not consider the life insurance proceeds as a separate, non-operating corporate asset for valuation purposes. This treatment would recognize that life insurance was purchased on the lives of shareholders for the specific purpose of funding the liability created by the operation of a buy-sell agreement. Under this treatment, life insurance proceeds, if considered as an asset in valuation, would be offset by the company’s liability to fund the purchase of shares. Logically, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back into income as a non-recurring expense.
An alternative treatment would consider the life insurance proceeds as a corporate, non-operating asset for valuation purposes. In valuation, the proceeds would then be treated as a non-operating asset of the company. This non-operating asset, together with all other net assets of the business, would be available to fund the purchase of shares of a deceased shareholder. Again, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back into income as a non-recurring expense.
Obviously, parties to an agreement could make a decision for treatment of life insurance proceeds between these two extremes, but that is beyond the scope of our example.
The choice of treatment of life insurance proceeds can have a significant, if not dramatic, effect on the resulting position of a company following the receipt of life insurance proceeds and the repurchase of shares of a deceased shareholder. The choice of treatment also has an impact on the resulting positions of the selling shareholder and any remaining shareholders. Consider the following example:
Harry and Sam own 50% interests of High Point Software, and have been partners for many years. Both are key managers in this small, but successful enterprise.
The buy-sell agreement states that the Company will purchase the shares of stock owned by either Harry or Sam in the event of the death of either. The agreement is silent with respect to the treatment of life insurance proceeds. The agreement calls for the Company to be appraised by Mercer Capital (wishful thinking, perhaps, but I’m writing this example).
The Company owns term life insurance policies on the lives of Harry and Sam in the amount of $6 million each.
Assume that Harry is killed in an unfortunate accident. Assume also that the Company is worth $10 million based on Mercer Capital’s appraisal prior to consideration of the proceeds of term life insurance owned by the Company on the life of Harry, and that earnings have been normalized in the valuation to adjust for the expense of the term policies.
Before finalizing the appraisal, Mercer Capital carefully reviews the buy-sell agreement for direction on the treatment of life insurance proceeds. It is silent on the issue. We call a meeting of Sam and the executor of Harry’s estate to discuss the issue, because we know that the choice of treatment will make a significant difference to Harry’s estate, the Company, and to Sam personally as the remaining shareholder.
We do not have to resolve this issue because it is a hypothetical situation. However, the example illustrates the importance of reaching agreement on the treatment of life insurance proceeds for valuation purposes when buy-sell agreements are signed. The valuation impact of each treatment is developed below in the context of the High Point Software example.
Table One summarizes the pre- and post-life insurance values and positions for High Point Software, Harry’s estate and Sam if life insurance proceeds are not considered as a separate, non-operating corporate asset in valuation.
On Line 3, we see that High Point Software is worth $10 million before consideration of life insurance, and both Harry and Sam have 50% of this value, or $5 million each. Upon Harry’s death, the company receives
$6 million of life insurance and recognizes the liability of $5 million to repurchase Harry’s stock. The post-life insurance value is $11 million (Lines 4-6).
Lines 7-10 reflect the repurchase and retirement of Harry’s shares. The remaining company value, after repurchasing Harry’s shares for $5 million, is $11 million. Since Sam owns all 50 shares now outstanding, his post-transaction value is $11 million. Harry’s estate has received the $5 million of life insurance proceeds from the sale of 50 shares for $5 million, which is the amount he would have received had he and Sam sold the company the day before he died.
Table Two summarizes the pre- and post-life insurance values and positions for High Point Software, Harry’s estate and Sam if life insurance proceeds are considered as a separate non-operating corporate asset in valuation.
Line 3 indicates the same $10 million pre-life insurance value of $10 million as in the treatment where life insurance is not a corporate asset. Now, however, the $6 million of proceeds from the policy on Harry’s life is treated as a non-operating asset and added to value, raising the post-life insurance value to $16 million, and the interests of Harry’s estate and Sam to $8 million each (Lines 4-5). After recognizing the repurchase liability of Harry’s shares ($8 million), the post-life insurance value of High Point Software is $8 million (Lines 6-7).
The shares are repurchased and new ownership positions are calculated on Lines 9-11. Harry’s ownership goes to zero, and Sam’s rises to 100% of the now 50 shares outstanding. This result is the same as above. However, Harry’s estate receives $8 million as result of the purchase of his shares, rather than $5 million. Note that the company’s value has been reduced from the pre-death value of $10 million to a post-death value of $8 million (Line 12).
The decrease in value is the result of Harry’s value of $8 million, which is in excess of the life insurance proceeds of $6 million, suggesting that the company had to issue a note to Harry’s estate for the remaining $2 million (Line 14). So the company is in a more leveraged position as result of the buy-sell transaction than it was before. Sam, on the other hand, owns 100% of the remaining value, or $8 million, rather than $11 million in the prior treatment.
It should be clear that the decision of how to treat life insurance for valuation purposes is important for all parties. Which treatment reflects the intentions of the parties? The fact is that life insurance proceeds create an asset that is unrelated to the operation of a business. The parties, therefore, should decide on the treatment of that insurance asset just like they decide on the investment or distribution of the company’s earnings.
Was it Harry and Sam’s intention for Sam to end up with $11 million in value while Harry’s estate only receives
$5 million if life insurance is not treated as a corporate asset? Sam and the company receive an increment in value, but Harry’s estate got precisely the amount that Harry would have received had he and Sam decided to sell the company prior to his death.
On the other hand, when life insurance proceeds are treated as a corporate asset, both Sam and Harry’s estate benefit from the increase in value from the proceeds. However, the company is saddled with additional debt to repurchase Harry’s shares at the moment of its greatest vulnerability, the death of one of the two key owner-managers. Is that the intention of the parties? The answers to these questions may not be immediately clear.
What is clear from this example is that the issue of the valuation treatment of life insurance proceeds is far too important not to be addressed specifically in buy sell agreements. If an agreement is silent on the issue and the life insurance proceeds are significant in relationship to the value of a business, rest assured that there will be an issue – probably litigation – when a significant shareholder dies.
With out-of-date fixed price agreements where value rises over time, the parties to that agreement make a bet that “the other guy” will die first. And one of them will be right! With life insurance proceeds, there is something of a similar bet if life insurance is treated as a funding vehicle only. In this case, however, the seller who dies first will get what his stock was worth before life insurance proceeds. His only “loss” is in not sharing in the incremental asset created by the insurance.
Parties to an agreement may feel differently about this “loss” or incremental gain depending on whether a company is entirely family-owned or the ownership is comprised of unrelated parties. However, regardless of they feel about it, the Internal Revenue Service may have a say about the treatment of life insurance proceeds in family-owned businesses.
If a buy-sell agreement is funded in whole or in part by life insurance, take the time to review the agreement to see what it states regarding the treatment of proceeds in the event of the death of a partner/shareholder. If it is silent, now would be the best time to get together with all parties to the agreement and to discuss the impact of life insurance.
Valuation advisers should be called upon and asked to make calculations like those above – or they can be made internally by corporate personnel based on an assumed value for the business. Armed with this information, the parties should decide now what will happen to the incremental asset created by life insurance proceeds?
Buy-sell agreements exist in many, if not most, closely held businesses having substantial size and/or value. And they exist between corporate joint venture partners in many thousands of enterprises.
Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself. They establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners. In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner.
Buy-sell agreements (or put agreements in some cases) are more important than most business owners, shareholders and boards of directors realize. I’ve often said that buy-sell agreements are written under the assumption that the other partner is going to die first – and one of the partners is right!
Seeing two different buy-sell agreements recently put the topic at the top of my mind and triggered a couple of memories, as well.
We reviewed a buy-sell agreement that was perfectly fine on the day it was signed by a company’s two major shareholders – more than ten years ago. The agreement states that the parties will reset the value each year.
Since then, the company has more than tripled in size and value. However, the valuation in the buy-sell when it was signed remains in effect today because it was never updated.
This creates no significant problems – unless something adverse happens to one of the shareholders. In that case, one shareholder would benefit from a bargain purchase price and the other’s family would suffer a true economic loss. With this item now in the open, those shareholders are working to update the document as rapidly as possible.
Many business owners want to create a formula to establish the pricing if a buy-sell agreement is triggered. And quite a few buy-sell agreements have them, usually with disastrous long-term results. However, this is not uncommon because this is an inexpensive alternative to hiring a business appraiser. Almost anyone can put a few numbers into a formula, whether it calls for book value at the preceding fiscal year-end or 4.5 times a 3-4-5 year (pick one) average EBITDA – less debt, of course. (I’ve actually seen the exclusion of debt to determine equity value omitted as part of the formula!)
The questions is, will formula results be fair for both sides in all circumstances? No rigid formula can realistically determine the value of a business over time with changing company, industry, and economic conditions. That’s why many buy-sell agreements use an appraisal process.
Many buy-sell agreements are written where the valuation mechanism involves multiple appraisal firms. Variations go like this:
And there are probably other variations on this theme.
There are at least two versions of the single appraiser pricing mechanism.
It should be clear that the pricing mechanism in a buy-sell agreement can be important to the outcome of a purchase event when it is triggered.
Before concluding this discussion of pricing mechanisms, let’s note some of the other important issues that need to be addressed when formulating your buy-sell agreement:
What’s so hard about specifying these things? We understand that it is, indeed, difficult. Owners have a hard time talking about some of these issues with their fellow shareholders when they are creating their buy-sell agreements. It makes people think about things they don’t want to think about. But think about them we must.
The process of drafting a buy-sell agreement requires the parties to address important issues in balanced form at the outset. In doing so, they are forced to realize that each party could be a buyer – in the event of the death of a partner – or a seller. Actually, if one thinks about being a seller, it is actually his or her estate that will be the seller. This can be tough stuff to deal with.
Know this. If these defining elements, including the pricing mechanism, are unclear in your (or your clients’) buy-sell agreement(s), they will be the only thing you will be able to think about following a trigger event until the situation is resolved. Absent a clear agreement, this can take lots of money, lots of time, and create lots of hard feelings. Dealing with the issues under adverse circumstances will absolutely distract you from the business of running your business.
You probably don’t spend much time at night thinking about your (or your clients’) buy-sell agreement(s). Take our word for it, you shouldn’t. You should be thinking about your buy-sell agreement now, in the light of day, and working to get a clear agreement that works for you and your fellow shareholders or partners.
We never practice law, so these are not legal opinions. They are, instead, business opinions.
Remember this about buy-sell agreements – someone will buy and someone will sell. You just don’t know who that will be when you sign the agreement. Your agreement needs to work for you and your family whether you are the buyer or seller. And it needs to work for your partner(s) and their families (or their shareholders) whether they are the buyers or sellers.
This is important. Send this article to any of your friends who own businesses. They will benefit greatly from taking time to review their buy-sell agreements. And send this article to attorneys, accountants, or other advisers of businesses. They can bring great value to their clients by suggesting a review of their buy-sell agreements from legal and valuation viewpoints.
I have been an expert witness in the business valuation and corporate damages areas for many years. When I wrote my first book, Valuing Financial Institutions, in 1992, I explained the steps I took before each testimony experience to assure, to the extent possible, that the outcome of each testimony was successful.
Lawyers are always trying to impeach expert witnesses. That’s a fairly benign way of saying that they seek to catch experts, through a process called cross-examination, in inconsistencies, errors, changes to prior testimony, or even untruths. What is bad is that even when an expert is telling the truth, attempting to be consistent and avoiding mistakes, a good attorney can, through skillful questioning, provide the appearance to the judge or jury that the expert has done one or more of those “bad” things. This appearance can be almost as damaging as the reality. So it is to be avoided.
