There is more definitive precedential case law in the general area of valuations for federal tax purposes than for any other business valuation purpose. Some issues are well settled, but decisions on other issues continue to evolve. This chapter attempts to distinguish which issues are well settled, nearly settled, or still in flux.1
Even among tax issues that are well settled in principle, there is still room for argument about magnitudes, especially in such areas as discounts for minority interest and lack of marketability. There are also issues about which decisions seem to be conflicting (for example, discounts for lack of marketability for controlling interests). However, as Judge David Laro has explained:
Each valuation case is unique. Although guidance can be obtained from earlier cases, one case is rarely on point with another, and a significant differentiation of the facts can usually be made.2
An understanding of valuations for federal tax purposes is also very important for valuations for many other purposes. Because of the extensive case law, IRS Revenue Rulings, and other literature, valuation principles and decisions for tax purposes are often cited in valuation reports and court decisions for other purposes.
Federal tax cases involving business valuations fall primarily into the following categories:
• Estate taxes
• Gift taxes
• Ordinary income and capital gains taxes
• Charitable contributions
• Transfer pricing
Although the standard of fair market value applies equally in all cases, the manner in which it applies can have extreme consequences, particularly for estate planning. While for gift tax purposes each transfer is valued individually, for estate tax purposes the entire amount in the estate is aggregated, regardless of the number of beneficiaries. For example, if an estate holds a 100 percent interest in a company, the interest will be valued as a 100 percent control interest, even if it is willed equally to three beneficiaries. But if three gifts of one-third interests are made, each will be valued as a minority interest, benefiting from the well-settled principle that the minority interest is discounted compared to a pro rata portion of the value as a whole.
Similarly, if the estate holds more than one class of security, the combined effect of all may be aggregated for the purpose of valuation,3 but in some cases it is more appropriate to value only the subject voting shares, rather than valuing all voting shares of the company and deriving a pro rata value from that.4
The standard of value for all federal tax cases is fair market value, defined by the Internal Revenue Service as follows:
The price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.6
There are many nuances to this definition, as discussed in a subsequent section. However, over several decades, the federal courts have developed seven standards that must be considered in determining fair market value:
1. The buyer and seller are both willing to engage in the transaction.
2. Neither the willing buyer nor the willing seller is under a compulsion to buy or sell the item in question.
3. The willing buyer and the willing seller are both hypothetical persons.
4. The hypothetical willing buyer and the hypothetical willing seller are both aware of all facts and circumstances involving the item in question.
5. The item is valued at its highest and best use, regardless of its current use.
6. The item is valued without regard to events occurring after the valuation date, unless the event was reasonably foreseeable at the valuation date or was relevant to the valuation.
7. The transaction is for cash and will be consummated within a reasonable commercial time frame.7
To this day, one of the most instructive cases on fair market value of closely held stock for federal tax purposes is Central Trust Company v. United States,8 a lengthy, detailed discussion of valuation issues written over 50 years ago. Although the reader must recognize that the structure of markets and financial theory and evidence have advanced in quantum leaps since that decision, it is still the most comprehensive tax case discussion of basic valuation issues, well worth reading today. Other cases worth reviewing are Foltz v. U.S. News and World Report,9 Estate of Furman (which is instructive reading in general),10 and Bank One Corporation v. Comm’r.11
Central Trust makes the point that “fair market value presupposes not only hypothetical willing buyers and sellers, but buyers and sellers who are informed and have adequate knowledge of the material facts affecting value.”12 As an example, in a 1999 case, Judge Laro rejected two sales proffered as evidence of fair market value, noting: “Neither seller was reasonably informed regarding the value of their stock. … Both took the offer … because it sounded like a good amount of money. Their testimony revealed that they were not knowledgeable sellers who aimed to realize the fair market value of their stock.”13
A common problem in tax cases is that the expert will focus solely, or unduly, on the buyer, with no or inadequate consideration given to whether the value would be acceptable to a hypothetical willing seller. Instructive examples can be found in the decisions in Estate of Kaufman v. Comm’r14 and Moore v. Comm’r.15
A transaction cannot take place at more than the highest price a willing buyer will pay. Fair market value assumes market conditions as they exist at the date of valuation. Therefore, if the seller is really willing, the implication is that he or she must accept what the market will bear at the valuation date. The existence of a market implies both buyers and sellers.16 However, it can be difficult to determine the market for a closely held company. For example, some buyers might be interested in continuing the business as their own, whereas others might be interested in the business as an investment. There might also be other buyers who see the business as offering synergies with other acquisitions or assets.17 Addressing this issue, some tax regulations require the value of the property be measured in the market where it would most likely be sold.18 To comply with this requirement, the business appraiser should analyze the marketplace to identify the most likely pools of buyers. In any event, the “selection of the proper market for valuation purposes is a question of fact.”19 The expert or reviewer should be sure that the willing seller part of the hypothetical willing buyer/willing seller combination is not ignored.
Finally, both the seller and buyer must be hypothetical. In one case, the tax court’s decision was reversed because, according to the court of appeals, it based its ruling on speculation and imaginary scenarios that identified particular buyers, rather than hypothetical buyers.20
While the quality of evidence is of primary importance, the tax court also is very interested in appraisers’ qualifications in deciding on the relative weight to accord the respective experts’ testimony. An instructive example can be found in the tax court’s opinion on Estate of Berg, which included lengthy discussions of the experts’ qualifications.21 While failure to submit a report from a qualified appraiser can have significant negative financial consequences (as it did in Estate of Berg), submitting a report from a qualified appraiser can help shield the taxpayer even if the appraiser’s report is not upheld; the tax court has on numerous occasions refused to impose the Section 6660 undervaluation penalty on the grounds that the taxpayer retained a qualified appraiser and submitted the amount shown on the return in good faith.
In Kohler v. Comm’r,22 the tax court gave no weight to the opinions of the IRS’s expert who, although a Chartered Financial Analyst (CFA) with a doctorate, was not credentialed in business valuation and did not provide a USPAP certification. The court also looked unfavorably at the expert’s innovative, but unsupported, financial model. In Estate of Thompson v. Comm’r,23 the tax court criticized the experts for both parties, finding that they were inexperienced and that their valuations generally lacked credibility. Conversely, in Caracci v. Comm’r,24 the court rejected the taxpayer’s attempt to challenge the IRS’s expert’s qualifications as “nonsensical and border[ing] on the frivolous” where the expert was a certified public accountant and principal in a business valuation firm that had conducted numerous business valuations. In Estate of Josephine Thompson v. Comm’r,25 the tax court rejected both parties’ valuations, and while declining to impose an underpayment penalty, it criticized the estate’s decision to hire an accountant and lawyer from Alaska (the estate was in New York) with relatively little valuation experience.
