Executive Summary: In this federal estate tax case, the Tax Court, through Judge Halpern, determined the fair market value of a 15% nonmarketable minority interest in a Kentucky limited liability company (LLC) that had elected to be taxed as an S corporation. The subject entity’s principal assets included various media interests (newspapers, specialty magazines, and a TV station). The Tax Court’s ruling was a victory for the estate. The case is appealable to the U.S. 11th Circuit Court of Appeals.
Facts: At the time of his death in 2005, the decedent, owned a 15% interest in a Kentucky LLC that had made an S corporation election and that owned media interests (newspapers, specialty magazines and a TV station).
Valuation Positions

The Tax Court noted that the IRS moderated its valuation position between the time of deficiency notice and trial. The Tax Court also sidestepped IRC Sec. 7491 burden of proof shift to the IRS by deciding the case on the preponderance of evidence.

The parties disagreed over:
(1) the date of financial information relevant to a date-of-death valuation of the decedent’s units;
(2) the appropriate adjustments to the LLC’s historical financial statements;
(3) the propriety of relying on a market-based valuation approach (specifically, the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that method;
(4) the application of the income approach (specifically, the discounted cash flow valuation method);
(5) the appropriate adjustments to the LLC’s enterprise value; and
(6) the proper type and size of applicable valuation discounts.

Relevant Financial Information

The relevant valuation date was the date of the decedent’s death: July 5, 2004. The issue was what financial statements should have been used. The IRS appraiser used internally generated financial statements dated June 27, 2004 and public company data from June 30, 2004. The estate’s appraiser used the latest issued internally generated financial statements as of May 30, 2004 and public company data as of March 28, 2004 arguing that the hypothetical willing buyer and seller wouldn’t have known of the latest financial statements. The Tax Court sided with the IRS appraiser, reasoning that the later financial statements better represented the market conditions on the valuation date and that the estate alleged no intervening change in financial condition of the LLC.

Adjustments to Subject Company Financial Statements

The parties disagreed over the proper adjustments to the LLC’s financial statements, specifically, a life insurance policy adjustment, a self-insured health insurance adjustment and an overfunded defined benefit plan. The estate’s appraiser made all of the adjustments, while the IRS appraiser did not. The Tax Court agreed with the IRS appraiser, pointing out that the estate’s appraiser failed to provide any explanation why the gains in each instance were non-recurring. Likewise, the Tax Court disregarded the other income adjustments that the estate’s appraiser made, noting that the court could not understand the rationale for the adjustments.

Applicability of the Market Approach

The IRS appraiser utilized the market approach and weighted its indication of value 50%, while the estate’s appraiser did not, arguing that he could not find enough similar guideline companies. The Tax Court sided with the estate’s appraiser, describing in detail a test for comparability of guideline companies and finding that there was only sufficiently similar guideline company, which was insufficient to justify reliance upon the market approach.

Application of the DCF Method

The appraisers disagreed on the following items in connection with the application of the DCF method:
(1) the LLC’s financial projections;
(2) whether or not to tax affect the LLC’s earnings in calculating the LLC’s value;
(3) adjustments to cash flow;
(4) the amounts to be included in the rate of return;
(5) earnings adjustments to LLC’s enterprise value; and
(6) the nature and amount of applicable valuation discounts.

The LLC’s Financial Projections

The IRS argued that the appraisers should have used the projections that a bank had prepared in conjunction with a 2004 loan. However, the IRS trial appraiser did not use those projections in his appraisal, so the Tax Court disregarded those projections. Each appraiser prepared his own projections. The Tax Court found the projections that the IRS trial appraiser prepared to be more persuasive for the following reasons: (1) the estate’s appraiser used a growth rate that he admitted was significantly higher than the LLC’s actual growth rate for prior years; (2) revenues from an acquisition that occurred after the valuation date should have been included because the acquisition was reasonably foreseeable on the valuation date; and (3) the estate’s appraiser did not explain his increasing costs adjustment in his projections.