To help me withstand these potentially damaging lawyerly techniques, I devised a little pre-testimony routine to help me stay focused on my objective, which is not to lose the “game” to the lawyer(s). To do that, I placed a blank sheet of notebook paper in front of me so that I could see it at any time during my cross-examination. The original version in Chapter 20 of Valuing Financial Institutions (“Expert Witnesses and Expert Testimony”) read as follows:
Over the years, I truncated the list to the following, and I did then and still do, write the list at the top of the page in clear block letters:
The advice to listen pertained to each and every question posed by a cross-examining attorney. Attorneys become highly skilled in their questioning of experts. They hope to engage in a routine of questions that can create a false sense of comfort for the expert. They then may change the pace of questioning, hoping for quick, knee-jerk responses from the expert that will be inconsistent with prior testimony, for example.
They may then switch from a series of easy questions to an extremely difficult line of questioning without even pausing to catch a breath. In this environment, the expert has to be on his or her toes.
Experts often have a tendency to anticipate the next question or line of questions coming from an attorney. This can be disquieting. The attorney is hoping that the expert will, through this process of anticipation, answer the question the way that the attorney desires, and not as the expert might later have wished.
“Wait and formulate” reminds me to think about what I am going to say before I say it.
After hearing the question, I think about it for a moment and focus solely on the question asked. Then it is time to answer it.
This process has become almost second nature for me as an expert witness, whether the testimony is in a deposition or at trial.
Joanne M. Wandry, Donor v. Commissioner, T.C. Memo 2012-88
In 1998, Albert and Joanne Wandry formed the Wandry Family Limited Partnership, a Colorado limited liability limited partnership (“Wandry LP”), comprised of cash and marketable securities. Their tax attorney advised them that they could institute a tax-free gifting plan by giving Wandry LP interests using their annual gift tax exclusions (then $11,000) per donee, and additional gifts in excess of their annual exclusion of up to $1 million (at that time) for each donor. The gifting program commenced on January 1, 2000. The tax attorney informed the Wandrys that:
In 2001, the Wandrys started a family business with their children and formed a Colorado limited liability company, Norseman Capital, LLC (Norseman). By 2002, all of Wandry LP’s assets had been transferred to Norseman. The Wandrys continued their gifting program with Norseman just as they had with Wandry LP. They also followed the three key guidelines specified by their tax attorney.
On January 1, 2004, the Wandrys executed their gift documents, specifying that a “sufficient number” of Units of Norseman be transferred as gifts so that the fair market value of such Units shall equate to specific dollar amounts as indicated in the gift documents — $261,000 to each of four children, and $11,000 to each of five grandchildren. Further, the gift documents provided:
Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.
Furthermore, the value determined is subject to challenge by the Internal Revenue Service (IRS). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such final valuation and a final determination of value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.
In 2006, the IRS examined the gift tax returns and determined that the value of the gifts exceeded the Wandry’s Federal gift tax exclusions. The gift tax returns had indicated percentage interests on them which the IRS took to mean fixed percentage interests. However, the percentage interests were actually derived from the dollar amounts specified in their gift documents relative to the total value of Norseman. Where the Wandry’s thought they were making gifts of $261,000 to each child and $11,000 to each grandchild, the IRS determined such amounts at $366,000 and $15,400, respectively, precipitating a deficiency notice. Prior to the trial, both sides agreed that such interests were worth $315,800 and $13,346, respectively.
Further, the IRS argued that the adjustment clause does not save the Wandrys from the tax imposed by Section 2501 because it creates a condition subsequent to completed gifts and is void for Federal tax purposes as contrary to public policy. The public policy issue derived from a transfer clause reversed in Commissioner v. Procter, 142 F.2d 524 (4th Circuit 1944), wherein a transfer clause that operated to reverse a completed transfer in excess of the gift tax was voided and deemed to be contrary to public policy since any effort by the IRS to collect the implicit tax would defeat the gift, thereby discouraging efforts to collect the tax.
Accordingly, the issues for decision before the Court were:
This case highlights the conundrum faced by wealthy clients seeking to accomplish a gifting program while minimizing gift taxes in the process. Since the gift takes place on a specific date, it is typically impossible to have a firm value of an intangible asset holding as of the valuation date. The valuation of intangible asset holdings, such as Member Interests in Norseman, can be determined by qualified business appraisers. Such appraisals require substantial documentation and time to accomplish. If the gift is made on say, December 31st, based on reasonable but undocumented expectations, how does the donor deal with the implicit gift tax when the appraised value, determined later, comes in higher than expected? Further, the donor’s appraisal expert may have such appraisal challenged by the IRS, resulting in another perspective on value and additional tax liability.
The Court drew a distinction between a “savings clause,” which a taxpayer may not use to avoid the tax imposed by Section 2501, and a “formula clause,” which is valid. A savings clause is void because it creates a donor that tries “to take property back.” On the other hand, a “formula clause” is valid because it merely transfers a “fixed set of rights with uncertain value.”
The Court determined that, under the terms of the gift documents, the donees were always entitled to receive predefined Norseman percentage interests, which the gift documents expressed as a mathematical formula. The numerator of the formula was the stated dollar amount of the gift, while the denominator was the fair market value of Norseman, the only unknown. The value was a constant.
From this perspective, with specified dollar amounts of the gifts, there could be no excess gift and accordingly no gift tax. The formula did not require that the donors “take back” the excess amount; rather, there was no excess amount ever given, and the formula simply adjusted the relative ownership percentages when the denominator amount, the fair market value of Norseman was known.
The Court applied the four-part benchmarks from Estate of Petter v. Commissioner, T.C. Memo 2009-280 to the Wandry case to ascertain the validity of the transfer clause:
With regard to the public policy issue, the Court recounted that the Supreme Court has warned against invoking public policy exceptio to the IRS Code too freely, holding that the frustration caused must be severe and immediate. The Court held that there is no well-established policy against formula clauses. Prior cases confirming formula clauses included charities which re-allocated gift amounts to charity, which is favorable to public policy. In this case, the re-allocated amounts were adjusted among the donors and the donees, based on specified dollar amounts of the gifts, so no unintended gift tax was incurred, and there was no charitable entity involved.
Estate of Natale B. Giustina v. Commissioner, T.C. Memo 2011-141, June 22, 2011.
The Tax Court determined the value of a 41.128 percent limited partner interest in Giustina Land & Timber Company, an operating business limited partnership engaged in timberland operations as a going business. The underlying net asset value of the partnership substantially exceeded the capitalized earnings value. The Tax Court also determined the applicability of an accuracy-related penalty under Section 6662 of the Internal Revenue Code.
Natale B. Giustina passed away on August 13, 2005, holding a 41.128% limited partnership interest in Giustina Land & Timber Company Limited Partnership (“Partnership”). The Partnership was formed effective January 1, 1990, and at the valuation date owned 47,939 acres of timberland in the area of Eugene, Oregon, and employed approximately 12 to 15 people.
The Partnership was engaged in growing trees, cutting them down, and selling the logs. The Partnership was governed by a written partnership agreement from the day the Partnership was formed, including several amendments.
The disparity among the three indications of value by the Estate, the IRS and the Tax Court are summarized below:
The Estate and the IRS each provided expert testimony at trial.
The Estate relied on four approaches:
The IRS relied on three approaches:
Each expert applied different weights to their individual methods, but the Court determined that only two methods should be considered: the Cash Flow Method and the Net Asset Value method.
The parties were in agreement as to the value of the underlying real estate, and other Partnership assets. The value of the timberlands, which constitute most of the Partnership’s assets is agreed to be $142,974,438. The value includes a 40% discount for the delays attendant to selling the Partnership’s approximately 48,000 acres of timberland. Total assets of the Partnership were worth $150,680,000.
The Estate’s expert did not give weight to the Asset Value, while the IRS expert gave that value a 60% weighting. The Court concluded a 25% weighting to the asset value. Recognizing that the owner of a 41.128% interest could not alone cause the Partnership to sell the timberlands, the Court considered that there were various ways in which a voting block of limited partners with a two-thirds interest could cause the sale. Accordingly, while admitting some uncertainty, the Court estimated the probability of the sale at 25%. The Court did not apply any marketability discount to the asset value component.
The Court did not find the IRS expert’s Cash Flow estimates to be persuasive, and essentially dismissed them.
The Court focused on the Estate’s expert with regard to the Cash Flow analysis. This analysis extrapolated cash flow from five consecutive years. However, the expert reduced each year’s predicted cash flows by 25% to account for the income taxes that would be owed by the owner of the respective partnership interest. The Court found this inappropriate, since the expert’s discount rate was a pretax rate of return, not a post-tax rate of return. The Court further modified the expert’s discount rate from 18% to 16.25% by applying their own Partnership-specific equity risk premium. Based on the change in the calculation of cash flows and the change in the discount rate, the Court determined the marketable minority interest value of the Partnership at $51,702,857 by this method.
The Estate expert had applied a 35% discount for lack of marketability, while the IRS expert applied 25%, both derived from two types of studies: 1) restricted stock studies and 2) pre-IPO studies. Based on testimony that the pre-IPO studies tend to overstate the marketability discount, the Court adopted a marketability discount of 25%. After the application of the marketability discount, it was clear to the Court that there was a significant spread between the Asset Value and the Cash Flow value. Recognizing that disparity, and the possibility of actually achieving that value with a voting block of limited partners, the Court assigned a 25% weight to the Asset Value method and 75% to the Cash Flow method.
Although the two experts considered other approaches, the Court relied upon only two: the Asset Value and Cash Flow. The Court did not apply the marketability discount to the Asset Value, but did apply the 25% discount for lack of marketability to the Cash Flow method, resulting in a non-marketable minority interest value at $66,752,857, or $27,454,115 for the 41.128% interest.
The underpayment of tax on the Estate’s tax return resulted from its valuation of the 41.128% limited partner interest. The valuation was made in good faith and with reasonable cause. The estate was not held liable for the Section 6662 penalty.
The Court received the reports and testimony from two experts, and utilized its own perspective on value and risk outcomes to adjust the calculation of cash flows, the discount rate and the marketability discount.
In April 2011, the court ruled in favor of the IRS (Respondent) in a conservation easement donation case. In Boltar, L.L.C. v Commissioner, 136 T.C. No. 14 (April 5, 2011) a motion in limine to exclude the Petitioner’s (Taxpayer’s) expert was upheld due in part to the advocacy of the expert for his client.
In a conservation easement donation case, the IRS moved to exclude the taxpayer’s experts’ report as unreliable and irrelevant under Federal Rule of Evidence 702 and Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993).
The Court held that taxpayer’s experts failed to apply the correct legal standard by failing to determine the value of the donated easement by the before and after valuation method, failed to value contiguous parcels owned by a partnership, and assumed development that was not feasible on the subject property. The IRS’s motion to exclude Petitioner’s report and expert testimony was granted.
Two parcels (Northern Parcel and Southern Parcel) of approximately ten acres each were acquired in 1999. In 2002, the Shirley Heinze Land Trust, Inc. (Shirley Heinze) quitclaimed 10 acres located east of the Southern Parcel (the Eastern Parcel) to Boltar.