For examinations commencing before July 22, 1998, if the IRS issued a notice of deficiency, the burden of proof was on the taxpayer to prove that the value claimed by the IRS was wrong26; see, for example, the opinion in Estate of Kaufman.27
For examinations commenced after July 22, 1998 (or, if no examination, court proceedings arising in connection with taxable periods beginning or occurring after July 22, 1998), the burden shifted to the IRS. Kohler v. Comm’r28 is a particularly instructive instance of the estate and taxpayer successfully shifting the burden of proof to the IRS. In that case, at issue was a determination of the fair market value of stock of the company owned by the estate of Frederic C. Kohler on the alternate valuation date. The estate elected the alternate valuation date and filed its return with a $47.01 million appraisal. The IRS determined that the fair market value of the Kohler holdings on the alternate valuation date was $144.5 million. The parties stipulated that the value of the Kohler stock at issue in related gift tax cases would be calculated by reference to the value of the Kohler stock determined in the estate tax case. The parties also agreed that the per share value for the different classes of Kohler stock in each case would be determined by reference to an agreed formula that would take into account the value of the Kohler stock determined in the estate tax case. The tax court ruled that all the requirements for shifting the burden of proof were met. Although the IRS argued that the estate did not cooperate fully because it filed a motion to quash certain discovery requests, the court determined that the estate had legitimate concerns about providing confidential and proprietary business information that was possibly irrelevant absent a court order. Once the tax court denied the estate’s motion to quash the summons, the estate provided the requested documents the respondent requested. Accordingly, the court found that the numerous exhibits that were part of the record belied the IRS argument, and the burden shifted to the IRS.
In Estate of Josephine Thompson v. Comm’r,29 the Second Circuit confronted the issue of whether, once the taxpayer submitted a credible appraisal, the burden shifted to the IRS to prove the value after the tax court rejected the IRS’s values, and whether, as a result, the tax court should have adopted the taxpayer’s values. The Second Circuit determined that the allocation of the burden of proof does not require the tax court to adopt the taxpayer’s valuation, however erroneous, whenever the court rejects the IRS’s proposed value; the burden of disproving the taxpayer’s valuation can be satisfied by evidence in the record that impeaches, undermines, or indicates error in the taxpayer’s valuation. In this case, the IRS not only presented evidence in support of its valuation but also successfully rebutted the estate’s valuation by identifying its errors and inconsistencies. The court reasoned that notwithstanding the allocation of the burden of proof in IRC Section 7491, the “Tax Court is not bound by the formulas and opinions proffered by expert witnesses. It may reach a determination of value based upon its own analysis of all the evidence in the record.”
A gift and its value must be adequately disclosed on a gift tax return in order to start the three-year statute of limitations on the assessment of gift tax.30 On December 3, 1999, the Internal Revenue Service published final regulations pertaining to the adequate disclosure of gifts.31 The regulations contain a list of what information must be included with the gift tax return in order for the gift to be deemed adequately disclosed. In response to extensive comments and concerns about the regulations as previously proposed, the IRS added a section to the regulations providing that a “qualified appraisal” may be submitted “in lieu of the information required” under one of the items in the list.32
It is clear that the tax court expects experts to have access to site visits, management interviews, and company records to the extent necessary for a thorough appraisal. In Estate of Bruce v. Comm’r, the court dryly commented:
It is also noted that petitioner’s counsel refused to allow respondent’s expert an opportunity to visit PCBCED’s warehouse and bottling plant. To the extent that this reflects counsel’s attitude and approach towards Tax Court litigation, the Court suggests that this is not the way we conduct proceedings.33
In Kohler v. Comm’r,34 one of the most instructive tax court cases, the court discredited an opinion based on a site visit that lasted under three hours because it did not provide the expert with adequate knowledge of the subject company, and the court lauded the opposing party’s expert’s detailed knowledge of the firm. In Polack v. Comm’r,35 the court credited the expert’s appraisal because it was based on a thorough site visit, with interviews of individuals at the company who were key to an understanding of the company’s value.
The tax court will accord some weight to arm’s-length sales of businesses or business interests, defined by Black’s Law Dictionary as “a transaction between two unaffiliated and unrelated parties.”36
For example, in Estate of Bennett, the court said, “Usually, in determining the value of untraded stock, one would look at actual arm’s-length sales of such stock in the normal course of business within a reasonable time before or after the valuation date.”37 (Although the decision clearly articulated the principle, there were no such transactions in the Bennett case.) In Morrissey v. Comm’r,38 the Ninth Circuit reversed the tax court’s rejection of the taxpayer’s evidence of actual sales near the valuation date. The appellate court concluded that because those actual sales had been arm’s-length transactions, they presented the best evidence of fair market value.
The tax court expects all approaches to value to be considered. The relative weight it will accord to the various valuation approaches and methods generally depends on three factors:
1. The type of company
2. The quality of available evidence
3. Whether the company might be liquidated or continue as a going concern
The tax court tends to rely more on an asset approach for holding companies and on an income or market approach for operating companies. For hybrid companies, the court may weight the approaches to correspond to the degree to which the company has assets and earnings.39 Estate of Kaufman v. Comm’r40 is a useful caution; the tax court opinion in the case was critical of an expert for not considering an asset approach for a company for which most appraisers would have been very unlikely to have accorded the asset approach any weight at all.
Other cases are also instructive; in Hess v. Comm’r,41 the court split the difference between the taxpayer’s discounted cash flow (DCF) and guideline publicly traded company approach and the IRS’s DCF, net asset value, prior transaction, and guideline publicly traded company approaches.
In Estate of Leichter v. Comm’r,42 the issue of liquidation versus going concern was key. There, the expert opined that the company was worth less on a going-concern basis than in liquidation, but the court criticized the expert for not explaining why a hypothetical seller would choose not to liquidate under such circumstances.
The tax court’s ultimate decisions, however, often are based on a single approach (in effect, a weight of 100 percent to one approach)—which is, more often than not, the market approach—or a blending of the results of two approaches.
The IRS and the tax court look very favorably on the market approach, which is heavily emphasized in Revenue Ruling 59-60. However, it is not uncommon for an expert’s utilization of the market approach to be rejected if the court is not satisfied that the companies selected are comparable to the subject company.
For example, in Estate of Brookshire, two experts for the taxpayer and the IRS’s expert all used the guideline public company method, among others. However, the court rejected the IRS’s version of the guideline company method:
Respondent’s expert overstates the value of the Brookshire common stock because of his use of three companies as comparable companies that have significant sales in markets other than retail grocery and that are not comparable to Brookshire. The use of these companies distorts each of the valuation methods used by respondent’s expert.43
Note that this is not a rejection of the guideline company method; the court accepted the guideline companies used by the taxpayer’s experts.
Revenue Ruling 59-60 uses the language “the same or similar.” Companies may be accepted as similar for reasons other than product or service line—for example, the markets into which they sell or their degree of brand dominance. In both Estate of Gallo44 (Gallo wines) and Estate of Hall45 (Hallmark greeting cards), the court relied entirely on the guideline publicly traded company method, even though there were no good public wine companies to use for Gallo and only one public greeting card company to use for Hall. In Gallo, the experts used breweries, distilleries, soft drink bottlers, and high brand recognition and market share food producers. In Hall, they used high brand recognition and market share consumer nondurable products companies, such as Parker Pen. In both cases, the court arrived at a value as if the stock were publicly traded, then applied a 36 percent discount for lack of marketability based on restricted stock and pre–initial public offering (pre-IPO) transaction study data. However, in Estate of Heck v. Comm’r,46 the court rejected the use of a single comparable company where it was insufficiently similar to the subject company. The court said, “As similarity to the company to be valued decreases, the number of required comparables increases.”