To Tax Effect or Not

Predictably, the appraisers disagreed on tax affecting, with the estate’s appraiser tax affecting at two different corporate tax rates (39% and 40%), while the IRS appraiser did not tax affect. The Tax Court denied tax affecting again and was critical of the estate’s appraiser, noting:

[Estate’s appraiser] failed to explain his reasons for tax affecting [the LLC’s] earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting [the LLC’s] projected earnings and discount rate, we decline to do so.
…
[Estate’s appraiser] has advanced no reason for ignoring such a [corporate tax] benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.

Adjustments to Cash Flow

The appraisers disagreed on two adjustments to cash flow: (1) capital expenditures and (2) working capital.

Capital Expenditures

With respect to the capital expenditures, the IRS appraiser projected equal capital expenditures as a percentage of revenue, while the estate appraiser projected unequal, but increasing, capital expenditures. The Tax Court again sided with the IRS appraiser, stating:

not only does [estate appraiser] fail to support his projection, but [the LLC’s] financial statements do not justify his estimated increase in capital expenditures.

Working Capital

Not surprisingly, the appraisers differed on the projected level of working capital for the LLC. The estate appraiser based his projection on fluctuating levels of working capital, while the IRS appraiser based his projection based upon the past performance of the LLC. The Tax Court again sided with the IRS appraiser, and provided:

[Estate appraiser] projected that [the LLC’s] future investment in working capital would fluctuate; however, he failed to explain how he arrived at those estimates. [Estate appraiser’s] only explanation consisted of an appendix to his report containing his projected income statement, balance sheet, and cashflow statement for [the LLC]. We shall ignore [estate appraiser’s] working capital projections because of their complete lack of support.

Weighted Average Cost of Capital (“WACC”)

Despite the fact that the Tax Court had a problem with the use of WACC, stating:

We have previously held that WACC is an improper analytical tool to value a “small, closely held corporation with little possibility of going public.” Estate of Hendrickson v. Commissioner, T.C. Memo. 1999-278; cf. Gross v. Commissioner, supra (allowing the use of WACC when the expert used the subject corporation’s actual borrowing costs to calculate the cost of debt capital component of the WACC formula). Neither party has indicated the likelihood of [the LLC] becoming a publicly held company; however, because both experts used WACC as the rate of return in their analyses, and neither party otherwise raised the issue, we shall adopt it, although we do not set a general rule in doing so.

The appraisers again disagreed in their determination of WACC, this time on three issues: (1) cost of equity capital, (2) total cost of capital and (3) relative weights of debt and equity in calculating WACC.

Cost of Equity Capital

The IRS appraiser calculated his WACC, assuming a zero corporate tax rate, while the estate appraiser assumed a 40% corporate tax rate. The Tax Court sided with the IRS appraiser on this issue. With respect to the cost of equity capital (the cost of equity capital plus the cost of debt capital equals WACC), the estate appraiser utilized a CAPM, while the IRS appraiser used a buildup method. The Tax Court again predominantly sided with the IRS appraiser, criticizing the estate appraiser’s use of CAPM for a closely held entity.

Total Cost of Capital

The IRS appraiser calculated a higher pre-tax cost of total capital than the estate appraiser did. While the Tax Court was not convinced by the work of either appraiser, the Tax Court again sided with the IRS appraiser, in part because the higher number was better for the estate and in part because:

In his expert report, [estate appraiser] calculated a 5-percent average cost of debt. The entirety of his reasoning lies in a footnote: “Based on [the LLC’s] existing costs of debt and estimated costs of debt, given the companies [sic] financial condition and the current interest rate environment.”