At the date of the subject easement, the Southern Parcel was encumbered by a 50 foot wide utility easement and the Northern and Southern Parcels were encumbered by an access (golf cart) easement. On December 29, 2003 an easement (Subject Easement) restricting the use of eight acres on the eastern side of the Southern Parcel was granted to Shirley Heinze. The Subject Easement prevented any use of the property that would significantly impair or interfere with the conservation values of the property. Approximately three acres of the Subject Easement, approximately nine acres of the eastern portion of the Northern Parcel, and all of the Eastern Parcel are forested wetlands.
At the valuation date, the Northern and Southern parcels were zoned R-1 (one single family home per acre). The Eastern Parcel was zoned as a Planned Unit Development (PUD) as part of a three phase proposed development.
Boltar claimed a charitable contribution of $3,245,000 related to the Subject Easement. The fair market value of the easement was reported as $3,270,000 and was reduced by $25,000 as a claimed enhancement in value to adjacent parcels owned by Boltar.
The real estate appraisal (“Taxpayer Appraisal”) attached to Boltar’s 2003 tax return determined that the highest and best use of the subject property was residential development and determined the Subject Easement value as the difference between the “Foregone Development Opportunity of 174 Condominiums on Finished Sites, Discounted to December 31, 2003” (Scenario B) $3,340,000 less the “Value of Raw Vacant and Developable Land” (Scenario A) $68,000. The Taxpayer Appraisal relied on a site plan for a condominium project situated on approximately ten acres and erroneously assumed the Subject Easement was zoned PUD.
In the final partnership administrative adjustment (FPAA), one of the IRS’s valuation engineers determined the fair market value of the Subject Easement was $42,400. The engineer opined that the Taxpayer Appraisal failed to determine the value of the Subject Easement before and after the grant of the easement. The engineer concluded that the highest and best use of the subject property was for “development of single-family detached residential homes, but not until the surrounding properties are developed,” partly because the Subject Easement was landlocked with no direct access to a public road.
The Court quoted IRS Regulations Section 1.170A-14(h)(3)(i):
The value of the contribution under section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. … If no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.
The Court commented that “while there may be cases in which the before and after methodology is neither feasible nor appropriate, petitioner has not provided any persuasive reason for not applying it in this case.”
The Court then commented that “In the context of this case, the task of the appraisers was to determine the fair market value of the eight acre parcel and the contiguous parcels owned by Boltar before and after the easement was granted.” The opinion went on to say:
Petitioner quotes this Court’s cases, Symington v. Commissioner, 87 T.C. 892 (1986), StanleyWorks & Subs. v. Commissioner, supra, and Hughes v. Commissioner, T.C. Memo. 2009-94, to emphasize the necessity of considering highest and best use by determining “realistic” or “objective potential uses”, to which the subject property is “adaptable” and which are “reasonable and probable” uses. We conclude, however, that the [taxpayer] appraisal’s valuations fail to apply realistic or objective assumptions.
The Taxpayer’s Appraisal’s highest and best use, prior to the conservation easement encumbrances, was a ten acre, 174-unit condominium development yet the Court noted “In support of the argument that the 174-unit condominium project assumed by the [taxpayer’s] report could not be physically placed on the subject property, respondent points out that the site plan for the proposal assumes ten acres, whereas the subject property was only eight acres, and the [taxpayer’s] experts ignored the effect of a preexisting 50-foot-wide utility easement for a gas pipeline across the property.” To make matter worse, the taxpayer’s experts “erroneously” concluded that the eased parcel was “within the city of Hobartand zoned PUD, which it is not.”
Addressing the taxpayer’s report and experts, the Court stated “Petitioner’s experts, however, did not suggest any adjustments or corrections to their calculations but persisted in their position that the original appraisal was correct, even when admitting factual errors. (By contrast, respondent’s experts conducted research in areas that were not within their specific expertise, acknowledged weaknesses, and corrected errors during their analysis.) Neither petitioner nor the Integra experts suggested any quantitative adjustment in response to their admitted errors or the problems addressed in respondent’s motion in limine. They simply persist in asserting an unreasonable position.”
The Court further noted that the Taxpayer’s Appraisal of the highest and best use for its “before” value, the condominium development, resulted in a value of $400,000 per acre. However, nearby property that could also be developed into condominiums was selling for only $12,000 per acre.
According to the Court, such “factual errors” defy “reason and common sense” and “demonstrated [a] lack of sanity in their result.”
Failure of the Taxpayer’s Appraisal Expert and the Daubert Challenge
The IRS aptly summarized the deficiencies of the taxpayer’s appraisal analysis as:
As a result, the [taxpayer’s expert] saw nothing wrong with a hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future.
The IRS asserted that the Taxpayer Appraisal had departed from the legal standard to be applied in determining the highest and best use of property and instead determined a value “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”
Boltar argued against a Daubert exclusion because:
The Tax Court refuted every argument of the taxpayer against a Daubert exclusion. The Court concluded that the Taxpayer’s Appraisal was not admissible under Rule 702, because it was not the product of reliable methods and the authors had not applied reliable principles and methods reliably to the facts of the case.
The Tax Court noted:
In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.…
Justice is frequently as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions. [emphasis added]
After decades of warnings regarding the standards to be applied, we may fairly reject the burden on the parties and on the Court created by unreasonable, unreliable, and irrelevant expert testimony. In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes. [emphasis added] …
We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions. Their report as a whole is too speculative and unreliable to be useful.
Although the [taxpayer’s] experts determined that sales of comparable land nearby were occurring at approximately $12,000 an acre, their conclusion would assign a value of approximately $400,000 per acre to the subject property.…
If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense. [emphasis added]
The Court concluded that the Taxpayer’s Appraisal failed to apply realistic or objective assumptions, did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted, and did not consider the effect on contiguous property owned by Boltar.
After excluding the Taxpayer’s Appraisal and testimony, the Court found the record contained factual evidence and the report and testimony of the IRS’s valuation expert. There was no credible evidence that a higher density development than single-family residential development was a use to which the property was adaptable, given the preexisting easements and existing zoning. There was no evidence that justified a value higher than the amount determined in the FPAA.
Quoting from L. Paul Hood, attorney and co-author (along with Timothy R. Lee, ASA of Mercer Capital) of The Business Valuation Reviewer’s Handbook: Practical Guidance to the Use and Abuse of a Business Appraisal from his post “Daubert Challenges and the Tax Court”:
Ouch! This is a very, very important decision and highlights the risk of trial for either party, especially where there is a wide chasm between the positions of the experts. While there are certainly two sides to every story, it certainly appears that in the opinion of the entire Tax Court, the appraisers in this case were guilty of hubris by even failing to address their own factual errors and other problems with the report except to continue to assert the correctness of their positions. What are some of the takeaway lessons from Boltar?
- It is critical that the appraiser be objective and reasonable. How do you know when your appraiser is not being objective and reasonable? It requires you to be objective and reasonable as well, even when you are zealously advocating your client’s position. Co-opting your appraiser into being an advocate is the absolutely wrong approach. This is one of the reasons why I believe that a trial appraiser should not also serve as a rebuttal expert. I believe that simultaneously serving in both capacities compromises the expert in the eyes of the court. I far prefer to keep my trial expert “above the fray” and suggest hiring a separate rebuttal expert where it is determined that one is needed, even though it admittedly adds to the cost. What if your appraiser’s conclusion of value differs greatly from that of another qualified appraiser on the other side (and by this, I don’t necessarily include the work of the IRS valuation engineers, many of whom are not qualified appraisers)? It puts the onus on you to consider the possibility of having another appraiser conduct a “review” (this is a technical valuation term of art) of the subject appraisal. On balance, reviews are suggested every time that there are large differences between the conclusions of value of qualified appraisers. True, this adds expense that the client may not go for, but it’s so important in my opinion that you should go on record in writing as having suggested it so that if your appraiser is wrong, you at least can say “I told you to get a review.”
- It is imperative that your appraiser correct errors and carefully consider how the errors affect the conclusion of value. Appraisers are human too and do make mistakes from time to time. Errors can easily be made, and in appraisal reports, errors can cascade into bigger errors as they factor themselves in at each level of the analysis, throwing the conclusion of value off even further. In Boltar, the appraisers apparently didn’t consider how their errors affected their analysis, which the Tax Court termed “fatal.”
- Where an appraiser is not following a required valuation approach format, such as that for conservation easements, or the appraiser desires to use a technique that is “cutting edge” and hasn’t been vetted with the appraiser’s peers, warning bells should go off! I normally wouldn’t permit my clients to be guinea pigs unless they understood that and were nevertheless willing to do so. I strongly encourage appraisers who are “inventive” to publish articles and speak about their technique first to their peers. I really don’t care too much about whether the technique is criticized, because appraisers are notorious in criticizing each other’s work. As long as the technique is being used by other appraisers, I’m comfortable with it being employed as long as it is done correctly and consistently.
The bottom line is to rely upon experienced and respected firms and professionals.
Mercer Capital’s work product is of the highest quality. Our professionals have been designated as expert witnesses and have testified in federal and state courts and before various regulatory bodies, including U.S. Federal District Court (Several Jurisdictions), County and State Courts (Numerous States), U.S. Tax Court, U.S. Bankruptcy Court, state regulatory bodies, and the American Arbitration Association.
To discuss a valuation issue in confidence, contact us at 901.685.2120.
A resource for attorneys and other users of appraisal reports:
A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal
To read the case, see Boltar, LLC v. Comr., 136 T.C. No 14 (April 5, 2011) at http://www.ustaxcourt.gov/InOpHistoric/Boltar.TC.WPD.pdf.
Originally published in Mercer Capital’s Value Matters (TM) 2011-02, released May, 2011.
The case of Astleford v. Commissioner1 is noteworthy for a number of reasons. For instance, the Court’s ruling provides further support for applying tiered discounts in asset holding entities, and not only were the discounts tiered but they were also significant on each level applied, resulting in total blended discounts of approximately 55% with respect to certain assets. Additionally, in the determination of the appropriate lack of control (i.e., minority interest) discounts, the Court made use of data pertaining to both REITs that were publicly traded and RELPs that were traded on secondary markets. The Court also made use of studies cited in an expert’s report to justify discounts that were more than twice those applied by the expert.
After M.G. Astleford, a real estate investor, passed away in 1995, his wife, Jane Z. Astleford (Taxpayer), created the Astleford Family Limited Partnership (AFLP) in 1996. After transferring property to the AFLP, she gifted a 30% limited partnership (LP) interest to each of her three children (the 1996 AFLP interests), and retained a 10% general partnership (GP) interest. In 1997, Taxpayer transferred additional properties to the AFLP including a 50% GP interest in Pine Bend Development Co. (Pine Bend). As a result of this transfer, Taxpayer’s GP interest in AFLP increased significantly. In order to return Taxpayer’s GP interest to 10% of AFLP, Taxpayer gifted to each of the three children additional LP interests (the 1997 AFLP interests) necessary to return the ownership structure to the initial 30/30/30/10 allocation.
The Court outlined three general issues to be addressed in its ruling:
This article will summarize the first two issues briefly, and then address the third issue, which deals with valuation discounts, in greater detail.
Issue #1 – Determine the value of 1,187 acres of Minnesota farmland (Rosemount Property)
The Taxpayer’s expert and the IRS expert each used a market approach by reviewing sales of similar properties.
According to the Court, the IRS expert was “particularly credible, highly experienced and possessed a unique knowledge of farm property located in the county in which the subject property was located.” The court used his initial value of $3,500 per acre.