In Hess v. Comm’r,47 the court upheld the comparison of the subject company to guideline companies solely on the basis of price-to-earning (P/E) ratios where the guideline companies were similar to the subject company and the guideline companies were properly adjusted.
Estate of Watts was a classic clash of opposing opinions on appropriate approaches to value—in that case, the taxpayer’s reliance on the market approach and the IRS’s reliance on the asset approach. Decedent’s estate filed a valuation of $2,550,000 for a 15 percent interest in a timber growing and processing partnership. The notice of deficiency valued the interest at $20,006,000, based primarily on the liquidation value of the assets. At trial, the taxpayers’ experts based their valuations on publicly traded companies that processed timber and held timberlands. Based on these companies, they presented valuation parameters such as price-to-earnings multiples, multiples of partnership interest value to book value and to adjusted net asset value, and capitalization of partnership withdrawals. Because the tax court did not accept the respondent’s liquidation value approach, it relied on values provided by the business valuation experts (including a 35 percent discount for lack of marketability) and ultimately concluded the estate’s value as originally filed of $2,550,000.48
Both the IRS and the tax court have traditionally leaned more toward the market approach than the income approach. This is partly because of language in Revenue Ruling 59-60, written before the development of modern capital market theory, which evolved particularly in the 1960s. It is also partly because of concern about possible manipulation of both cash flow forecasts and discount rates in the discounted cash flow (DCF) method. The tax court has rejected the DCF method in cases in which it believed the model used by the expert was far too sensitive to minor changes in assumptions, such as the discount rate and/or the growth rate.50 The court also rejected the income approach where the capital asset pricing model (CAPM) was used to value a small closely held company, as the CAPM does not address unsystematic risk.51 The tax court has also been known to reach its conclusion by giving partial weight to a DCF method and partial weight to a market approach method.52 Noteworthy decisions include those in Estate of Jung53 and Rakow v. Comm’r.54
In Estate of Lehmann v. Comm’r,55 the tax court accepted the DCF method for valuing an interest in a real estate partnership that owned a property with a hotel, noting: “The value of any interest in real property that has an income stream can be estimated by the DCF method. See Estate of Bennett v. Comm’r.”56 (The court then took into consideration the minority, nonmarketable status of the partnership interest.)
Revenue Ruling 59-60 suggests that the asset approach should be accorded more weight for holding companies, while earnings-related methods should be accorded more weight for operating companies. For example, in Estate of Jameson v. Comm’r,57 which involved the valuation of a controlling interest in a holding company the primary asset of which was timber, the tax court determined that the asset approach was appropriate since earnings were relatively low as compared to the fair market value of the assets. The IRS has tended to push this notion to the ultimate in the case of family limited partnerships, where they often have used the asset approach exclusively.58
The principle that minority blocks of closely held stock are worth less, because of the lack of a ready market, than otherwise similar publicly held stock is thoroughly entrenched in tax court rulings. The argument is not whether, but how much?
There appear to be two long-term trends:
• The size of marketability discounts concluded has gradually increased.
• The court has increasingly emphasized reliance on empirical data in deciding on the size of the lack of marketability discount.
In the 1980s, discounts purely for marketability reached 36 percent, the highest up to that time.60 In the late 1990s there were several conclusions of a 40 percent lack of marketability discount.61 In 2006, a 50 percent discount for lack of marketability (DLOM) was recognized.62
To some extent, the gradually increasing level of marketability discounts is attributable to the growing body of empirical data available to assist in quantifying such discounts and the tax court’s increasing emphasis on that data. The relevant empirical data have for a long time been the restricted stock studies (sales of blocks of nonregistered or restricted stock of public companies) and the pre-IPO studies (transactions in stock of private companies that subsequently had successful initial public offerings). With time, these studies have been criticized for various deficiencies, and other ways of arriving at discounts for lack of marketability have been put forth, including the use of put options, put-call collars, regression analysis of the restricted stock studies, private placement studies, the Quantitative Marketability Discount Model (QMDM), and even analyses of stock illiquidity versus lack of marketability. All of these alternatives have their own weaknesses and flaws.
The restricted stock studies were first published starting in the early 1970s and include data going back to the late 1960s. They were recognized as valid evidence supporting discounts for lack of marketability in Revenue Ruling 77-287. The pre-IPO studies first appeared in the early 1980s, with data back to 1975. They were first introduced in Estate of Gallo63 and also used in Estate of Hall.64
In the late 1990s, the tax court explicitly directed attention to both these lines of studies in reaching conclusions based on a discount for lack of marketability.65 However, the court has not always accepted these data. Some criticisms of these studies are that they are dated, they have limited sample sizes, they are spread out over long periods of time, and they may have substantial standard errors in their estimates. In Estate of Jelke v. Comm’r66 (affirmed as to the discount issue by 507 F.3d 1317 [11th Cir. 2007]), for example, the court rejected the use of restricted stock studies, determining they were insufficiently similar to the subject company as to size. A prevailing theme in tax court criticism of the application of restricted stock studies has been that many such uses unfairly exclude pertinent information about the company’s specific industry; significant examples include McCord v. Comm’r,67 Estate of Kelly v. Comm’r,68 Lappo v. Comm’r,69 Peracchio v. Comm’r,70 Estate of Deputy v. Comm’r,71 and Janda v. Comm’r.72 Other questions as to the applicability of restricted stock studies were raised by Temple v. United States,73 Robertson v. United States,74 and Estate of Green v. Comm’r.75 Although Litman v. United States76 rejected a generalized use of restricted stock studies, the claims court expressed a preference for using individual transactions from the restricted stock studies rather than averages, a procedure that Shannon Pratt, one of the authors of this book, advocates and has used effectively many times.
A brief description of some of the other sources of empirical data supporting discounts for lack of marketability (or lack of liquidity) follows.77
Put Options. The put option method calculates a discount for lack of marketability by calculating the cost of locking in the current price to protect the downside risk of price movements while the security is illiquid. The price of the put provides market evidence of the price investors will pay to ensure marketability, and the formula for this model, as well as its key inputs (such as the risk-free rate and volatility) can be audited. The term of this model is more subjective. Potential criticisms of using this model are that it is a short-term, theoretical pricing model designed for liquid securities that is being applied to an illiquid security and that put options protect only against downside price movements. See Estate of Gimbel v. Comm’r78 for an example of the tax court’s rejecting this model in specific circumstances.
Put-Call Collars. A put-call collar locks in a security’s price by selling away the upside while protecting against the downward price movements. This is done by buying a put option and selling a call option. Criticisms of this type of analysis are that the lack of a derivatives market in the subject security results in significantly understating the cost to execute this strategy for a privately held security and that cost information is not available and can result in significant subjective judgment. Where this analysis is feasible, it can be used to establish a floor for the discount. See Litman v. United States79 and Estate of Gimbel v. Comm’r80 for instances in which the tax court rejected the use of an option collar approach in specific circumstances, principally that there would not have been a market for such hedging contracts in their instances.