Relative Weights of Debt and Equity in Calculating WACC

The IRS appraiser basically employed the company’s debt/equity ratio because he was valuing a minority interest, reasoning that the minority owner could exercise no influence to change the capital structure. The estate appraiser employed the guideline company debt/equity ratio, despite failing to find any comparable guideline company in his market approach. The Tax Court called the estate appraiser down for inconsistency, pointing out:

In contrast, despite [estate appraiser] conclusion that the guideline companies were not comparable under the guideline company method, he declared that the same companies were sufficiently comparable under the DCF method to justify using their capital structures to calculate [LLC’s] WACC. We lend no weight to [estate appraiser’s] wavering stance and therefore use [the LLC’s] own capital structure at book value for purposes of this case.

Adjustments to the LLC’s Enterprise Value

The appraisers disagreed over the proper adjustments to the LLC’s enterprise value, as follows: (1) long-term debt, (2) working capital deficit, (3) S corporation benefits and (4) stock options outstanding on the valuation date. With respect to the long-term debt issue, the appraisers were very close together, with the only difference being the date of the financial statements that each used. The Tax Court sided with the IRS appraiser, criticizing the estate appraiser as follows:

Moreover, [estate appraiser] identified differing debt amounts throughout his report.

We will not rely on a consistently changing number, especially one that [estate appraiser] fails to justify.

On the working capital deficit issue, the estate appraiser made an adjustment, while the IRS appraiser did not. Again, the Tax Court sided with the IRS appraiser:

We do not find [estate appraiser’s] analysis to be persuasive. [Estate appraiser] once again failed to explain why the public companies that he deemed to be not comparable to [the LLC] under the guideline company method provide a sufficient comparison upon which to base a working capital adjustment. We lend little weight to his seemingly contradictory positions. In addition, although explaining the need for a working capital adjustment under the guideline companies methodology, he failed to do so under the DCF method despite applying the adjustment to the results under both methods. For these reasons, we disregard his working capital deficit adjustment.

The estate appraiser made adjustments to reflect the S corporation benefits, while the IRS appraiser made no such adjustments. Because the estate failed to justify the adjustments, the Tax Court disregarded those adjustments.

Finally, the Tax Court accepted the adjustment made by the estate appraiser relative to the stock options outstanding as of the valuation date because he assumed that all of the options would be exercised. This time, the Tax Court called down the IRS appraiser for failing to justify his position that the stock options would not be exercised.

Applicable Valuation Discounts

Discount for Lack of Control

In the DCF method, the estate appraiser calculated his indication of value on a minority interest basis, so he took no discount for lack of control as that would have been duplicative. On the other hand, the IRS appraiser made his DCF calculations on a control basis, so he took a 17% discount for lack of control. The IRS appraiser obtained his data on minority interest discounts from Mergerstat Review. While the Tax Court generally agreed that a discount for lack of control was appropriate, it was critical of the IRS appraiser’s analysis, stating:

[IRS appraiser] only vaguely supported his chosen control premium with the above-referenced statistics. [IRS appraiser] determined a control premium for [the LLC] that is 10 percentage points below the median control premium paid for transactions in all industries and 20 percentage points below control premiums paid in [the LLC’s] own industry. He provided no explanation as to why he chose such a comparatively low control premium, besides listing general factors that affect a control premium’s size. We cannot justify [IRS appraiser’s] control premium and resulting minority interest discount without a more comprehensive explanation. Since the parties are in general agreement that a minority discount is appropriate, we determine a 23-percent minority discount to the equity value of [the LLC] computed on a 30-percent controlling interest basis under the DCF method.

Discount for Lack of Marketability

The appraisers were very close in their discount for lack of marketability analysis because both employed a benchmark analysis. The IRS appraiser limited his analysis to seven restricted stock studies, arriving at a 31% discount, while the estate appraiser reviewed those seven studies, plus four additional restricted stock studies as well as two pre-IPO studies, arriving at a discount of 30%. In the Tax Court’s opinion:

We have previously disregarded experts’ conclusions as to marketability discounts for stock with holding periods of more than 2 years when based upon the above-referenced studies. See Furman v. Commissioner, T.C. Memo. 1998-157 (finding the taxpayer’s reliance on the restricted stock studies in calculating a lack of marketability discount to be misplaced since owners of closely held stock held long term do not share the same marketability concerns as restricted stock owners with a holding period of 2 years). Given both experts’ reliance on the studies, however, we shall accept them as setting the benchmark discount size for decedent’s units. We find a 31-percent lack of marketability discount to be appropriate.

