Current Valuation Controversies in Estate Planning

Phillip S. WilliamsEric M. Baltes

Agenda• Introduction

• 100% Interest Issues

• Valuation Discounts

• Family Limited Partnerships (FLPs) and related entities– Court rulings on discounts

100% Interest Issues• S-Corp Valuation

– To tax affect or not to tax affect, that IS the question

• Control Premiums– Public company control premium or investment value

• Equity Risk Premiums & Capital Structure

S-Corp Controversy• IRS uses Gross v. Commissioner case to challenge

taxes applied to S-Corp’s earnings– No taxes = more earnings = higher value = higher estate taxes

• Estimates indicate that an S-Corp could be worth as much as 67% higher than identical C-Corp

• In spite of less than ringing endorsement from Appeals Court– “The Tax Court…determined that tax affecting was not appropriate

in this case. I do not find its conclusions clearly erroneous.”

– The ruling challenges status quo valuation methods and “upsets” BV Profession

• Sample articles/quotes:– A Gross Result in the Gross Case: All your Prior S Corp

Valuations are Invalid (Hawkins and Paschall, BVR 3/02)– “Before and after the (split) appellate decision, numerous analyses

have attempted to prove that the reasoning underlying the Tax Court’s decision was generally faulty.” The S-Corporation, Fair Market Value, and Their Intersection with the Real World, Lurie, Business Appraisal Practice

S-Corp Controversy cont…• “Bad Facts” in Gross case

– Sale to a C-Corp not considered• Taxpayer’s expert did not bring up the fact that tax affecting or not tax affecting

depends on who the likely buyer is. If C-Corp were likely buyer, earnings would be tax affected

– 100% payout of earnings• The Company had a history of paying out 100% of earnings. Assuming this type

of payout always results in an S-Corp advantage– Poor arguments made by Taxpayer’s Valuation Analyst

• Tax affecting has been approved in Tax Court– “Thus, the fact that tax affecting may have been approved in other cases…

does not, and should not, preclude a different result in another case…” (Appeals Court)

• The IRS has a guide and handbook that say we should do it this way– “…both the guide and handbook provide that they are not to be relied upon

as binding authority…” (Appeals Court)• Tax affecting was generally accepted by valuation professionals

– The Taxpayer’s expert’s “…testimony, when carefully reviewed, reveals that even he was not certain whether tax affecting was generally accepted, acknowledged some disagreement on this point, and was equivocal on whether he would continue to tax affect.” (Appeals Court)

S-Corp Controversy cont…

• Impact of pay-outs—Why 100% pay-out supports IRS position

Traditional No Tax Affecting

Income before taxes 100,000 $ 100,000 $

Corporate Income Taxes @40% (40,000) -

Net Income 60,000 $ 100,000 $

Dividends Paid 60,000 $ 100,000 $

Income Tax for Shareholders (20% for C-Corp, 40% for S-Corp) (12,000) (40,000)

Cash Flow for Shareholders 48,000 $ 60,000 $

100% Distribution of Earnings

S-Corp Controversy cont…• Some in Profession retreat into denial

– I have been valuing companies by tax affecting earnings my entire life

– If enough articles are written, the Tax Court will come around

• Some come up with complex models– There must be a solution and I can prove it, especially

if I use Algebra

• IRS comes up with more rulings– Estate of Heck, Estate of Adams, and Dallas v.

Commissioner

S-Corp Controversy cont…• Heck reinforced Gross

– Taxpayer and IRS experts both did not tax affect S-Corp earnings

• Adams rules out tax affecting using a discount rate and dismisses concept of pre-tax v. after-tax earnings– “The estate contends that (Taxpayer expert) properly converted the

capitalization rate from an after corporate tax rate to a before corporate tax rate to match estimated prospective net cashflows and that the conversion increased his capitalization rate from 20.53 percent to 31.88 percent. We disagree with the estate on both points.”

and

– “We disagree that (Taxpayer expert) converted the capitalization rate because there was no need to do so”

– “…it is appropriate to use a zero corporate tax rate to estimate net cashflow when the stock being valued is stock of an S corporation.”