However, the IRS appraiser did not apply an absorption discount to this value. The Court determined that an absorption discount was appropriate, but not to the extent applied by the Taxpayer’s appraiser. Using present value mechanics and making assumptions with respect to the holding period, discount rate, and appreciation rates, the Court applied an effective absorption discount of about 20%. The discounted price per acre was $2,786.
Issue #2 – Determine whether 50% GP interest in Pine Bend (held by the FLP) should be valued as a GP interest or an assignee interest
The Taxpayer’s appraiser argued that it should be valued as an assignee interest. As such, he discounted the interest because under Minnesota law a holder of an assignee interest would have an interest only in the profits of the partnership and would have no influence on management.
The IRS appraiser argued that the “substance over form doctrine” should apply, and therefore, the interest should be valued as a GP interest.
The court adopted the “substance over form doctrine” and rejected the Taxpayer’s argument; however, as discussed below, the Court applied a combined lack of control and lack of marketability discount of 30% to the Pine Bend interest, consistent with the Taxpayer’s appraiser’s methodology.
Issue #3 – Determine the lack of control and the lack of marketability discounts that should apply to the limited and GP interests
Figure Two summarizes the discounts applied by the Taxpayer, the IRS, and the Court.
The Taxpayer. The Taxpayer’s expert relied upon RELP secondary market data to determine that the lack of control discounts applicable to the 1996 and 1997 gifts of AFLP Interests were 45% and 40%, respectively. The RELP data, which reflected a group of four selected RELPs, provided a range of discounts of 40% to 47%. It is unclear how the Taxpayer’s expert determined that the lack of control discount applicable to the 1996 interests was greater than that applicable to the 1997 interests.
The Court noted that two of the four selected RELPs were more leveraged than AFLP. In addition, AFLP’s distribution yield of 10% was greater than the 6.7% average yield of the RELP group. The Court considered these two factors to be indicative of a lack of control discount less than that reflected in the RELP pricing. Due to these differences, among others, the Court concluded that the RELPs selected were “too dissimilar to AFLP to warrant the amount of reliance [the Taxpayer’s] expert placed on them” and the discounts for lack of control were excessive.
The IRS. The IRS expert relied upon REIT data to derive discounts for lack of control. The REIT data, which included approximately 75 REITs, indicated that the selected group traded at a median premium of 0.1% in 1996 and a median discount of 1.2% in 1997.
The Court explained that REIT prices are “in part affected by two factors, one positive (the liquidity premium) and one negative (lack of control).” The Court went on to say that liquidity premiums should be reversed out of the trading prices so as to determine the embedded discount for lack of control.3
The IRS expert used a regression analysis to determine that REITs traded at a liquidity premium of 7.79% relative to closely held partnership interests. Based upon this liquidity premium and the 1996 REIT group median premium of 0.1% and the 1997 REIT group median discount of 1.2%, the IRS expert calculated discounts for lack of control of 7.14% and 8.34% in 1996 and 1997, respectively.4
The Court. The Court ultimately decided to use the REIT data presented by the IRS expert to determine the appropriate lack of control discount, but the Court deemed the 7.79% liquidity premium offered by the IRS expert to be “unreasonably low.” Accordingly, the Court sought to calculate a more reasonable liquidity premium by calculating the difference in “average discounts observed in the private placements of registered and unregistered stock.” The Court considered any such difference as representative of “pure liquidity concerns.” Using this methodology, the Court referenced two studies cited by the IRS expert which indicated that a general premium for liquidity in publicly traded assets was on the order of 16.27%. Based upon this observed premium and the REIT group premium of 0.1% in 1996 and discount of 1.2% premium in 1997, the Court concluded that the discounts for lack of control in 1996 and 1997 should be 16.17% and 17.47%, respectively.5
Little explanation was provided with respect to the marketability discounts applicable to the gifts of AFLP interests.
The following relates to the 1996 AFLP interests:
[The Taxpayer’s] expert estimated a discount of 15%, and [the IRS] expert estimated a discount of 21.23%. We perceive no reason not to use [the IRS’s] higher marketability discount of 21.23% without further discussion, which we do.
The following relates to the 1997 AFLP interests:
Because both parties advocate a lack of marketability discount of approximately 22%, we apply a lack of marketability discount of 22%.
The Taxpayer’s expert relied upon data regarding 17 RELPs to determine a range of discounts of 22% to 46%, and he then selected a 40% discount without fully explaining the selection of that measure over the midpoint of the range or some other measure. The IRS appraiser did not apply any discount, as he claimed that any such discounts should be applied at the AFLP level only.
The Court rejected the position of each appraiser and performed its own analysis of RELP data. The Court concluded that a 30% combined discount for lack of control and lack of marketability was appropriate at the Pine Bend level, providing further support for applying tiered discounts in asset holding entities.
Figure Three summarizes the valuation conclusions reached by the Taxpayer’s expert, the IRS’s expert, and the Court.
As shown, the Court’s opinion fell within the range defined by the conclusions of the experts representing the Taxpayer and the IRS, with a slight overall bias towards the Taxpayer’s expert.
The Court’s application of an absorption discount appears to be well-grounded in present value mechanics using seemingly reasonable assumptions. Further, the general application of valuation discounts to not only the FLP interests but also the GP interest held by the FLP seems to be supported by valuation theory. However, the Court’s reliance on RELP and REIT data to determine the lack of control discount to be applied to AFLP interests is questionable.
In general, the price-to-NAV ratios observed in the REIT and RELP marketplace often reflect a numerator (price) which is current and a denominator (NAV) which is more dated. A REIT’s NAV may be determined once per year (usually at year-end) while market prices are determined by trading activity throughout the year. Under this system, some properties held by a REIT may experience rapid and unexpected appreciation in June, but NAV would still reflect the appraised values as of the preceding December, resulting in an understated NAV measure, all else equal. In this case, the price-to-NAV ratio may indicate the REIT is trading at a substantial premium to NAV due to the understated measure used in the denominator.
More meaningful valuation discounts may be derived using investment classes that have NAV measures which are updated throughout the year. One example is closed-end funds. In our experience, closed-end funds (equities and bonds) frequently trade at a discount to NAV between 0% and 15%. These discounts may be interpreted to represent a discount for lack of control.
Finally, the Court relied upon two studies (cited in the IRS expert’s report) in the determination of a liquidity premium. We note that these studies make use of equity market data (registered and unregistered stock information). The Court selects the liquidity premium implied in the equity markets and applies it to a FLP holding real estate. In a sense, the Court seems to have assumed there is only one liquidity premium for all asset classes in the marketplace. The Court uses this liquidity premium in tandem with the price-to-NAV ratios of REITs to calculate the resulting discount for lack of control for the AFLP interests. Intuitively, there appears to be a disconnect between REIT market pricing and the premiums paid for registered versus unregistered equity interests.
Endnotes
1 Jane Z. Astleford v. Commissioner, T.C. Memo 2008-128, filed May 5, 2008
2 The Court’s absorption discount was based upon assumed market absorption over a four-year period, a discount rate of 10%, appreciation of 7% per annum, sales expenses of 7.25%, and property taxes of 60 bp. Taxpayer’s expert made similar assumptions, but applied a discount rate of 25% (rather than 10%).
3 With respect to REIT data, discounts and premiums are based upon the ratio of price to NAV.
4 The relevant formula is: (1 + Liquidity Prem.) x (1 – LOC Discount) = (1 + Disc. or Prem. to NAV). Using 1997 as an example: (1.0779) x (1 – LOC Discount) = 0.988. (1 – LOC Discount) = 0.9166. Lack of Control Discount = 8.34%.
5 For 1996: 16.27% – 0.1% = 16.17%. For 1997: 16.27% + 1.2% = 17.47%.
Reprinted from Mercer Capital’s Value Added™, Vol. 20, No. 2, 2008
The Estate of Charlotte Dean Temple in United States District Court (No. 9:03 CV 165(TH) was adjudicated on March 10, 2006. This was a civil action for recovery of federal gift taxes and related interest. Plaintiff Arthur Temple (“Temple”) individually and as executor of the estate of his wife, Charlotte Dean Temple paid gift taxes on various gifts during the period 1997 – 1998 which upon audit were deemed to be undervalued. Temple paid the assessments and filed claims for a refund.
There were four entities at issue in this case: Ladera Land, Ltd (“Ladera Land”); Boggy Slough West, LLC (“Boggy Slough”); Temple Investments, LP; and Temple Partners, LP (collectively the “Temple Partnerships”). All four entities were asset holding entities: one LLC and three partnerships, all appropriately valued based on the underlying net asset value approach. As the Court saw it, “A critical factor in this case is determining the appropriate diminution in value between a hypothetical willing buyer and a hypothetical willing seller.” In other words, the key analytical factors in dispute were the prospects for a minority interest discount and a marketability discount.
For an analysis of the appropriate discounts for Ladera Land, Temple engaged the services of appraiser Nancy M. Czaplinski. Net asset values do not appear to have been in dispute. Czaplinski utilized the net asset value approach to this entity, although the Court chided her for discussing the appraisal only with Temple’s attorney, and not with any principals of the entity.
Minority Interest Discount
Czaplinski selected a 25% minority interest discount, based on “the inverse of the premium for control”, which in turn was derived from Mergerstat data. Czaplinski testified in court that the Mergerstat data is a study of operating companies but that she classified Ladera Land as a holding company.
Marketability Discount
Czaplinski utilized the Quantitative Marketability Discount Model (QMDM) to assess the lack of marketability discount for Ladera Land. She assumed the following input items to implement the QMDM: 1) the holding period of a Ladera Land partnership interest is between 10 and 15 years; 2) the minority investor requires a holding period return on investment of 18-20%; 3) Ladera Land’s distribution yield is 5%; and 4) the expected appreciation of Ladera Land’s real property is 3%. These parameters provide a range of marketability discounts from 47% to 61%, as shown in Table 1.
The Court was unconvinced on several assumptions, but not on the applicability of the model. The 5% yield assumption was made without talking to anyone at Ladera Land, and the entity was not making distributions (although the assumption of a 5% yield would tend to reduce, rather than increase, the marketability discount). The expected property appreciation at 3% was based on conversations at Czaplinski’s own firm, not based on real estate appraisals. The Court did not understand the concept of the prospective holding period, saying “…the Court finds that it is inappropriate to assume a particular holding period for the hypothetical buyer” since there is no holding period requirement for the partnership interest.
It is on this last point that the Court missed the mark. As securities analysts, we make investment decisions in the marketplace every day, based on prospective holding periods. Life insurance policies are priced based on actuarial tables which clearly imply a holding period; corporate bonds are often priced at “yield-to-maturity” which thereby captures the current distribution yield as well as the implicit gain from a discount from par to maturity at par value. If you don’t hold it until maturity, you don’t get that full yield. Tax law recognizes holding period distinctions in the segregation of short-term gains from long-term gains. Common stock investors manage stock portfolios according to business, product cycle or interest rate cycle moves, with an investment time horizon in mind that dictates the relative mix of the portfolio.
In the case of closely held common stock, the analyst must make a reasonable assumption with regard to a prospective holding period; i.e., not necessarily until the termination of the partnership, but until that future date when some liquidity event occurs that may feasibly convert a security interest into cash. During that interim period, the investment has a security interest growing at some internal growth rate and possibly distributing some cash along the way. But a longer time horizon (holding period) implies a larger marketability discount, other things being equal.