Regression Analysis. Francis Longstaff and others use regression analyses of restricted stock studies to provide a quantitative indication of the DLOM. The mathematical method and its inputs can be audited. The key drivers of this approach are duration and volatility. Criticisms include the fact that a key assumption—that an investor could perfectly time the market—may not be realistic. In contradistinction to the put-call collar approach, this approach can be used to establish a ceiling for the discount.
Liquidity Versus Marketability. Ashok Abbott differentiates between marketability and liquidity, defining marketability as relating to a security’s registration (ease of transfer or salability) and liquidity as relating to the actual sale of the security (converting the asset to cash). Abbott postulates that the cost to trade becomes a critical factor, which most trading models overlook but “where the difference between marketability and liquidity become even more pronounced.” According to Abbott, large blocks of stock are illiquid, so he uses the Black Scholes or Longstaff models to calculate “look back put” data as a way to reveal discounts from liquidity-related issues. He finds that, for the largest publicly traded companies (more than $100 billion), the liquidity discounts range from 4 percent for the smaller blocks of stock up to 12 percent for the larger blocks. But for smaller companies, a 25 percent block creates a discount of around 35 percent. Still, these companies are bigger than most in a valuation pool.81
Minority interest and marketability discounts are two different concepts, although there may be some overlap. The tax court has clearly articulated this distinction:
Two conceptually distinct discounts are involved here, one for lack of marketability and the other for lack of control. The minority shareholder discount is designed to reflect the decreased value of shares that do not convey control of a closely held corporation. The lack of marketability discount, on the other hand, is designed to reflect the fact that there is no ready market for shares in a closely held corporation.82
In the majority of tax court cases in the 1980s and 1990s, minority and marketability factors were treated separately. However, more recent cases have combined the two factors in the final decision.83
A 50 percent interest is neither controlling nor minority. In most cases, the court will allow some discount for lack of control and also some discount for lack of marketability. See particularly Estate of Fleming v. Comm’r84 as one example.
In many reported decisions, the tax court has recognized that discounts for lack of marketability for controlling interests in closely held companies are appropriate. The courts have used language such as the following:
Even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer its stock.85
The tax court has allowed discounts for lack of marketability for controlling interests up to 30 percent.86 While Estate of Cloutier87 is a particularly striking example of circumstances in which the tax court allowed no such discount, there are many more examples of the court allowing it, including Estate of Dougherty,88 Estate of Maggos v. Comm’r,89 and Estate of Dunn v. Comm’r.90 There are many cases in the 10 to 15 percent range for discounts for lack of marketability for controlling interests91; Estate of Bennett92 is a particularly useful example.
Discounts are applied to noncontrolling ownership interests. This type of discount is sometimes referred to as a discount for lack of control (DLOC) or minority discount. These discounts may be granted independently of, or in addition to, the discount for lack of marketability.
A particularly important (and still controversial) example is Estate of Jelke v. Comm’r,93 in which the taxpayer’s expert discounted the subject minority interest by 25 percent for lack of control, whereas the IRS’s discounted it by 5 percent. The taxpayer’s expert assumed that the company was most like a closed-end fund and it was not a widely traded investment fund holding publicly traded securities. Applying this assumption, the expert arrived at a 20 percent discount base and added an additional 5 percent discount because the subject company had fewer assets, paid fewer dividends, and posted lower short-term returns than the comparable funds. The IRS expert’s analysis began with an average discount (8.61 percent) for closed-end funds and reduced this on the basis that the company outperformed the comparables used by the estate. The court adopted a 10 percent lack-of-control discount, finding that although the company was smaller than some of the comparables presented, it was well diversified, which reduced investment risk, and that investors in the company would base their investments on the company’s history of good performance.
Other examples of such discounts include Estate of Green v. Comm’r94 (17 percent), Estate of Thompson v. Comm’r95 (15 percent), Adams v. United States96 (20 percent—based on the taxpayer’s expert providing “the lone specific analysis of the issues”), and Robertson v. United States97 (19 percent—and noteworthy for the court’s comment that the taxpayer’s expert’s use of the median was more appropriate than the average, which could be unduly influenced by outliers).
The experts for both sides in Hess v. Comm’r98 agreed that a 15 percent DLOC applied, but the court criticized the taxpayer’s expert for using a discount under the guideline public company method, concluding that such a discount is already included and inherent in that method. In Temple v. United States,99 the court determined minority discounts in a range of 3.3 to 10.1 percent for limited partnerships holding publicly held marketable securities. The court arrived at this range by using closed-end funds data. The IRS’s expert used all reporting closed-end funds and calculated the discount based on the mean of the reported discounts and premiums from net asset value. The taxpayer’s expert used a limited universe of funds and computed the discount using the 75th percentile of the limited universe. The court preferred the IRS’s expert’s approach, finding it was more comprehensive.
Blockage is a term used primarily in conjunction with publicly traded stock. It denotes a block of stock that is so large relative to the typical daily or weekly trading volume that it would require a long time to release it into the public market slowly enough to avoid depressing the price of the stock.
Blockage discounts tend to be relatively modest, often in the 3 to 10 percent range. However, sometimes the tax court denies the discount totally, sometimes even inexplicably.100 At the other extreme, the tax court allowed a 25 percent blockage discount on a block of thinly traded public stock of Frederick’s of Hollywood.101 More typical is the Estate of Foote, for which the tax court concluded a 3.3 percent discount for blockage.102 Nonetheless, unique facts and circumstances can lead to a higher discount.103 In Estate of Adams v. Comm’r,104 the court applied both a discount for lack of marketability and a blockage discount on the same block of stock.
Dependence on a key person introduces a risk of the consequences of the loss of that person’s services in case of death, disability, or resignation. This risk is sometimes recognized through a separate discount for the key person factor.
In Estate of Furman v. Comm’r,105 the tax court found the following:
Where a corporation is substantially dependent upon the services of one person, and where that person would no longer be able to perform services for the corporation by reason of death or incapacity, an investor would expect some form of discount below fair market value when purchasing stock in the corporation to compensate for the loss of that key employee.
The court specifically cited Estate of Huntsman v. Comm’r, 66 T.C. 861, 1976 WL 3635 (1976); Estate of Mitchell v. Comm’r, 250 F.3d 696 (9th Circuit 2001); Estate of Feldmar v. Comm’r, T.C. Memo. 1988-429; and Estate of Yeager v. Comm’r, T.C. Memo. 1986-448. The court also made the important observation that while the company could have purchased key person life insurance, a minority shareholder could not compel the company to purchase such insurance, and in fact the company had had no such insurance in effect. The court went on to settle on a key person discount of 10 percent.
In Estate of Mitchell v. Comm’r,106 the tax court applied a 10 percent key person discount but rejected a key person discount in Estate of Renier v. Comm’r107 in which factual reasons supporting such a discount were absent from the valuation report.
If a company has nonvoting as well as voting stock outstanding, the nonvoting stock may be discounted compared to the value of the voting stock. For public companies that have both voting and nonvoting stock, the discount for nonvoting in most cases is quite small, often less than 5 percent, and that level of discount is often used for private companies and accepted by the IRS and the tax court.