S-Corp Controversy cont…• Dallas reinforces Gross and shows what happens to bad

Taxpayer arguments– Taxpayer’s expert arguments unpersuasive

• “He has always tax-affected S corporation income for the past 20 years:• an informal poll at a recent conference showed 90 to 95 percent of

responding appraisers tax-affect S corporation income;• the ASA Board of Review rejects any application for certification if the

candidate submits test answers or reports for review that do not tax-affect S corporation income;

• his experience is that all bankers, investment bankers, and business brokers use tax-affecting in estimating the value of S corporation stock; and

• (Company) uses tax-affecting in valuing S corporation stock held by employee stock ownership plans (ESOP) that it submits to Department of Labor.”

– “We conclude that there is insufficient evidence to establish that a hypothetical buyer and seller would tax-affect (Company’s) earnings and that tax-affecting (Company’s) earnings is not appropriate.”

S-Corp Controversy cont…• Theory behind the Controversy

– Personal after tax returns are higher for S-Corp shareholders

• “An S Corporation owner will end up with more cash in their pocket because of the avoided dividend tax. This is the benefit that economic models for the valuation of the S corporations measure.” [Fannon, Nancy J., Subchapter S Corporation Valuation—A Simplified View, Business Valuation Review, Spring 2007]

– Shareholders tend to choose S-Corp Structure• Since Shareholders are the “Hypothetical Sellers,” their method

of analysis should be considered

S-Corp Controversy cont…• Example of advantages to S-Corp shareholders

C-Corp S-Corp C-Corp S-Corp

Income before taxes 100,000 $ 100,000 $ 100,000 $ 100,000 $

Corporate Income Taxes @40% (40,000) - (40,000) -

Net Income 60,000 $ 100,000 $ 60,000 $ 100,000 $

Dividends Paid 30,000 $ 50,000 $ 60,000 $ 100,000 $

Income Tax for Shareholders (20% for C-Corp, 40% for S-Corp) (6,000) (40,000) (12,000) (40,000)

Cash Flow for Shareholders 24,000 $ 10,000 $ 48,000 $ 60,000 $

Capital Gains 30,000 50,000 - -

Net Benefit to Shareholders 54,000 $ 60,000 $ 48,000 $ 60,000 $

100% Distribution of Earnings50% Distribution of Earnings

S-Corp Controversy cont…• Theory behind the controversy

– It’s more complicated for Buyers

– Individual investor with choice of identical S and C-Corps

• would not tax affect earnings

– Individual investor wanting to go public with choice of identical S and C-Corps

• would tax affect earnings

– Investor is a C-Corp• would tax affect earnings

S-Corp Controversy cont...• No Consensus Approach has Emerged

– Many Solutions are dogmatic

– Many Solutions are hideously complicated

– Many Solutions are still clinging to traditional methods

S-Corp Controversy cont…• List of Solutions

S-Corporation earning $500,000 per yearUsing same assumptions re: growth and risk

Implied Value

Traditional Method 3,000,000 $

No Tax Affecting 5,000,000 $

C-Corp Equivalent 3,380,000 $

Pre-tax Discount Rate 3,670,000 $

Economic Adjustment Model 3,530,000 $

There is no difference Model 3,000,000 $

Simplified Model 3,600,000 $

S-Corp Controversy cont…• So, how should an S-Corp be valued?

– Both Buyers’ and Sellers’ method(s) of analyzing cash flows should be considered

• “. . .the willing buyer willing seller rule does not permit a determination of fair market value based solely on the price lowering desires of the willing buyer.” (Appeals Court, Gross v Commissioner)

• Note: I am not aware of the buyer’s tax status being considered by the Tax Court

– Method selected should address IRS “doctrine” of not tax affecting earnings of S-Corps

– Dumb reasons for tax affecting should not be argued in front of the Tax Court

Control Premiums• Use of Control Premiums for Guideline Company

Comparables– Stock market trading values are used to get valuation multiples,

such as EBITDA multiples, to apply to privately held companies

– Public companies are usually acquired at a premium to the stock market trading value (these are called control premiums)

– Therefore, the multiples need to be adjusted when applied to the value of 100% of a privately held company

– Concept now being criticized• Premiums overstated because premiums measure “investment value”

not “fair market value”• Premiums overstated due to data issues (negative premiums not

counted in Mergerstat data and outliers distort averages)

Control Premiums cont…• So?