Lacking specific testimony at the valuation date with regard to alternative minority interest discounts, the Court did not specify a minority discount. Rather, it combined the minority and marketability discounts into a single 33% discount for the limited partnership interests, and combined that with an “additional incremental marketability discount because of their status as private and non-registered interests.” It is unclear how private and unregistered interests are distinguished from those impacted by the 33% marketability discount. Clearly, the Court was getting beyond its grasp in the application of this separate, ill-defined discount. The overall result is shown in Table 2.
For an analysis of the appropriate discounts for Boggy Slough, Temple also employed Czaplinski, who utilized the same assumptions as in Ladera Land, also without discussing the appraisal with management. She concluded a 25% minority interest discount and a 45% marketability discount, again utilizing the QMDM. The Court echoed its concern over the assumptions in the QMDM, but had additional testimony from another expert, William J. Lyon, who testified about the difficulties in partitioning the underlying properties. Based on this additional input, the Court concluded that “Lyon’s valuations support Czaplinski’s calculations”, at least in the gift of larger interest. For four smaller gifts to grandchildren, the Court defaulted to its 38% overall discount as shown in Table 3.
The Temple Partnerships include Temple Investments, LP and Temple Partners, LP, both asset holding partnerships owning marketable securities in public companies. For the assessment of appropriate discounts for these entities, Temple engaged Mr. Charles Elliott, and the government expert was Mr. Frances Burns. Details in the case write-up are sketchy with regard to the minority and marketability discounts, however, the Court favored the Burns approach.
Minority Discount
Burns relied on a published weekly list of closed end funds, which showed discounts or premiums to net asset value. He did not exclude any funds, and calculated the mean discount at the three valuation dates, showing that the discount varied by date: 7.5%, 10.1% and 3.3%. Elliott had excluded some funds without explanation. The Court concluded that “Burns properly examined transactions involving closed end funds” and the minority interests corresponded to the published mean discounts to net asset value. “This method was used by the Tax Court in Peracchio v. Commissioner, 86 T.C.M. (CCH) 412 (2003). The Court observed that this was ‘an approach we have previously followed in the context of investment partnerships … and we shall do so again here.’ “
Marketability Discount
The QMDM was not utilized for the Temple Partnerships by either appraiser. In the determination of the marketability discount, Burns considered and relied upon seven factors: 1) restricted stock studies; 2) academic research; 3) the costs of going public; 4) secondary market transactions; 5) asset liquidity; 6) partnership interest transferability; and 7) whether distributions were made. By contrast, Elliott used restricted stock sales but did not analyze them as fully as Burns. Rather than taking restricted stock sales and explaining its relation to the gifted interests, Elliott simply listed the studies and picked a discount based on the range of numbers in the studies. The Court concluded: “The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner, as Burns did.” The Court accepted the 12.5% marketability discount derived by Burns. The summary results are shown in Table 4.
Minority Interest Discount
The Court here and with reference to prior cases has concluded that minority interest discounts (for investment companies) based on transactions involving closed end funds is an acceptable method. They focused on the mean as the statistical measure of central tendency. The median can also be useful, since it is not as distorted by extreme data at either end of the spectrum. The concept on both data bases is identical.
Marketability Discount
The Court is still struggling with this issue, and as jurists, cannot be expected to have a complete grasp of investment analysis. In the Temple case, they defaulted to the restricted stock studies, although concluding that the better approach was to “analyze the data” from the restricted stock studies to ensure applicability to the subject case. The Court appeared to be moving away from restricted stock studies in Peracchio, although it is clear overall that the Court is seeking more relevant analysis that it can apply directly to the facts and circumstances of a particular case.
At Mercer Capital, we have carefully reviewed the restricted stock studies and concluded that the dissection of academic studies into homogeneous sub-groups that can be applied with confidence to a particular case is not a helpful approach. The determination of a marketability discount is an investment decision, not an academic one, and it is necessarily based on investment facts and assumptions. These facts and assumptions include: competing rates of return for alternative investments; the growth rate of the underlying asset during the holding period; the expected dividend yield; the growth rate of the dividend; and yes, an expected holding period until some prospective liquidity event. As appraisers, we must deal with incomplete information all the time and base our analysis on the facts as we know them and on assumptions that are reasonable and defensible.
The QMDM fulfills the Court’s demand for analysis, and provides a framework for making a reasonable investment decision that can be applied to the facts and circumstances of a particular case. Facts are a key part of this, but so are the assumptions, some of which can be based on relevant market data and some of which must be based on a discussion with management. Again, in the end, it’s an investment decision, not an academic one. In the Temple case, the Court did not dismiss the QMDM, it just had a problem with the appraiser’s assumptions; and it missed the important perspective of the holding period as a necessary component of any investment decision.
At Mercer Capital, we have used the QMDM to assess the prospects for a marketability discount for over 10 years. It forces us as securities analysts to consider the facts and circumstances of an individual case and make an informed investment decision. Please give us a call if we may help you in your investment decision process.
Estate of Noble v. Commissioner was filed on January 6, 2005.1 In a 30 page decision, the Court gave short discussion to the reports of two experts, rather, focusing the decision on a discussion of a sale of the subject block some 14 months after the date of death (the valuation date). Two important issues are raised by Noble.
This article addresses both issues in the context of Noble and within one appraiser’s understanding of the meaning of fair market value.
The subject of the valuation was 116 shares of Glenwood State Bank (“the Bank”), representing 11.6% of its 1,000 shares outstanding at September 2, 1996 , the date of death of Helen M. Noble (“the Estate”). Glenwood State Bank was a small ($81 million in total assets), over-capitalized (17.5% equity-to-assets ratio), low-earning bank (3% to 5% return on equity for the last four years) located in rural Glenwood , Iowa . Historical growth of the balance sheet had been anemic prior to the valuation date, and prospects for future growth were similar. Management’s philosophy, implemented over many years, was to reinvest all earnings back into the Bank and to pay no shareholder dividends. There was no market for the Bank’s shares.
The Estate’s 11.6% block of the Bank’s stock was the only block of the Bank that Glenwood Bancorporation, the parent holding company (“the Company”), did not own at the valuation date. The Company had, over a period of many years, gradually consolidated its ownership of the Bank to this point. The Company’s historical philosophy had mirrored that of the Bank, and no dividends were paid historically or anticipated for the near future.
In short, the subject 11.6% interest in the Bank was not a very attractive investment, when viewed in terms of then-current expectations for growth, dividends, and overall returns for publicly traded bank shares.
Two appraisals were submitted to the Tax Court in this matter:
In addition, Glenwood State Bank had obtained an appraisal from Seim, Johnson, Sestak & Quist, LLP, an accounting firm, of the fair market value of the same shares as of December 31, 1996 (“the Seim Johnson Report”). This report concluded that the fair market value of the shares was $878,004 ($7,569 per share).
The Estate originally reported the fair market value of the shares at $903,988 ($7,793 per share based on then-current book value less a minority interest discount of 45%).
One more fact is important for this introduction. The Estate sold its 116 shares to Glenwood Bancorporation on October 24, 1997 , almost 14 months after the valuation date, for $1,100,000.2
Focusing on the expert reports of Herber and Mercer, the total difference in value between the two appraisals of the 11.6% interest was $259,000. Herber’s result was about 30% higher than Mercer’s. Relative to many valuation disputes, the differences were fairly small. Both appraisers agreed on the relative unattractiveness of the subject shares as an investment. Herber’s appraisal represented 73% of the Bank’s book value, while Mercer’s appraisal represented 56% of book value.
The major difference in valuation conclusions between the two appraisers was the difference in their concluded marketability discounts. This was an opportunity for the Court to address these differences in a meaningful way; however, that did not occur. We present information here not found in the opinion to inform the reader of the rest of the story.
After discussing two sales of minority interests of the Bank’s stock, one of which occurred some 15 months prior to the valuation date (at $1,000 per share), and the other of which occurred about two months prior to the valuation date ($1,500 per share), the Court’s decision notes:
As to the third sale, which occurred on October 24, 1997, approximately 14 months after the applicable valuation date, we disagree with petitioners that only sales of stock that predate a valuation date may be used to determine fair market value as of that valuation date. The Court of Appeals for the Eighth Circuit, the court to which an appeal of this case most likely lies, has held specifically that “In determining the value of unlisted stocks, actual sales made in reasonable amounts at arm’s length, in the normal course of business, within a reasonable time before or after the basic date, are the best criterion of market value.”3 [citations omitted, emphasis added]4
No mention is made in the Court’s decision as to what constitutes a “reasonable time” before or after a valuation date. The Court goes on to say, after further discussion of the subsequent transaction, that:
When a subsequent event such as the third sale before us is used to set the fair market value of property as of an earlier date, adjustments should be made to the sale price to account for the passage of time as well as to reflect any change in the setting from the date of valuation to the date of sale. [citing Estate of Scanlan5] These adjustments are necessary to reflect happenings between the two dates which would affect the later sale price vis-à-vis a hypothetical sale on the earlier date of valuation. These happenings include: (1) Inflation, (2) changes in the relevant industry and the expectations for that industry, (3) changes in business component results, (4) changes in technology, macroeconomics, or tax law, and (5) the occurrence or nonoccurrence of any event which a hypothetical reasonable buyer or hypothetical reasonable seller would conclude could affect the selling price of the property subject to valuation (e.g., the death of a key employee [citing Estate of Jung6].
The record before us does not establish the presence of any material change in circumstances between the date of the third sale and the applicable valuation date. [emphasis added]7
The Court noted that the 116 shares sold for a total of $1.1 million, or $9,483 per share, on October 24, 1997 . In response to the above guidance regarding “the happenings between the two dates” the Court stated: “While the record does not accurately pinpoint the appropriate rate to apply for that purpose [inflation], the Bureau of Labor Statistics has stated that the rate of inflation during each of the years 1996 and 1997 was slightly less than 3 percent.”
The five factors noted above are now considered:
Neither Mercer nor Herber provided an analysis of events in the stock market, in the market for bank stocks, or of detailed financial performance of Glenwood State Bank subsequent to the valuation date. Both appraisers were providing valuation opinions as of September 2, 1996 . Mercer mentioned the subsequent transaction in his report, and both appraisers mentioned the transactions prior to the valuation date. The Mercer Report discussed the subsequent change in dividend policy in detail.
It should be clear from the above analysis of the factors mentioned by the Court, that there were material changes, virtually all positive regarding the value of 116 shares of Glenwood State Bank, between the valuation date of September 2, 1996 and the subsequent transaction on October 24, 1997.
The Court’s analysis of subsequent transactions raises several questions:
It is my understanding of the investment process that investors consider all relevant information, including that which is known and that which is reasonably foreseeable, or reasonably knowable, up to the moment that an investment is executed. After that, there are no second chances. Real-life investors know that one of only two things will happen with respect to the return performance of any particular investment:
The investment’s ultimate performance will be the (net) result of many factors, including the actual performance of the underlying entity, changes (favorable or unfavorable) in national economic conditions or specific industry conditions, the general level of the stock markets and the particular performance of a particular industry, and the other factors noted above.
The Court’s decision in Noble causes great uncertainty for both appraisers and taxpayers.
A Four-Factor Test for Bargaining Parity
The second fundamental issue in Estate of Noble relates to the nature of arm’s length transactions. This writer understands the nature of the standard of value known as fair market value to consist of:
A transaction involving these characteristics would be an “arm’s length” transaction in the context of fair market value. Fair market value transactions presume bargaining parity. Note from this definition that an actual transaction in nonpublicly traded stock would not meet the definition of arm’s length transactions in the context of fair market value if one or more of the following four conditions of bargaining parity are not met:11
It will be helpful to review the concept of arm’s length transactions in the context of these four essential elements of bargaining parity, i.e., through the four factor test outlined above. Although this test was not employed explicitly in this manner in the Mercer Report, it was employed implicitly in the discussion and analysis of the three transactions.
