Estate Gift & Taxation Planning

One purpose of determining the value of an interest in a closely held business is to determine gift and estate tax liability. Business appraisers are called upon to provide such valuations know that this can be a painstaking task. It is not an exact science but an educated estimate when, as often is the case, there is no identifiable market for the interest. This uncertainty can cause unintended gift or estate tax consequences for transfers between related parties during the transferor’s life and at death.

The difference between what a person transferring an interest in a business believes is its fair market value and any higher amount the IRS determines is its fair market value can result in a greater gift tax liability. Likewise, a redetermination by the IRS of the fair market value of such interests held in an estate can spell an underpayment of estate tax. Fortunately for valuation analysts, there are methods that are recognized by taxing authorities and courts as providing a valid basis for those estimates. In applying those methods, however, qualified appraisers will take stock of recent court decisions for guidance. This article gives an overview of valuation principles for gift and estate tax purposes, reviews some current trends in determining fair market value for such purposes, and makes suggestions for seeking a qualified appraiser.

WILLING-BUYER / WILLING-SELLER TEST
For gift and estate tax purposes, the fair market value of property transferred to another party is measured on the date of the transfer as “the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” (the “willing-buyer, willing-seller test,” Treas. Reg. § 20.2031-1(b)).

For assets traded on an established market or that have a readily ascertainable value, the value for gift and estate tax purposes is their fair market value on the date of the transfer or death. For other assets, valuation must be established by an educated estimate.

METHODS OF VALUING CLOSELY HELD ENTITIES
Three types of valuation methods are generally used in calculating the fair market value of an interest in a closely held entity. The market method (also referred to as the comparable sales method) compares the closely held company with its unknown stock value to similar companies with known stock values. The income (or discounted cash flow) method discounts to present value the anticipated future income of the company whose stock is being valued. The net asset value (or balance sheet) method relies generally on the value of the assets of the company net of its liabilities.

The market method or income method is most often used when the closely held company carries on an active trade or business. The net asset value is most often used when a closely held company holds primarily real estate or investment assets and does not carry on an active trade or business.

TRENDS IN VALUATION DISCOUNTS

The valuation of closely held entities for gift and estate tax purposes has been a hotly contested issue—especially with the proliferation of family limited partnerships and limited liability companies that are implemented primarily for estate planning purposes. In many instances these closely held entities do not carry on an active trade or business.

Court cases reveal that the valuation of closely held entities is a judgment call that relies upon the opinion of experts. Courts have long upheld a premise often reflected in expert opinions—that the value of closely held interests is usually less than the value of similar publicly traded interests. The factors underlying this premise include the inability to quickly convert the property to cash at minimal cost (“lack of marketability”) and the inability, if the interest held is less than a majority interest, to control managerial decisions and other aspects of the entity (“lack of control”).

DISCOUNT FOR LACK OF MARKETABILITY
Two types of empirical studies are commonly used to benchmark discounts for lack of marketability (DLOM)—restricted stock studies and pre-initial public offering (pre-IPO) studies.

Public companies often issue restricted stock (unregistered shares). SEC rules restrict the transferability of such shares by mandating a minimum holding period and by limiting the pool of eligible buyers for such shares. Restricted stock studies compare the price of publicly traded, unrestricted shares of companies with the private market price of restricted shares of the same companies and attribute the difference to the lack of marketability of the restricted shares. Approximately 15 such studies exist, showing discounts ranging from 13% to 45%. The SEC restrictions have become less stringent, and consequently the average discounts in the newer studies are lower than in previous studies.

Pre-IPO studies compare the price at which a stock was sold while its issuer was still closely held (and the shares were unregistered) with the price of the same company’s common stock at the time of an initial public offering. Sources of pre-IPO studies include Willamette Management Associates’ Valuation Advisors’ Lack of Marketability Discount Study and those developed by John D. Emory of Emory & Co. These studies generally show a discount for lack of marketability ranging from 18% to 59%—higher than in restricted stock studies.

Recent court decisions have made it clear that more important than the type of study used to quantify a discount is the analysis done by the appraiser to tie the study to the facts of the specific case.

The failure to tailor the analysis to specific facts can have drastic consequences.

So why not take the portion of the discount related to the holding period restrictions into account? The IRS expert argued that he could not think of an economic reason why the partners in this situation would not agree to let another partner be bought out. Since the partnership agreement allowed for dissolution by unanimous consent and the sole asset held by the partnership was highly liquid Dell stock, the partners could dissolve the partnership by unanimous agreement, transfer the Dell stock pro rata to the exiting partner, and then reconstitute the partnership with the remaining partners with little economic risk.

Both parts of the decision are troubling— the Tax Court’s acceptance of the argument that the DLOM inherent in restricted stock studies is only 12%, and that the court accepted without much reasoning or computation of the likelihood of liquidation, that the partnership would be dissolved upon the request of a limited partner simply because the dissolution would pose little economic risk to the remaining partners.

The argument that the discounts shown by restricted stock studies contain components other than lack of marketability is not new. Another critic of restricted stock studies (and pre-IPO studies), Mukesh Bajaj, attempted to isolate the DLOM. He performed a study in 2001 with David Denis, Stephen Ferris and Atulya Sarin of registered and unregistered private placements and concluded (albeit controversially) that the average discount attributed exclusively to marketability is only 7.23% (“Firm Value and Marketability Discount,” Journal of Corporation Law, Vol. 27, No. 1).

Adding pressure to the argument for lowering discounts is the argument that the older restricted stock studies are outdated, since the restrictions placed on the securities by the SEC have been relaxed over time. This argument is flawed because, during that period, the inherent limitations faced by private companies have not changed.

DISCOUNT FOR LACK OF CONTROL
The discount for lack of control (DLOC—also referred to as a minority discount) is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds to the net asset value per share of the same funds. For entities holding real estate, the DLOC is determined by comparing the trading price of shares of a selected sample of registered real estate limited partnerships (RELPs) or real estate investment trusts (REITs) to the net asset value of the respective shares.

Citing mere averages or using generic samples of data is not sufficient. As with the DLOM, the appraiser’s skill in relating the sample of closed-end funds used to not only the asset type but also the size and other attributes of the assets of the entity being valued is critical.

The courts said the choice of comparable funds by the taxpayer’s expert was flawed because he gave insufficient justification for eliminating two funds as comparables, and among those he retained in the sample, he ignored significant differences in investment strategy and risk between them and the interest being valued. Without explaining exactly how it determined the figure, the court held that the appropriate lack-of control discount was 10%.

The first question was whether separate discounts should be applied to the AFLP interest and the Pine Bend interest. The IRS’ expert stated that since Pine Bend was an asset of AFLP, no discounts were appropriate in valuing Pine Bend. The Tax Court disagreed with this argument, holding that tiered discounts (that is, discounts at the lower-tier entity level and the upper tier entity level) were appropriate where a taxpayer owned a minority interest in an entity that held a minority interest in another entity.