• From an estate tax standpoint, these control premiums are used to determine discounts for lack of control (DLOCs)

• If the observed Control Premiums are too high, then DLOCs are too high

(Not aware of cases addressing this issue)

Risk Premiums & Capital Structure• Appropriate Equity Risk Premium for discount rate

(based on Morningstar’s SBBI Yearbook)– Premiums for corporation size vary from negative 0.34% for 1st

decile to 5.82% for 10th decile

• Source of Equity Risk Premium data– Morningstar (formerly Ibbotson) v. Duff & Phelps

• Source of Capital Structure data– Debt to equity ratio has huge impact on values– One major source’s (Morningstar) data being challenged

(Not aware of cases dealing with these issues)

Theory of Valuation Discounts• Entity-level and Shareholder-level

• Entity-level discounts include trapped-in capital gains, key persons, or contingent liabilities, among others

• Shareholder-level discounts may include control, marketability, and nonvoting, among others

• Focus on discount for lack of control and discount for lack of marketability

Discount for Lack of Control• Discount for Lack of Control or Minority Interest discount

(DLOC)

An amount or percentage deducted from the pro rata share of value of one hundred percent (100%) of an equity interest in a business to reflect the absence of some or all of the powers of control. [Pratt, Shannon P., Valuing a Business, 4th ed.]

• Powers of control may include paying dividends, setting compensation, policy making, selecting suppliers, negotiating, marketing decisions, etc.

• Control does not necessarily mean a 100% interest, may not even mean a 50% percent interest, as in Estate of Hendrickson v. Commissioner

DLOCs• Operating entities

– DLOCs typically based on inverse of Mergerstat Control Premiums

– Issues with Mergerstat data including• Excludes negative premiums• Based on a point in time (5 days prior to transaction)• Transactions involving at least 10% interest• May include a foreign party in the transaction

– Appraisers value a minority interest of a company on either a minority or controlling basis

• Minority basis does not require DLOC or ownership normalization adjustments to the income statement

• Control basis would require DLOC and may also require ownership normalization adjustments

DLOCs• Non-operating entities

– Includes most partnerships and some LLCs– DLOCs often dependent on assets of the entity– Sources of DLOCs

• Cash: Peracchio v. Commissioner allowed 2%• Marketable securities: closed-end fund discounts/premiums• Real estate: RELP discounts (e.g. Partnership Profiles) or REIT

discounts• Non-marketable securities: depends, Mergerstat, others?• Other assets: case by case

– DLOCs, particularly for FLPs, have been addressed extensively by the courts

DLOCs• Other notable cases

– Estate of Dunn v. Commissioner: court applied a 7.5% discount on a 62.96% block

– Rushton v. Commissioner: several gifts made on the same day to several donees should be valued as individual gifts, rather than in the aggregate

– Lappo v. Commissioner, Peracchio v. Commissioner, & McCord v. Commissioner: court affirmed the use of a weighted average minority interest discount

– Kelley v. Commissioner: court allowed 12% minority interest discount for portfolio of 100% cash

– NOTE: sources of minority discounts (i.e. Mergerstat, closed-end funds, and RELPs) have largely been affirmed by the courts, except when the assets used by the source are not consistent with the underlying assets of the entity (e.g. Temple v. U.S.)

Discount for Lack of Marketability• Discount for lack of marketability (DLOM)

An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. [Pratt, Shannon P., Valuing a Business, 4th ed.]