The Court paraphrased Polack v. Commissioner12 and Palmer v. Commissioner13 in introducing its discussion of arm’s length transactions:
While listed stocks of publicly traded companies are usually representative of the fair market value of that stock for Federal tax purposes, the fair market value of nonpublicly traded stock is “best ascertained” through arm’s-length sales near the valuation date of reasonable amounts of that stock as long as both the buyer and the seller were willing and informed and the sales did not include a compulsion to buy or to sell.14
While this guidance is flawless as far as it goes, it needs to be viewed, as just indicated, through the filter of the four factors of bargaining parity.
The Court’s decision discusses three transactions in the stock of Glenwood State Bank, the two occurring before the valuation date and the subsequent transaction some 14 months after the valuation date. The Court determined that the two prior sales were not at arm’s length:
As to the two prior sales of stock in this case, we also are unpersuaded that either of those sales was made by a knowledgeable seller who was not compelled to sell or was made at arm’s length.15
The Court actually made two additional comparisons in reaching its conclusion regarding the two prior sales. First, the decision notes that they were both smaller in size (1% or less of the shares) than the subject interest (11.6%). And second, it was noted that neither of these two transactions was made based on an appraisal.
The Court discussed the subsequent transaction at some length at this point:
Petitioners try to downplay the importance of the subsequent (third) sale of the estate’s 116 Glenwood Bank shares by characterizing it as a sale to a strategic buyer who bought the shares at greater than fair market value in order to become the sole shareholder of Glenwood Bank. Respondent argues that the third sale was negotiated at arm’s length and is most relevant to our decision. We agree with respondent. Although petitioners observe correctly that an actual purchase of stock by a strategic buyer may not necessarily represent the price that a hypothetical buyer would pay for similar shares, the third sale was not a sale of similar shares; it was a sale of the exact shares that are now before us for valuation. We believe it to be most relevant that the exact shares subject to valuation were sold near the valuation date in an arm’s length transaction and consider it to be of much less relevance that some other shares (e.g., the 10 shares and 7 shares discussed herein) were sold beforehand. The property to be valued in this case is not simply any 11.6% interest in Glenwood Bank; it is the actual 11.6-percent interest in Glenwood Bank that was owned by decedent when she died. [emphasis added]16
It would appear that the Court determined that because the same 116 shares sold 14 months after the valuation date for $9,483 per share, they were therefore worth the same $9,483 per share (less a discount for inflation) at the date of death some 14 months prior.
In reaching this conclusion, the Court did something that both appraisers warned against, in effect, assuming that the exact transaction that occurred was foreseeable.17,18 There is a world of difference in the relative risk assessment by hypothetical willing buyers and sellers between two different situations: 1) it is reasonably foreseeable that a transaction will occur at a specific price and at a specific time in the future; or 2) it is generally foreseeable that a transaction, or a variety of potential transactions, could occur at some unknown and indefinite time (or times) in the future. The Court’s analysis effectively assumed the first situation existed at the valuation date when, in fact, the second situation existed. In doing so, the Court ignored the risks of the expected investment holding period from the perspective of hypothetical buyers and sellers at the actual valuation date.
The Court also did not believe that Glenwood Bancorporation had specific motivation to purchase the shares which would cause it to pay more at the subsequent date.
Moreover, as to petitioners’ argument, we are unpersuaded by the evidence at hand that Glenwood [Bancorporation] was a strategic buyer that in the third sale paid a premium for the 116 shares. The third sale was consummated by unrelated parties (the estate and Bancorporation) and was prima facie at arm’s length. In addition, the estate declined to sell its shares at the value set forth in the appraisal and only sold those shares 5 months later at a higher price of $1.1 million. Although the estate may have enjoyed some leverage in obtaining that higher price, as suggested by Mercer by virtue of the fact that the subject shares were the only Glenwood Bank shares not owned by the buyer, this does not mean that the sale was not freely negotiated, that the sale was not at arm’s length, or that either the estate or Bancorporation was compelled to buy or to sell. 19
The Court is assuming that transactions occurring between unrelated parties provide prima facie evidence of their arms’ length natures. However, independence is only one of the four factors insuring bargaining parity and therefore, arms’ length transactions. The Court asked Mercer about the nature of this particular transaction. Mercer testified that while a transaction may appear to be at arm’s length, it should not be evidence of fair market value if there is an inequality of information regarding the potential transaction.20
Another Analysis of the Three Transactions
The Mercer Report provided background information for the two transactions prior to the valuation date as follows:
The Mercer Report also discussed the subsequent transaction at some length, and analyzed it in light of the facts and circumstances in existence at the subsequent transaction date, at least as they related to Glenwood State Bank and Glenwood Bancorporation. As noted above, the Mercer Report indicated that a significant change in policy would have materially changed the value of the subject 116 share block. Glenwood Bancorporation, after many years of not desiring to upstream dividends from Glenwood State Bank, changed its mind. The reason for this change was a decision to build a new bank in Council Bluffs , Iowa , to enter the greater Omaha metropolitan market. This decision required capital that was lying dormant in the Bank, and would require that significant dividends be paid by the Bank to the Company. Importantly, Glenwood Bancorporation did not inform the Estate’s representatives of this change in policy prior to the transaction. So the second factor of the four-factor bargaining parity test was not met. This was noted in the Mercer Report.
The Mercer Report did indicate that such a change in dividend policy could occur at Glenwood Bancorporation (i.e., was reasonably knowable); however, the analysis indicated that no rational, independent investor would assume that the change would occur in such a short time as a year or so, and that if dividends were to be paid, there would be a material, upward pressure on the value of the Bank’s minority shares.
It is important to place this subsequent change in dividend policy in perspective. The following table, provided in the Mercer Report in the discussion of the subsequent transaction, should indicate clearly that if the dividend policy had been in place at the valuation date, the valuation conclusion should have been significantly higher than either the Mercer conclusion or the conclusion of the Herber Report or that of the Court based on the subsequent transaction.
As noted above in the discussion of the nature of subsequent transactions, something material changed between the date of death and the subsequent transaction. Glenwood Bancorporation decided that it desired to receive dividends from Glenwood Bank after many years of not having the Bank pay dividends. This change in policy necessarily had a change on the value of the Bank’s shares since, other things being equal, an investment that pays dividends is worth more than one that does not pay dividends.
The Court’s analysis does not mention the remaining, critical element of a fair market value transaction – that both parties be reasonably (and equally) informed about the investment. This is a point that Mercer addressed both in his direct testimony (report) and in cross-examination.
Given that the Estate sold 116 shares for $1,100,000 on October 24, 1997 , consider the following regarding equal and reasonable information:
In fact, both the Seim Johnson and Herber Reports stated the following about the expectation of future dividends:
“Glenwood State Bank has not paid any dividends since May of 1984 and has indicated no intention to pay dividends in the near future. This decreases the value of the common stock, and, also, it adversely impacts a willing buyer’s decision to purchase the stock.” [emphasis added, Seim Johnson Report at page 7]
“As of September 2, 1996 , Glenwood State Bank had not paid a dividend in over a decade and had no plans to pay dividends in the future.” [Herber Report, page 15]
These valuation reports, prepared just shortly after the date of death (Seim Johnson) and much later (Herber), affirm the stated policy of the Bank that was provided to Mercer Capital during interviews held in 2004. They also affirm the fact that there was a significant change in policy between the date of death and the time of the third transaction some 14 months later.
The point of this discussion is that there was a material change of facts between the valuation date and the subsequent transaction and this change of facts was known to only one of the two parties to the transaction. This causes the subsequent transaction to fail the four factor bargaining parity test and disqualifies the transaction as an arm’s length transaction in the context of a determination of fair market value. In fact, had the change of policy been known, it is almost certain that the subsequent transaction would have occurred at a price substantially higher than the actual price of $9,483 per share.
The four-factor bargaining parity test is summarized for the three transactions below.
It would appear that the prior transaction involving Mr. Hopp, the former director of Glenwood State Bank, would meet the four-factor test. It occurred at a very low price (relative to book value) at a time when a knowledgeable, independent buyer had no expectations of future dividends or other avenues to liquidity within a reasonable timeframe.
It is simply unknown if the second prior transaction meets the four-factor test.
But it is clear that the subsequent transaction does not meet the test. The parties were clearly not equally informed about the change in dividend policy that Glenwood Bancorporation planned to implement immediately following the transaction.
So the question is, how can a subsequent transaction that would not pass the four-factor test for arm’s length bargaining parity at the date it occurred provide evidence of the fair market value of shares some 14 months prior to that date? In the opinion of this writer, it cannot.
The Court considered that the sale was negotiated at arm’s length as prima facie evidence that the subsequent transaction was evidence of fair market value. However, it should be clear from the analysis above, which was presented to the Court in the Mercer Report, that there was a material change of circumstances between the date of death the date of the subsequent transaction. It should further be clear that the parties engaging in that subsequent transaction were not dealing with the same information about the value of the subject interest.
Estate of Noble raises two very important issues for business appraisers:
Should transactions (or events) occurring subsequent to a given valuation date be considered in the determination of fair market value as of that valuation date? If so, how should they be considered in the context of facts and circumstances in existence at the valuation date? How long after a given valuation date can information from a subsequent transaction be considered relevant? Opening the door to the routine analysis of subsequent transactions as providing evidence of valuation at earlier dates would seem to fly in the face of the basic intent of the fair market value standard of value.
Are transactions occurring between apparently independent parties prima facie evidence of arm’s length transactions in the context of fair market value? The four-way test of bargaining parity introduced above questions the relevance of at least certain otherwise arm’s length transactions as providing evidence of fair market value.
The questions and issues raised by Estate of Noble are important for appraisers and for taxpayers. Regarding subsequent transactions, it would seem that appraisers and the Tax Court should focus on events known or reasonably foreseeable as of the valuation date as the basic standard for fair market value determinations. Any other approach would seem to raise more questions than can be answered, and would seem to place at least one party in a valuation dispute at a distinct disadvantage.
Finally, regarding the nature of arm’s length transactions, it would seem that a more definitive understanding of the nature of “arm’s length” is needed than the mere fact that parties appear to be independent of each other. The four-way bargaining parity test above indicates that independence is only one of four factors needed to define an arm’s length transaction characterized by equal bargaining power.
1 Estate of Helen M. Noble v. Commissioner, T.C Memo. 2005-2, January 6, 2005.
2 In the final analysis, this fact was determinative of value in the Court’s decision. There was surprisingly little discussion of any of the three valuation reports before the Court in Noble.
3 The Herber Report did not mention the subsequent transaction. The Mercer report mentioned the subsequent transaction, but did not rely on it in reaching its appraisal conclusion. Herber’s conclusion, however, was identical to the value of the subsequent transaction. Mercer’s report analyzed the subsequent transaction and placed it into perspective with his valuation-date conclusion, indicating that circumstances had changed between the valuation date with respect to expected dividend policy at Glenwood Bancorporation (and therefore, with respect to Glenwood Bank). Mercer noted that while Glenwood Bancorporation knew of this change in policy, it was not communicated to the Estate’s representatives prior to the transaction.