In the unusual situation in which the voting stock that controls the company is only a tiny percentage of the total stock outstanding, voting control may be quite valuable, and it might be meaningless to measure the difference in value on the basis of a percentage discount. In the case of Estate of Simplot,108 a tiny percentage of all the stock was voting stock, but it was owned by four parties, each a minority. The tax court placed a superpremium on the voting stock. On appeal, however, the Ninth Circuit reversed, finding that the tax court had based its ruling on speculation by creating a scenario in which a buyer would purchase a minority share of the voting stock but with time would be able to play a role in the company.109
Premiums may be added to value for factors such as control, or a swing vote.
In Estate of Simplot v. Comm’r,110 the decedent owned a minority interest in a small control block of stock. The tax court, adopting the IRS’s position, attributed a 3 percent premium to the swing vote block and then took a 35 percent discount for lack of control from the decedent’s pro rata share in that block. This resulted in a multi-million-dollar control premium on the noncontrolling interest in the control block. On appeal, the Ninth Circuit reversed, finding that a buyer of the block could never recover the premium. In accepting the taxpayer’s application of a zero premium, the court decided that a controlling block of stock is not to be valued at a premium for estate tax purposes unless it can be shown that a purchaser of the block would be able to use it “in such a way to assure an increased economic advantage worth paying a premium for.”
In Estate of Maggos v. Comm’r,111 the decedent’s controlling block of stock in a company was repurchased by the company without the benefit of a formal valuation. After applying a 25 percent DLOM, the court applied a 25 percent control premium based on average premiums paid in the industry at the time of purchase. However, in Estate of Wright v. Comm’r,112 the court refused to apply a control premium asserted by the IRS’s expert that was based on a hypothetical scenario in which other investors might purchase the decedent’s block of stock.
One of the most dramatic developments in tax court decisions, starting in 1998, was explicit recognition of liability for capital gains taxes on significantly appreciated property.
In cases arising before 1987, a corporation could liquidate its assets, distribute the proceeds, and dissolve within 12 months, and by so doing it could eliminate the payment of capital gains taxes at the corporate level. The Tax Reform Act of 1986 eliminated that option. Before 1986, at least partially relying on the tax-free liquidation option (known as the General Utilities Doctrine, named after a case that exercised the option), the tax court had steadfastly denied recognition of any trapped-in gains tax liability unless liquidation of the appreciated assets was clearly imminent.
After 1986 there were no C corporation gift or estate tax valuation cases clearly isolating this issue until the Eisenberg113 case in 1997, when the tax court again denied recognition of capital gains liability as a factor diminishing value. In 1998, in Estate of Davis, the tax court decided as follows:
We reject respondent’s position that, as a matter of law, no discount or adjustment attributable to ADDI&C’s built-in capital gains tax is allowable in the instant case. … We are convinced on the record in this case, and we find that, even though no liquidation of ADDI&C or sale of its assets was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of ADDI&C’s built-in capital gains tax.114
The court ultimately recognized a diminution in value equal to approximately half the trapped-in capital gains tax liability. Shortly following the Davis decision, the Second Circuit Court of Appeals, citing favorably Estate of Davis, reversed Eisenberg.115
In 1999, in Estate of Simplot, the tax court reached a decision that reflected a valuation deduction of 100 percent of the trapped-in capital gains tax on a block of stock owned by the company being valued.116
Another 1999 case, citing Davis, recognized the trapped-in capital gains tax liability of a company’s timber. The court estimated the rate of growth, the rate of inflation, the capital gains tax rate, and the time period over which the timber would be cut. It discounted the estimated capital gains tax for each year to a present value, using an estimated equity cost of capital (discount rate). It then deducted the full present value of the capital gains liability thus estimated.117
The majority of cases that have followed, either at the tax court level or on appeal, have permitted discounts for trapped-in capital gains. The tax court in Estate of Welch v. Comm’r118 denied such a discount but was reversed by the Sixth Circuit. In Estate of Borgatello v. Comm’r,119 the tax court allowed a 24 percent discount for trapped-in capital gains on a controlling interest in a real estate holding company. The tax court in Estate of Dunn v. Comm’r120 permitted only a 5 percent discount, but on appeal, the Fifth Circuit ruled that a dollar-for-dollar reduction, amounting to a 34 percent discount, had to be applied to the company’s asset-based value. In Estate of Jelke v. Comm’r,121 the tax court rejected a dollar-for-dollar reduction for trapped-in capital gains on a minority interest, reasoning that a hypothetical willing buyer of a minority interest would not adjust the purchase price to reflect the entire amount of the company’s built-in capital gains tax liability and that a hypothetical seller would not accept that it was reduced for such liability. Finding the Fifth Circuit’s approach in Dunn persuasive, the Eleventh Circuit reversed, essentially assuming that all company assets were sold in liquidation on the valuation date and that 100 percent of the trapped-in tax liability would be offset against the fair market value of the stock, dollar for dollar. The court thus rejected the tax court’s distinction between a minority and controlling interest for purposes of the discount, noting that “whether or not a majority or minority interest is present is of no moment in an assumption of liquidation setting.”
Cases that have rejected the discount for trapped-in capital gains have involved partnership interests, where the capital gains tax could have been avoided by an IRC Section 754 election. The courts in those cases have reasoned that a hypothetical buyer and seller would negotiate with the understanding that such an election would be made.122
Regulation Section 1.170A-13(c) requires a summary appraisal by a qualified appraiser in conjunction with any charitable contribution in the form of a closely held business interest valued at over $5,000. The section defines a qualified appraiser as an individual who:
1. Holds himself or herself out to the public as an appraiser or who regularly performs appraisals
2. Is qualified to appraise property because of his or her qualifications
3. Is aware of the appraiser penalties associated with the overvaluation of charitable contributions under IRC Section 6701
Certain individuals, however, may not act as qualified appraisers, including:
1. The property’s donor (or the taxpayer who claims the deduction)
2. The property’s donee
3. A party to the property transfer transaction (with certain very specific exceptions)
4. Any person employed by, married to, or related to any of the above persons
5. An appraiser who regularly appraises for the donor, donee, or party to the transaction and does not perform a majority of his or her appraisals for other persons
6. An individual who would otherwise be a qualified appraiser, but the donor has knowledge of facts that would cause a reasonable person to expect the appraiser falsely to overstate the value of the donated property (for example, the donor and the appraiser make an agreement concerning the amount at which the property will be valued and the donor knows that such amount exceeds the fair market value of the property)
The IRS and the tax court enforce this requirement. In one case the IRS completely disallowed charitable deductions claimed in two years because the donor failed to comply with the appraisal requirement, even though the commissioner conceded that the values claimed as deductions were the same as the fair market value of the stock contributed. The tax court upheld the commissioner’s determination. The court of appeals found that “Congress intended the qualified appraisal requirement to be mandatory.” Accordingly, the taxpayer’s failure to obtain an appraisal was fatal to any claim of deduction for his charitable contributions.123
In addition, other valuation issues arise in the charitable deduction context, such as the appropriate discounts to apply. For example, where shareholders owned a 45 percent interest in a corporation and simultaneously donated their interest in “lockstep” with the corporation’s other minority shareholders, as part of a prearranged plan, the tax court reduced the IRS’s proposed 22 percent minority discount to 10 percent but failed to explain why any minority discount was justified, since collectively 100 percent of the company was being transferred.124
With regard to contributions of qualified appreciated stock, an issue that can arise is whether on the transfer date market quotations with respect to the shares are readily available on an established securities market. In Todd v. Comm’r,125 the stock at issue had not been listed on any exchange, and the taxpayer based the claimed deductions on subsequent sales of stock that occurred shortly after the contributions were made. The tax court disallowed the deductions, holding that the shares were not qualified appreciated stock on the transfer date. Therefore, the taxpayer was subject to substantiation requirements, which the taxpayer failed to provide. The case thus illustrates the importance of obtaining a formal appraisal when shares are not traded on an exchange.