• Marketability refers to the ability to convert a business ownership interest (at whatever level) to cash quickly, with minimum transaction costs, and with a high degree certainty of realizing the expected amount of proceeds

• Marketability is often interchangeable with liquidity, but Barron’s Dictionary of Business Terms offers two different definitions:– Marketability is the speed and ease with which an interest may be

bought or sold– Liquidity implies the preservation of value when an interest is bought or

sold

History of DLOMs• Pre-1971

– Appraisers initially relied on court case precedent in determining DLOMs

– This approach was not case specific• 1971

– SEC published the Institutional Investor Study– Established DLOMs based on transactions in letter

stock (or restricted stock) compared to their unrestricted counterpart

– DLOM ranged from 15% premium to 80% discount– Median was 24% and average was 26%

History of DLOMs• 1972-1990

– Five more restricted stock studies• DLOMs ranged from 30% premium to 91% discount• Median DLOMs ranged from 33% to 45%• Average DLOMs ranged from 33% to 36%

– Four Pre-IPO studies• Measured prices of transactions relative to the IPO price and

subsequent market prices• DLOMs ranged from 3% to 94%• Median DLOMs ranged from 40% to 66%• Average DLOMs ranged from 43% to 60%

– The IRS recognizes DLOMs in Revenue Ruling 77-287 (1977)• “…the longer the buyer of the shares must wait to liquidate the shares,

the greater the discount.”

– 1990 Amendment to Rule 144 allowed buyers of restricted stock to include seller’s holding period

History of DLOMs• 1991-1997

– Four more restricted stock studies• Two studies related to the pre-1990 Amendment period and one study

bridged both periods• DLOMs ranged from 13% premium to 84% discount• Median DLOMs ranged from 29% to 31%• Average DLOMs ranged from 23% to 34%

– Eighteen Pre-IPO studies• DLOMs ranged from 6% premium to 94%• Median DLOMs ranged from 40% to 63%• Average DLOMs ranged from 24% to 56%

– 1997 Amendment to Rule 144 reduced holding period from two years to one for affiliates and three years to two for non-affiliates

History of DLOMs• 1998-Present

– Five more restricted stock studies• Three studies related to the pre-1997 Amendment period• DLOMs ranged from 10% premium to >70% discount• Median DLOMs ranged from 9% to 20%• Average DLOMs ranged from 13% to 23%

– Ten Pre-IPO studies (one excluded for just 2 trans.)• DLOMs ranged from 23% premium to 94%• Median DLOMs ranged from 26% to 76%• Average DLOMs ranged from 18% to 56%

– Post-1997 studies not useful for private companies; holding period for private companies typically expected to be much longer than one or two years

DLOMs• Notable court cases

– Estate of Gallo: court accepted 36% DLOM based on restricted stock transactions

– Okerlund v. U.S.: court found that taxpayer’s use of restricted stock and pre-IPO data was persuasive

– Estate of Davis: court found taxpayer’s broader use of restricted stock and pre-IPO studies more accurate

– Furman v. Commissioner: court found no persuasive evidence for use of restricted stock studies

– Estate of Cloutier: court rejected use of restricted stock and pre-IPO studies on a 100% interest

– Estate of Lea K. Hillgren: IRS appraiser relied on restricted stock studies to arrive at a 35% DLOM

– McCord v. Commissioner, Lappo v. Commissioner, & Peracchio v. Commissioner: court rejected use of “standard” marketability discounts (in favor of Mandelbaum-like approach in two of them)

Quantifying DLOMs• Restricted stock and Pre-IPO studies have often been

used as a benchmark (Benchmark Average Approach)

• Some studies identified factors impacting the magnitude of the DLOM– Amount of dividends or partnership distributions, if any– Expected duration of holding period– Measures that bear on risk (i.e. size, earnings, etc)

• Mandelbaum v. Commissioner: court used the Benchmark Average Approach adjusted for nine factors impacting magnitude of the DLOM