4 Supra. Note 1, pp. 21-22.
5 Estate of Scanlan v. Commissioner, T.C. Memo. 1996-331
6 Estate of Jung v. Commissioner, 101 T.C. at 431.
7 Supra. Note 1, pp. 28-29.
8 The Court asked Mercer a direct question on the appropriateness of discounting a subsequent transaction to the valuation date “at interest.”
THE COURT: Okay. Another question for you. I asked you earlier about the possible use of the October transaction as a potential for a valuation. If one wanted to look at that and factor in an interest rate what rate would you use in order to factor that in?
THE WITNESS: Well, let me answer it just one other – one slightly different way. If you look at our valuation, my valuation, that 841,000, and I understand that Mr. Herber’s problem with talking about I and we, because we do that as firms, and you apply a 17 percent rate of return you would get to about , oh, a million. The 1.1 million, the 1.14 years implies about a 25 of 26 percent rate of return. That would not be unusual for an earlier [than anticipated] transaction.
THE COURT: But you are looking at a rate of return. I am simply saying wouldn’t you just factor, couldn’t one just factor in an interest rate, in other words, like a discount rate for time value of money?
THE WITNESS: Well, no, because the fact of the matter is an interest rate for the time value of money would not include premium for the risk of holding the stock for that period of time. So at the very least if you were going to do that to reverse back to the present you would build up a discount rate to 16, 18, 20 percent, or 26 percent, or some number, and bring that back to the present. The time value of money would not account for that risk.
THE COURT: Okay.
THE WITNESS: When you buy stock now, you have the risk going forward, and you don’t know about the transaction.
9 Clearly, the conclusions of both appraisers would have been higher had there been any reasonable expectation of such dividends in the readily foreseeable future.
10 The answer to this question is “obviously not.”
11 Mercer Z. Christopher, Valuing Enterprise and Shareholder Cash Flows – the Integrated Theory of Business Valuation ( Memphis , TN : Peabody Publishing, 2004). These issues are discussed at some length in chapter 8: “Fair Market Value vs. the Real World.”
12 Polack v. Commissioner, 366 F.3d 608, 611 (8th Cir. 2004), affg. T.C. Memo. 2002-145.
13 Palmer v. Commissioner, 62 T.C. 684, 696-698 (1974).
14 Supra. Note 1, pp. 12-13.
15 Supra. Note 1, p. 20.
16 Supra. Note 1, p. 25.
17 Counsel for the Internal Revenue Service asked Mercer a series of questions regarding the third transaction. The last question and answer was:
Q. Right. And this stock was liquidated in slightly over one year.
R. Sure. Hindsight is 20/20. I’m saying that [it] is not a reasonably foreseeable event that in 1.14 years that the stock would be sold at the price it was sold at, in my opinion.
18 Mr. Herber, the expert retained by the Internal Revenue Service, was asked directly about whether he thought the third transaction was foreseeable:
THE COURT: Do you think that as of the valuation date that subsequent sale was foreseeable by a hypothetical buyer and seller?
THE WITNESS: No.
THE COURT: Why not?
THE WITNESS: Because of the facts that are talked about in the report. They had not paid dividends. They did not want to sell the bank. There was definitely – you could not foresee that specific transaction.
THE COURT: But could you foresee the fact that there would be some transaction with a period of time?
THE WITNESS: Oh, yes, yes.
19 Supra. Note 1, pp. 25.
20 The Court’s question was raised immediately following Mercer’s “20/20 hindsight” comment quoted in Footnote 17 above.
THE COURT: That sale, though, Mr. Mercer, as far as you know that was an arm’s-length sale?
THE WITNESS: Your honor, as far as I know it was an arm’s-length sale, but let me be careful to answer a little further. An arm’s-length sale does not necessarily provide evidence of fair market value even if the transaction occurs prior to the valuation date. An arm’s-length sale with compulsion is – that’s arm’s-length, but there is compulsion [and it] would not qualify as evidence of fair market value. An arm’s-length sale with lack of knowledge would not qualify as evidence of fair market value. And I’m suggesting that this transaction was an arm’s-length sale with lack of knowledge.
THE COURT: And specifically what was the lack of knowledge? I know you have testified earlier to it, but if you would repeat it, I would appreciate it.
THE WITNESS: That the relationship between Glenwood Bank Corporation [Bancorporation], the likelihood that dividends would be paid in the future, or that I would have a chance to negotiate for this a favorable sale. The existence of Glenwood Bank Corporation, we don’t know that anyone knew that Glenwood Bank Corporation even existed because the shareholders of the bank had no reason to know anything about it. They file separately to the Federal Reserve, you know, to the federal authorities.
And the only reason we know about it is because we asked. And when we asked about the holding company, then we looked at the historical financial statements of the holding company. Now to show you the relationship between the bank and the holding company and the lack of interest of this management in paying shareholder dividends prior to the valuation date, there was over $400,000 of debt at the parent company, Glenwood Bank Corporation. It would have been an easy thing to do to upstream a dividend to pay that debt.
Rather than do that and pay the dividend to the shareholder [the 11.6% that would go to the 11.6% interest holder in the Bank], they went and bought more stock in Glenwood Bank Corporation, putting $400,000 into Glenwood Bank Corporation and paying down that debt externally. That’s a fact. That would not give me a great deal of conviction that I was likely to get dividends any time real soon.
Reprinted from Mercer Capital’s Value Matters™ 2005-02, March 4, 2005.
The Family Limited Partnership (“FLP”) has been a common estate planning technique for the nation’s wealthy. For years it allowed families to avoid some tax liability when transferring assets to heirs by first placing those assets in a FLP. And for years the U.S. Tax Court ruled in favor of these tax-minimizing vehicles. The IRS responded by fighting those who might use the FLP to avoid paying taxes on the full and undiscounted value of their estate. While the IRS’s early opposition hinged on the valuation discount applied to FLP interests, recent cases have focused on the inclusion of a FLP’s underlying assets in a taxpayer’s estate via §2036.
According to §2036: (a) General Rule.–The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death– (1) the possession or enjoyment of, or the right to the income from, the property … [emphasis added]. The “bona fide sale” exemption is important to our topic today. In essence, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception.
The IRS has raised a number of considerations in its recent challenges of FLPs. Such considerations include whether or not the taxpayer respected the FLP’s formality on both a formation and operational basis, whether or not the taxpayer contributed assets for personal use to the FLP, and whether or not the taxpayer maintained assets outside of the FLP sufficient to maintain a pre-FLP lifestyle.
The Estate of Thompson v. Commissioner (2002) illustrates the first success of the IRS.[1] The deceased created two FLPs, one for each of his children. The Tax Court, however, found that the deceased had retained benefits from the assets that he had transferred to the FLP. It rejected the family’s argument that the exchange for limited partner interests was a bona fide sale; instead, the Court deemed the transfer a “recycling of value.” Accordingly, the Tax Court stated that the asset contributions had “no legitimate business purpose” and held that the value of all the assets in the estate should be taxed at the full amount.
The next big win for the IRS came in the Appeals Court in Strangi II (2003).[2] Continuing its assault on FLPs in relation to §2036, the IRS found favor in the Appeals Court because the Tax Court found that the transferor continued to enjoy the benefits of the assets transferred and derived his economic support from the assets; thus, the Tax Court concluded that the FLP had no business purpose.
A third case that illustrates the success of the IRS is Kimbell v. US.[3] The IRS now had two strategic assault methods in its use of §2036. The first method focused on demonstrating that the FLP had no operational aspects, and the second method attempted to demonstrate that the FLP contained an “implied understanding” that the transferor would retain benefit or control of the assets. Because the deceased retained “legal right” in the FLP’s documents to control partnership assets, the Tax Court found that the FLP was in violation of §2036 and would pay taxes on the full value of the assets.
In spite of a series of victories, such as those summarized above, the IRS’ §2036 argument was not victorious in Estate of Stone.[4] In its November 7, 2003 decision, the Tax Court provided much needed clarity related to confusion surrounding §2036. Relevant background information includes:
At first reading, the fact set in this case has similarities to the §2036 challenges raised in Thompson, Kimbell, and Strangi. These include death soon after formation of the FLP, distributions from the FLP used to pay the estate taxes, distributions that were not made on a pro-rata basis, retention of significant FLP interests, as well as retention of the controlling general partner interest.
As noted in the decision, “In order to resolve the parties’ dispute under §2036(a)(1), we must consider the following three factual issues presented in each of the instant cases:
As to the question regarding the transfer of property, the Court concluded “… that Mr. Stone and Ms. Stone each made a transfer of property under §2036(a).[6] As to question (2), the IRS argued that the transfer did not qualify under the bona fide sale exception, citing that the average 43% discounts claimed for tax purposes conflicted with the exception’s stipulations, which describe an exempt transfer as “a sale for adequate and full consideration only if that received in exchange is ‘an adequate and full equivalent reducible to money value.’”[7] Several facts which proved critical to the Tax Court’s approval of the transfers as bona fide sale exceptions included the following:
The Tax Court concluded that the transfers of assets by Mr. and Mrs. Stone to the FLPs were for adequate and full consideration in money or money’s worth. Furthermore, unlike in Estate of Harper, in which the Tax Court indicated that the creation of the partnerships was not motivated primarily by legitimate business concerns, the Court stated that the transfers executed by Mr. and Mrs. Stone failed to constitute unilateral recycling of value.[9]
As to question (3), because the transfers qualified under the bona fide sale exemption, the Tax Court deemed unnecessary the consideration of whether or not the decedents retained possession or enjoyment of or rights to income from the transferred property.
In spite of Thompson, Kimbell, and Strangi, among others, the FLP’s viability as an effective estate planning tool appears intact based on Estate of Stone. As stated earlier, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception and that seems to be the linchpin in these cases.u
Endnotes
1 Estate of Thompson – T.C. Memo. 2002-246 (September 26, 2002)
2 Estate of Strangi – T.C. Memo. 2003-145 (May 20, 2003)
3 Kimbell v. U.S. – No. 7:01-CV-0218-R, USDC ND TX., Wichita Falls Div. (January 14, 2003)
4 Estate of Stone v. Commissioner – T.C. Memo. 2003-309 (November 7, 2003)
5 Ibid.
6 Ibid.
7 Ibid.
8 Ibid.
9 Estate of Harper – T.C. Memo. 2002-121 (May 15, 2002)
Reprinted from Mercer Capital’s Value Matters™ 2003-08, December 4, 2003.
The Tax Court’s decision in Albert J. and Christine M. Hackl v. Commissioner1 has provoked a lively discussion about how to achieve discounts to net asset value and still qualify for the annual exclusion. We challenge the notion that obtaining deep discounts requires a host of restrictive provisions in the operating agreements. We also propose a broader definition of economic interest that includes the growth in value of underlying assets.
A.J. Hackl established a tree farm for the purpose of long-term growth (no pun intended). As he expected, it incurred losses in the first few years of operation. However, according to forestry consultants, Hackl managed the farm in a manner that would generate a steady income stream in the future.
Upon establishing the tree farm as an LLC, Hackl and his wife began to transfer ownership units to family members. On their tax returns, the Hackls treated these gifts as eligible for the annual exclusion. The IRS contested this classification, claiming that the transfers did not provide a present interest to the donees. To contain said interest, the gift must convey “substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property.”2
The Court ruled that the unusual restrictions in the operating agreement prevented the gifts from conferring a present interest. Specifically, the agreement granted the manager (A.J. Hackl) the authority to 1) appoint his own successor, 2) prevent withdrawal of capital contributions, 3) negotiate terms of resale of interests, and, most important, 4) prohibit any alienation or transfer of member interests. The Court focused not on the features of the interest gift, but on the underlying limitations on the interests being gifted. The Court employed a three-part test to determine whether income qualified for present interest: receipt of income, steady flow to beneficiaries, and determination of the value of that flow. Because the LLC did not make distributions in the first years of operation, the Court ruled that the donees received no enjoyment of income from the property.