The most common contingent liabilities are environmental liabilities (discovered or potential) and outcomes of lawsuits. The uncertainty, of course, makes it very difficult to quantify the impact on value of these contingencies at a moment in time. In a true market setting, the solution normally would be to create a reserve account in escrow pending resolution of the uncertainties, but in a tax setting, one must arrive at a specific number as of the effective valuation date.
A 1999 case involved a paint company that was considered a hazardous waste producer with potential environmental liability. The court allowed a 10 percent discount from the value indicated by the discounted cash flow method but no discount from the value indicated by the guideline public company method, on the theory that the guideline company stock market prices probably already reflected the potential environmental liability.126 In Estate of Mitchell v. Comm’r127 the tax court took a $1.5 million discount for a pending compensation lawsuit. In Estate of Klauss v. Comm’r128 the court permitted a 10 percent discount for product liability and environmental claims.
One of the authors, Shannon Pratt, was involved in a case valuing three creosote plants on the shores of Puget Sound. The IRS and the company management agreed that the environmental damage was great enough that all three operations would potentially be shut down. But the company had been operating for ten years since the problems were known. The case was informally settled at an arbitrary 50 percent discount from the value that was reached by conventional approaches.
The principle is clear that only events or information that were known or foreseeable as of the valuation date may be taken into consideration. Clear as the principle may be, the admissibility and relevance of post-valuation date information is often a major controversy.
If valuing stock late in a fiscal period, it usually is acceptable to use financial data as of the end of that period. The philosophy is that late in a fiscal period, the performance for the period would be reasonably foreseeable in most cases.
Useful examples can be found in Rabenhorst v. Comm’r129 and Central Trust v. Comm’r.130 A particularly relevant caution can be found in Polack v. Comm’r,131 in which the taxpayer used unaudited financials for years subsequent to the valuation date to argue that actual results were significantly lower than projections provided by the IRS at trial. The Eighth Circuit did not admit these, saying that “post-transaction earnings would not have been known to a prospective purchaser” as of the valuation date.
Rulings on the “known and knowable” financial information in the circumstances of the decease of the taxpayer can be problematic, and the circumstances should be considered carefully. In Okerlund v. United States132 the Federal Circuit affirmed the Court of Federal Claims’ ruling that estate plan provisions requiring the purchase of stock upon decedent’s death should not have been included in valuing the stock when decedent’s death was untimely and unexpected. The court said that valuation must always be made as of the donative date relying primarily on ex ante information; ex post data should be used sparingly.
However, in Estate of Noble v. Comm’r133 the court permitted the use of a post-death event to value minority shares in a bank. The estate presented as evidence of value an offer by the controlling shareholder to purchase the decedent’s shares for $878,004 a few months after the date of death. However, the IRS presented evidence of the estate’s sale of the shares to the bank for $1.1 million 10 months later. The court noted that there had not been any material change in circumstances between the sale date and the date of death. The court reasoned, “An event occurring after a valuation date, even if unforeseeable as of the valuation date, also may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date. … Unforeseeable subsequent events which fall within this latter category include evidence, such as we have here.”134
The tax court frequently relies on subsequent sales as evidence of value. The court distinguishes between subsequent sales that affected the value and those that are merely evidence of value.
A subsequent sale surfaced as an issue in Estate of Jung in an opinion released in November 1993. The matter involved the fair market value of a 20 percent interest in an operating company as of October 9, 1984. In mid-1986 the company was approached about selling its major operating assets, a transaction was completed on December 29, 1986, and the company was liquidated. The tax court explained its position as follows:
Respondent contends that, in valuing Jung Corp. stock, this Court should consider the sale to Kendall, the other sales, and the ensuing liquidation of Jung Corp.
Petitioner contends the 1986 sales and the liquidation are irrelevant because the sales and liquidation were unforeseeable at the valuation date.
We agree in part with respondent and in part with petitioner.
A distinction may usefully be drawn between later-occurring events which affect fair market value as of the valuation date, and later-occurring events which may be taken into account as evidence of fair market value as of the valuation date.
If a prospective October 9, 1984, buyer and seller were likely to have foreseen the 1986 sale to Kendall, and the other activities leading to the liquidation, then those later-occurring events could affect what a willing buyer would pay and what a willing seller would demand as of October 9, 1984. We conclude, and we have found that, on October 9, 1984, Jung Corp. was not for sale, the sale to Kendall was not foreseeable, and the liquidation was not foreseeable. Accordingly, we conclude that those later-occurring events did not affect the October 9, 1984, fair market of decedent’s stock. Estate of Gilford v. Comm’r, 88 T.C. 38, 51-55 (1987).
However, we have stated that “for purposes of determining fair market value, we believe it appropriate to consider sales of properties occurring subsequent to the valuation date if the properties involved are indeed comparable to the subject properties.” Estate of Thompson v. Comm’r, 89 T.C. 619, 628-629 n. 7 (1987), rev’d. on other grounds 864 F.2d 1128 (4th Cir. 1989). To the same effect are, e.g., Krapf v. United States, 977 F.2d 1454, 1458-1460 (Fed. Cir. 1992); Estate of Kaplin v. Comm’r, 748 F.2d 1109, 1111 (6th Cir. 1984), rev’g. T.C. Memo. 1982-440 (1982); Estate of Brown v. Comm’r, 425 F.2d 1406, 1407 (5th Cir. 1970), aff’g. T.C. Memo. 1969-91 (1969). See Estate of Jung v. Comm’r, T.C. Memo. 1990-5 and cases cited therein.
Of course, appropriate adjustments must be made to take account of differences between the valuation date and the dates of the later-occurring events. … Although any such changes must be accounted for in determining the evidentiary weight to be given to the later-occurring events, those changes ordinarily are not justification for ignoring the later-occurring events (unless other comparables offer significantly better matches to the property being valued).
When viewed in this light—as evidence of value rather than as something that affects value—later-occurring events are no more to be ignored than earlier-occurring events.
Accordingly, we do not consider the sales and eventual liquidation as affecting the October 9, 1984, value of Jung Corp., but we do consider these events as evidence of the October 9, 1984, value.135
Ultimately, the tax court determined that some of the petitioner’s higher indications of value were reconcilable with the subsequent sale.