Tax Court’s Holding on Value

Given all of the facts and conclusions of the Tax Court, it determined that the value of the estate’s interest in the LLC was lower than the value that the estate valued the interest as on the federal estate tax return, resulting in a 100% victory for the estate.

Comments

This is a very interesting valuation case because if you didn’t read the opinion except for the numbers, you’d have concluded that the estate’s appraiser prevailed! But you’d be dead wrong. The estate’s appraiser got hammered for failing to sufficiently explain himself in the report and for being internally inconsistent.

I get the idea that Judge Halpern is a frustrated appraiser. He did a fairly good job in ferreting out the problems in the reports and testimony of the business appraisers. However, I disagree with him on several fronts in this opinion.

For starters, the Tax Court’s failure to tax-affect again in this case confounds common sense and Economics 101. As a buyer of an interest in a pass-through entity, there is no reason why anyone would pay for the share of the business that will go to Uncle Sam in income tax. Buyers and sellers acknowledge the tax effect in real life and the transaction values underlying their behavior reflect this incontrovertible fact. It’s not about how much you gross, but how much you net. But this reality seems lost on the Tax Court. Perhaps the concept of not tax effecting would be palatable if the economic value of the Estate’s liability (and that of any successor to the interest) arising from the perpetual income of the entity was also recognized on the Estate’s balance sheet. A thought – would not the entity’s non taxable status be forfeited if the Estate did not make good on this perpetual, pass-through tax liability?

Secondly, the Tax Court’s failure to accept the use of the CAPM in determining a discount rate for a closely held business is just unacceptable. Again, the Tax Court must accept general appraisal principles and procedures. It remains an ongoing astonishment that some valuation practitioners and stakeholders view the build-up approach and the CAPM as something other than highly incestuous as means to the same end. Appraisers use the CAPM or some variant to develop a discount rate every day. That they cannot do that in the Tax Court only strains credulity.

Thirdly, and perhaps I don’t understand this one most of all. The Tax Court’s failure to understand that if restricted stock studies and the pre-IPO studies say anything, and that is debatable, they should set a floor on the discount for lack of marketability. Unlike companies the stock of which is restricted but which is otherwise publicly traded, it takes even longer to sell interests in most closely held companies. In other words, the discounts for lack of marketability for interests in closely held companies should generally be much higher than the discounts for lack of marketability of restricted stock companies. Using a growing base of quantitative tools to develop marketability discounts, many appraisers rely on benchmark data for what it implies rather than for what it might specify. In my opinion, the benchmark analysis, i.e., the restricted stock studies and the pre-IPO studies, represent outdated (or at least incomplete) methodologies.

Finally, Judge Halpern did not explain several of his findings in significant detail. Query: Is he guilty himself of the sin of failure to properly document that he accused the estate appraiser of?

There are some appraisers who disagree with the Tax Court’s determination that the guideline companies offered were not similar enough to be considered in the market approach. I don’t necessarily have a problem with the Court’s determination in this regard because the Court made a determination, right or wrong, and then stuck to it throughout the opinion.

One of the most important reasons that I always insist on reviewing a draft appraisal report before it goes final is to check the draft for internal inconsistencies like the ones that the estate’s appraiser committed. Many business appraisers don’t have sufficient review backup, so a thorough review of a report in draft form can act as a second set of eyes. That does not mean that the estate planner should write or rewrite the draft report, but it is common for me to question use of methods and approaches, ask for clarifications, ask for additional explanations, and find internal inconsistencies.

Cites: Gallagher Estate v.Comr., T.C. Memo 2011-148; Gross v. Comr., T.C. Memo 1999-54, aff’d., 272 F. 3d 333 (6th Cir. 2001).