Some believe that the abnormally restrictive operating agreement produced the Hackl result. If they are correct, then Hackl is an aberration that will have little effect on the construction of LLC agreements.
The reaction to Hackl presents the discount and the annual exclusion as an either/or proposition—i.e., the restrictions that produce deep discounts will deprive the recipients of the present interest required for annual exclusion. One observer concludes that estate planners must decide either to gift large interests at heavy discounts based on highly restrictive agreements or to dribble out value with annual exclusion gifts based on much less restrictive agreements.3
The other valuation issue concerns the definition of a present interest. The Court insists that, unless donees are receiving income distributions right now, their holdings contain no economic benefit today. Carried to its logical conclusion, this position says that only a portfolio of investment-grade fixed income securities has economic value at any given point in time.
Mercer Capital has certain strong beliefs on both of these issues. With regard to the restrictions in operating agreements, we maintain that analysts have constructed a false dichotomy between discounts and annual exclusion. It is possible to obtain both within the same gift. We would even cast doubt on the idea that unusually heavy restrictions guarantee any additional discounts beyond those contained in typical, “plain vanilla” agreements. The discounts for minority interest and lack of marketability derived from these latter type of agreements are substantial in size and indisputably eligible for annual exclusion. Furthermore, these discounts can be computed with high degrees of accuracy. How does one systematically determine the discount associated with a host of oddball provisions? And why would one, aware of the unfavorable tax consequences, endeavor such a calculation? LLC members gain nothing from restrictions that, in the process of deepening discounts, remove the present interest and disqualify the transfer for annual exclusion. While unusual restrictions may be necessary for the parties, they are not necessary for calculating discounts.
In defining present interest, we believe that economic benefit entails more than immediate distributions. In the case of Hackl, the tree farm was highly likely to turn a profit in the long-term. Using the income approach, appraisers take the quantity of that future income and convert it to a present value. An income stream tomorrow counts for an economic benefit today. In short, present interest should also entail growth in value—the benefits from the appreciation of an underlying asset’s worth during the holding period. Unless this concept is real, a portfolio of non-dividend growth stocks carries no value. The valuation community should put pressure on the narrow definition of present interest through solutions that explicitly incorporate growth in value into its appraisals.
A widely advocated solution grants the equivalent of a Crummey power to owners of membership interests. This power is like a temporary put, allowing the holders to sell their interests back to the company in exchange for cash.4 A similar arrangement (really the same transaction, in reverse) would involve the transfer, to defective grantor trusts, of gifts of cash used to purchase discounted interests.5 This solution responds to the Court’s statement that “an ability on the part of a donee unilaterally to withdraw his or her capital account might weigh in favor of finding a present interest.”6
However, the Crummey power or any similar provision invites other questions. Members (or willing sellers) would not gift interests to individuals who intend to turn right around and sell them back for cash. Furthermore, individuals would hesitate to use the provision for fear that they would not receive future interest gifts.
From the valuation perspective, Crummey-like powers carry dubious merit compared to an agreement with more traditional provisions. For example, what is the price of withdrawal from the capital account? Would managers consent to fair market value, or tack on a premium or discount? The ability to obtain immediate cash requires generous liquidity assumptions. If these assumptions are realistic, then the ownership interests do not warrant a marketability discount. Therefore, the LLC is exchanging one economically reliable discount in a straightforward arrangement for a murky discount in a heavily restricted agreement.
We ponder a simpler approach. Agreements should rely on traditional approaches to achieve discounts, namely the right of first refusal (ROFR) and applicable state law.7 The ROFR, by allowing members to preempt the sale of interests to outside buyers, balances the competing concerns. Owners retain a necessary level of control without those extraneous restrictions, and members who want to exit the company may do so at fair market value.
Also, agreements should take advantage of existing state laws. This recommendation applies especially to those restrictions on the transfer of interests by members and the withholding of distributions by managers. The Service has ruled that a gift conveys no present interest when the manager can both unilaterally withhold distributions and prohibit the members from withdrawing or transferring their interests. Going beyond the established legal provisions risks disqualification for annual exclusion.
Therefore, the ROFR and state laws are sufficient to support minority and marketability discounts. LLCs need not load up their operating agreements with superfluous restrictions, lest they compromise the favorable tax treatment of such gifts. If such restrictions are necessary for other reasons, then we suggest that the attorney advise the appraiser to ignore them for tax purposes.
As for the (re)definition of present interest, we recommend a technology that, in computing discounts, explicitly considers all economic factors, including both distributions and growth in value. Our quantitative marketability discount model (QMDM) accomplishes this objective. It does not depend on averages computed from benchmark studies. Rather, the QMDM relies on characteristics endogenous to the entity being valued—such as holding period and growth in value. In particular, the QMDM forces members to think specifically about the timing and amount of distributions, fuzzy issues in the Hackl agreement.8 With the QMDM, the discounts match the economic assumptions related to distributions and payouts.
Endnotes
1 Albert J. and Christine M. Hackl v. Commissioner, 118 T.C. No.14. Filed March 27, 2002.
2 Hackl decision, p. 17.
3 Ron Aucutt in Steve Leimberg’s Estate Planning Email Newsletter, Archive Message #403.
4 Owen Fiore and Erwin Wilms, “Pass-Through Entities and Valuation Discounts,” Trusts & Estates (May 2002), pp. 8, 10, 52.
5 Andrew Katzenstein and David Schwartz, “Tax Court Limits Annual Gift Tax Exclusion for Gratuitous Transfers of LLC Interests,” Journal of Taxation (2002). Sample article online.
6 Hackl decision, p. 30.
7 See also James M. McCarten, Esq., “FLPs, The Gift Tax Annual Exclusion, and the Size of the Minority Interest Discount,” ACTEC 16th Annual Southern Regional Meeting (April 2002).
8 Hackl decision, p. 33.
Reprinted from Mercer Capital’s Value Added, Volume 14, No. 3, 2002.
On January 18, 2000, the U.S. District Court for the Western District of Texas issued an opinion in the first limited partnership case to be tried in federal court. The opinion resulted from a bench trial. Plaintiff had prayed for a refund of estate taxes they argued were wrongfully assessed and collected. This victory for the taxpayer provides us with an interesting fact pattern and judicial treatment of them.
On October 22, 1993, Elsie Church and her two children, Marshall Miller and Mary Elsie Newton, executed an agreement that resulted in the formation of the Stumberg Ranch Partners Ltd. under Texas limited partnership law. On October 24, 1993, Elsie Church died suddenly of cardiopulmonary collapse. On October 26, 1993, the Certificate of Limited Partnership was filed with the Office of the Texas Secretary of State.
On July 25, 1994, the Estate of Elsie Church filed its return, valuing her limited partnership interest at $617 thousand. The IRS served a notice of deficiency of $212 thousand, plus interest. On April 8, 1996, the Estate paid a total of $230 thousand. On June 26, 1997, the Estate filed a lawsuit seeking a refund of this payment after the IRS denied its claim earlier in the year.
The Stumberg Ranch Partners Ltd. (the “Partnership” or “Stumberg”) was formed for two purposes. First, the partners wanted to consolidate their undivided interests in a family ranch in order to centrally manage their interests and preserve the ranch as an ongoing enterprise. Mrs. Church’s two children actively managed the ranching operation. Second, Mrs. Church wanted to protect her assets against creditors in the event of a catastrophic tort claim against her. Mrs. Church and each of her children were limited partners. The general partner was designated as Stumberg Ranch L.C. and was to be owned by Marshall and Newton equally. This entity was not formed when the agreement was signed.
Capital contributions to the Partnership consisted of each limited partner’s undivided interest in the ranch and $1 million in marketable securities held by Mrs. Church in a Paine Webber account. The undisputed value of the interest in the Ranch contributed by Mrs. Church was $380 thousand, while her children’s interests were $233 thousand.
The partnership agreement allocated profits or losses from the ranch operations in proportion to the interests contributed by the partners. Ninety-nine percent of the taxable income from securities was allocated to Mrs. Church. Essentially, Stumberg was a pro rata partnership because profits, losses and income were allocated in proportion to each partner’s capital contribution.
At trial, the government advanced several arguments in support of their denial of a refund of estate taxes. Defendants argued that the partnership was not valid because the paperwork was not complete at the time of death and was formed in contemplation of Mrs. Church’s death. The court disagreed because medical facts indicate there was no contemplation of death. In addition, the court cited the fact that all the paperwork was not completed on the date of formation as an indication that no one involved had considered the potential for Mrs. Church’s death.
The government argued that the partnership was formed solely to reduce Mrs. Church’s taxable estate. The court disagreed. The court recognized that the partnership was formed for two valid reasons. First, it was formed to consolidate the family’s interest in the family ranch to provide for centralized management and to preserve the ranch as an on-going enterprise for future generations. Facts were introduced at trial indicating there had been difficulty with another owner of an undivided interest who had interfered with the ranch’s operation. In addition, the Partnership was formed to protect Mrs. Church’s assets from judgment creditors in the event of a tort claim against her.
The government suggested that the Partnership was simply a means of transferring property to family members for less than full consideration. The government contended the difference between the fair market value of the assets Mrs. Church contributed to the Partnership, $1.5 million, and the value of her Partnership interest, $617 thousand, should be taxed as a gift. The court rejected this argument, indicating that Mrs. Church received a partnership interest proportional to the contributions and partnership interests of the other partners and there was no evidence that anyone experienced a financial benefit or increase in wealth.
The government argued that the securities held in a Paine Webber account, valued at $1.4 million were not conveyed to the partnership since her name, rather than that of the Partnership, was on the account several months after formation of the Partnership. Therefore, the estate should be taxed on their $1.4 million value. The court disagreed, stating that well established law directs judicial attention to intent of the parties when determining ownership of property, not legal title.
Finally, the government argued that the valuation of the partnership interest should not consider restrictions on sale contained in the partnership agreement, which reduce their value. The court rejected this indicating that there is nothing in the legislative history of the estate tax suggesting Congress wanted to address restrictions on sale/assignment of partnership interests. Rather Congress (sec. 2703) indicated that rights and restrictions like below-market buy sell agreements and options that artificially depress the FMV of the taxable property should be disregarded because they are not inherent components of the property itself.
Rejecting all the arguments put forth by the government, the court granted the estate a full refund based on the value advanced by its expert. The government never presented an alternate valuation opinion.
This case is interesting because the taxpayer scored a complete victory. In the present case, none of the government’s arguments regarding the validity of the partnership or the appropriate taxation of the partnership interests were accepted. The facts of the case supported the conclusion that the limited partnership was a valid entity. However, readers should be cautioned that judicial acceptance of this partnership does not mean any limited partnership will be accepted for estate tax purposes. That determination is very fact specific.
In addition, it should be noted that part of the reason this opinion might be characterized as a “taxpayer victory” resulted from the absence of a “battle of the experts”. Many times, it seems that judicial opinions seem to “split the baby” when determining the value of a business interest between various expert opinions. The estate received its full prayer for relief in this case because the government offered no alternative valuation.
Reprinted from Mercer Capital’s BizVal.com – Vol. 12, No. 2, 2000.