In Saltzman v. Comm’r136 a holding company sold its major asset, film rights, seven months after the valuation date at a much higher price than the taxpayer’s expert had appraised the rights at as of the valuation date. The court relied on the sale value, discounted for the time value back to the effective valuation date. The court explained its position as follows:
Generally, a sale of the property close in time to the valuation date is the best evidence of fair market value. Estate of Spruill v. Comm’r, 88 T.C. 1197, 1229, 1233 (1987); sec. 20.2031-1(b) Estate Tax Regs. A sale of the property after the valuation date is highly relevant evidence of value if there are no material changes in the interim. Estate of Kaplin v. Comm’r, 748 F.2d 1109, 1111 (6th Cir. 1984), rev’g. T.C. Memo. 1982-440 (sale 2 years after the valuation date). In contrast, material market changes following the valuation date may make a later sale price less probative or irrelevant in deciding the value on the valuation date. Estate of Spruill v. Comm’r, supra at 1233.137
The tax court also cited Estate of Kaplin v. Comm’r (748 F.2d 1109, 1111 [6th Cir. 1984], rev’g. T.C. Memo. 1982-440) and Estate of Gilford in this decision.
The most extreme case of the tax court’s relying on a sale long after the effective valuation date is found in Estate of Cidulka.138 The effective valuation date was January 25, 1982. Four years later (January 1986) the company, an outdoor advertising sign company, sold its assets to a major competitor for 2.89 times gross revenue. The tax court used this sale to conclude that the value of the stock should be 2.5 times the company’s gross revenue for 1981 (the year prior to the effective valuation date).
In one case, the tax court relied on a January 1994 sale to value minority stock in an estate as of July 16, 1991. The estate tax return valued the stock at $35.20 per share, based on an update of an appraisal done in 1989. The 1994 sale took place at $75.15 per share. The tax court reduced the sale price by 30 percent, resulting in a value of $50.51 per share. The reason for the reduction was because the IRS offered no expert testimony, and the court rejected the taxpayer’s expert’s opinion for several reasons (highly instructive cautions for any professional dealing with a valuation in any way):
• He was unable to explain certain parts of the analysis contained in the reports.
• He arbitrarily applied a 35 percent marketability discount.
• He made no mention of a hypothetical seller.
• Whereas the 1989 report states that [taxpayer’s expert] toured the facilities, there is nothing in his testimony or the 1991 report to suggest that he did likewise before preparing the 1991 report.
• The 1991 report does not adequately account for the fact that the company’s 1991 earnings increased dramatically over the years covered by the 1989 report.
• The 1991 report does not adequately take into account that the company began paying dividends after the time covered by the 1989 report.
• The 1991 report refers to the financial data of publicly traded companies, yet never explains how those companies were selected, or in what respects their lines of business were similar to the subject company.139
The estate tax value filed might well have held up in court had it been adequately supported. In some other valuation context, such as family law, the case may have been remanded due to lack of adequate valuation evidence, but the tax court goes ahead and reaches a conclusion based on whatever it has before it.
In Estate of Trompeter v. Comm’r, the tax court relied on a redemption 16 months following the valuation date. Again the IRS offered no expert testimony, and the court rejected the taxpayer’s expert’s opinion as unpersuasive, noting, among other shortcomings, reliance on companies that were not comparable. The final determination of value was the redemption amount of $1,947,845, compared to $15,335 filed on the decedent’s federal estate tax return. The court also upheld the fraud penalty under Section 6663(a).140
The value established by a buy-sell agreement may be controlling, may be ignored, or may be a factor to consider.
For buy-sell agreements entered into after October 8, 1990, a buy-sell price is binding for federal estate tax purposes if it meets all of the following criteria141:
• The price must be fixed or determinable as of a determinable date.
• The agreement must be binding on the parties both during life and after death.
• The agreement must have been entered into for a bona fide business reason.
• It must not be a substitute for testamentary disposition.
• The agreement must result in a fair market value for the subject business interest at the time the agreement is executed.
• Its terms must be comparable to similar arrangements entered into by persons in arm’s-length transactions.
The tax court, in Estate of Lauder v. Comm’r (Lauder II),142 adopted this test and ruled that the test’s elements are conjunctive, meaning that all of them must be independently satisfied to give the buy-sell price dispositive effect.
Regulations Section 20.2031-2(h) provides the following:
Such price will be disregarded in determining the value of the securities unless it is determined under the circumstances of the particular case that the agreement represents a bona fide business arrangement and not a device to pass the decedent’s shares to the natural objects of his bounty for less than full and adequate consideration in money or money’s worth.
In Estate of Blount v. Comm’r143 the tax court disregarded a buy-sell agreement in determining the decedent’s interest in a closely held company on the date of his death because the decedent had the unilateral ability to modify it, thus failing to satisfy the requirement that it be binding during life. The court also disregarded the agreement under IRC Section 2703, which requires that to be included in a valuation, a buy-sell agreement’s terms must be “comparable to similar arrangements entered into by persons in an arm’s length transaction.” Here, the court concluded that the parties were “related” and had not engaged in arm’s length bargaining. The Eleventh Circuit affirmed.
Interestingly in this case, there was a life insurance policy owned by the company that provided $3.1 million to pay off the mandated buyout of the shares. The tax court included the full amount of the insurance proceeds as nonoperating assets, and it also concluded that because the buy-sell agreement had been disregarded, the issue of whether the company’s obligation under that agreement to redeem the decedent’s stock should offset the proceeds was not before the court. As to the insurance proceeds, the Eleventh Circuit ruled that the tax court had erred because those proceeds had already been taken into account in the determination of net worth. The court noted that even when a buy-sell agreement is inoperative for establishing the value of the company for tax purposes, the agreement remains an enforceable liability against the valued company if state law fixes such an obligation—which it had in this case. Here, the insurance proceeds were offset dollar for dollar by the company’s obligation to satisfy its contract with the decedent’s estate. The court thus concluded that such nonoperating “assets” should not be included in the fair market valuation of a company where, as here, there was an enforceable contractual obligation that offset such assets.
In Estate of True v. Comm’r,144 one issue was whether the book value price specified in the buy-sell agreements controlled estate and gift tax values of the subject interests in several family companies gifted and deeded to children. The analysis focused on the Lauder II factors. The court found that the fact that the children did not have independent legal or accounting advice, while not dispositive, reasonably suggested less than arm’s length dealings. The court was critical that the companies’ buy-sell agreements did not provide a mechanism for periodic review or adjustment to the tax book value formula. The court also considered an analysis under the adequacy of consideration test. This test requires that the formula price (1) be comparable to what persons with adverse interests dealing at arm’s length would accept and (2) bear a reasonable relationship to fair market value. As the court said, “These standards must be applied with the heightened scrutiny imposed on intrafamily agreements restricting transfers of closely held businesses.” The court concluded that “the True family buy-sell agreements do not satisfy the Lauder II test because they are substitutes for testamentary dispositions. As a result, under Section 2031 and the related regulations, the tax book value buy-sell agreement price does not control estate tax values of interests in the True companies at issue in the estate tax case.” The court also determined that the buy-sell agreements were not controlling for the gift tax case. The Tenth Circuit affirmed.
An example of a case in which the buy-sell agreement price was controlling is Hutchens Non-Marital Trust v. Comm’r.145 The court upheld the buy-sell price because it found that the negotiations had been at arm’s length and in the ordinary course of business. In arriving at this decision, the court noted that a formal appraisal had been conducted and that each of the parties to the agreement had been individually represented by attorneys during negotiations. This case demonstrates the benefit of having an appraisal conducted after the buy-sell agreement has been entered into and also to aid in setting a buy-sell price or formula.
Revenue Ruling 59-60 is negative toward the idea of reconciling two or more indications of value by applying mathematical weights to each. Judge Laro discusses the issue as follows:
In spite of this, some valuation practitioners apply weights to various factors in reaching their valuation conclusions because this allows them to clearly demonstrate the importance that they attach to various valuation considerations. This approach was used by the Tax Court in Estate of Feldmar v. Comm’r. T.C. Memo. 1988-429; Estate of Titus v. Comm’r, T.C. Memo 1989-466; Estate of Campbell v. Comm’r, T.C. Memo. 1991-615. The weighing of various methods, however, was squarely rejected by the Court in Estate of Mueller v. Comm’r, T.C. Memo. 1992-284.
With what appears to be conflicting judicial positions on this issue, there is some concern about whether the weighing of factors is a proper method of appraisal.
I believe that one should consider carefully all relevant factors but should not assign weights to each factor. However, practitioners may emphasize a few factors that could influence the ultimate valuation.146
Another case in which the court ultimately utilized an explicit percentage weighting of factors is the oft-quoted Central Trust v. United States in the U.S. Court of Claims. The court relied entirely on the guideline public company method and applied 50 percent of the weight to the price-to-earnings multiples, 30 percent to the dividend yield, and 20 percent to the price-to-book value multiple.147 In Hess v. Comm’r,148 the IRS’s expert did not assign any weight to the discounted cash flow method because the company’s future income was difficult to predict and because valuation conclusions were highly sensitive to small changes in assumptions. The tax court indicated that while less weight should be accorded to this method under such circumstances, it should nonetheless be considered in the valuation process. The court did not, however, specify an exact percentage of weight to be accorded to the method. In Estate of Dunn v. Comm’r,149 the court indicated that weighting was a key issue. The IRS’s expert accorded the asset approach a 100 percent weight, whereas the taxpayer’s expert weighted the income and asset approaches equally given that no liquidation was planned. The tax court decided that the appropriate weight was 65 percent for the asset approach and 35 percent for the income approach, based on various factors, such as the depressed nature of the industry and the company’s low profitability and high debt. On appeal, the Fifth Circuit determined that the likelihood of liquidation was a relevant factor for weighting and ruled that the earnings-based method should be weighted at 85 percent to reflect the low likelihood of liquidation.150
If the expert says, “I accorded more weight to x factor,” the judge may ask, “Well, how much weight?” My colleagues and I have previously opined on this dilemma as follows:
Despite this wording, the method has been used successfully in many gift and estate tax cases both in dealing with the IRS and in cases decided in court. The wording of Revenue Ruling 59-60 indicates concern that the averaging or weighted average method leaves room for omission of pertinent factors. However, it is possible to use the basic weighted average of factors procedure and still, at one stage or another, incorporate consideration of all the pertinent factors mentioned in Revenue Ruling 59-60. Of course, it is important to be careful to demonstrate in each case that all other pertinent factors were actively considered and reflected in the result to the appropriate extent.151
All this discussion leads to the conclusion that neither explicit nor implicit weighting of varying indications of value is clearly superior. If an explicit weighting is used, we suggest a disclaimer to the effect that there is not an empirical basis for the weighting; it is presented only to help the reader understand the analyst’s thinking regarding relative importance.152
The tax court has consistently urged taxpayers and the IRS to attempt to settle valuation disputes rather than bring them to trial. For example:
Once again we must advise counsel that valuation cases such as this are better suited for the give and take of the settlement process than adjudication. See Buffalo Tool & Die Manufacturing Co. v. Comm’r, 74 T.C. 441, 451 (1980); Messing v. Comm’r, 48 T.C. 502, 512 (1967). It is quite clear from the record that the experts have not been permitted to meet to discuss their reports and attempt to resolve their differences. Furthermore, the Court concludes that counsel have failed to meaningfully confer with each other regarding settlement and stipulation as required by the Court’s Standing Pre-trial Order. The result of this “Rambo” approach to Tax Court litigation is that the parties and the Court have had to spend considerable time and effort in trial, on briefs, and in opinion writing to resolve a question which clearly should have been settled.153
Similar opinions were expressed in Estate of Furman v. Comm’r,154 citing both Estate of Hall v. Comm’r and Messing v. Comm’r.
Bellatti, Robert M., and Shari L. West. 1999. Estate Planning for Farms and Other Qualified Family-Owned Businesses. Boston: Warren, Gorham & Lamont. Covers Section 2032A and Section 2057 special-use valuations.
Bogdanski, John. Federal Tax Valuation, 1996, Boston: Warren, Gorham & Lamont, plus annual supplements. Includes thousands of case citations with discussions.
Feld, Daniel E. 2002. Estate and Gift Tax Digest, 4th ed. Boston: Warren, Gorham & Lamont. Cites, and digests, cases and rulings.
Fishman, Jay, et al. Annual. “Estate and Gift Tax Valuations.” In PPC’s Guide to Business Valuations. Fort Worth, TX: Practitioners Publishing, pp. 10-1 to 10-75.
Howitt, Idelle A. 2002/2003. Federal Tax Valuation Digest: Business Enterprise and Business Interests. Boston: Warren, Gorham & Lamont. Summarizes most federal cases involving valuations of businesses and business interests from 1945 through the present. Each annual edition is cumulative.
Kasper, Larry J. 1997. “Federal Tax Valuations.” In Business Valuations, Advanced Topics. Westport, CT: Greenwood Publishing, pp. 211–258.
Pratt, Shannon. 2003. “Tax Related Valuations.” In Business Valuation Body of Knowledge, 2nd ed. New York: Wiley, pp. 309–314.
Pratt, Shannon P., and Alina V. Niculita. 2007. “Valuation for Estate and Gift Tax Purposes” and “Valuation for Income Tax Purposes.” In Valuing a Business, 5th ed. New York: McGraw-Hill, pp. 627–660, 723–752.
Saltzman, Michael J. 2006. IRS Practice and Procedure, rev. 2nd ed. Boston: Warren, Gorham & Lamont. Covers the complete range of IRS procedures from rulings to collection of taxes.
Solomon, Lewis D., and Lewis J. Saret. 1998. “General Rules of Valuation: Tax Perspective.” In Valuation of Closely Held Businesses. New York: Panel Publishers, pp. 67–104.
Trugman, Gary. 2002. “Revenue Ruling 59-60.” In Understanding Business Valuations, 2nd ed. New York: American Institute of Certified Public Accountants (AICPA), pp. 409–448.
www.BVResources.com contains the BVLibrary.com. Contains full text of all case opinions in this chapter, all searchable by key word.
www.ustaxcourt.gov contains all appealable tax court opinions from January 3, 1999, to the present.