Quantifying DLOMs cont…• Mandelbaum factors to consider relative to the

benchmark studies:– Financial statement analysis – earnings, growth, stability– Dividend policy – dividends and magnitude– Nature of company, history, industry position, and economy– Management – quality, longevity, breadth and depth– Amount of control in transferred shares – extent minority status– Restrictions on transfer – approvals needed, right of first refusal– Holding period for the stock – time to liquidity– Company’s redemption policy – basis of price, timing– Costs associated with a public offering – transaction costs, time

to market, registration

• The Mandelbaum factors have probably become the most widely used approach in quantifying the DLOM in conjunction with the benchmark studies

Quantifying DLOMs cont…• However, the Benchmark Average Approach often

criticized as a tool to quantify DLOMs– Transaction selection bias – successful IPOs, compensation

element– Restricted stocks have access to public markets once the

holding period has expired

• Newer marketability discount model – QMDM– Quantitative Marketability Discount Model– Developed by Z. Christopher Mercer in the 1990s– Five inputs: stock value, expected growth rate, expected holding

period, rate of return required, and expected dividends

• QMDM has been discredited in the courts– Estate of Weinberg– Janda v. Commissioner– Temple v. U.S.

Quantifying DLOMs cont…• Where does that leave us?

– Mandelbaum-like approach most widely accepted, but…

– Comparative Analysis with Restricted Stock favored by the courts in several recent cases; basically a more analytical version of the Mandelbaum-like approach being marketed by FMV, the company that databases restricted stock transactions

– LEAPS

– Others?

New Twist on DLOMs• LEAPS (Long-term Equity AnticiPation Securities)

– Purchasing LEAPS put protects an investor from the downside risk during period of the option contract

– Cost of LEAPS put said to be cost of maintaining today’s price during period of the option contract

– Cost of LEAPS put as a percent of the underlying security price is DLOM

– Criticized for allowing upside potential to remain– Should reflect the cost of locking in today’s price from upside

and downside potential

• What about a LEAPS Collar?– Purchase LEAPS put and sell a LEAPS call– LEAPS put has a cost, but selling a LEAPS call reaps income– The net “cost” as a percent of the underlying security price is the

DLOM

Valuation Discounts Conclusions• DLOCs more “settled,” because sources of data rarely

disputed, just the application

• For DLOMs, courts appear most widely accepting of Mandelbaum-like factors to adjust a broad benchmark or a specific comparative benchmark

• The appraisal community has not “settled” on this approach, because…

• New ideas are being proposed, such as LEAPS

Discounts for FLPs—DLOMs• Cases involving marketable securities

– Estate of Jelke v. Commissioner: 15% held• Taxpayer expert sought 35% based on restricted stock studies• Court criticized both experts, relied on Mandelbaum factors

– Estate of Kelley v. Commissioner: 23% held• Court rejected both experts, but did rely upon restricted stocks

– Peracchio v. Commissioner: 25% held• Court used upper limit of Respondent’s expert’s range

• Cases involving real estate– Lappo v. Commissioner: 24% held

• Both experts agreed on use of restricted stocks, but not which ones– McCord v. Commissioner: 20% held

• Court selected “middle” group of restricted stocks from expert’s analysis• “We are not persuaded that we can refine that figure any more to incorporate

characteristics specific to MIL.”– Astleford v. Commissioner: 21.23% and 22% held (two gifts)

• “We perceive no reason not to use respondent’s higher marketability discount of 21.23 percent without further discussion, which we do.”

Discounts for FLPs—DLOCs• Closed-end Funds (CEFs) for marketable securities

– Estate of Jelke v. Commissioner: 10% held• Average CEF per IRS expert was 8.6%• Taxpayer expert sought 25% based on selective CEFs• Judge criticized taxpayer expert’s logic

– Lappo v. Commissioner: 8.5% held• Experts recommended 7.5% to 8.5% (presumably CEFs)

– Estate of Kelley v. Commissioner: 12% held• Both experts used general equity closed end funds• Taxpayer expert sought 25% based on “4th Quartile” CEFs • IRS expert used whole data set and got 12%• “We are not persuaded that (Taxpayer expert’s) exclusive use of the fourth

quartile of closed end funds is proper.”– McCord v. Commissioner: 10% (equity and municipal bond funds)

• Experts argued for higher/lower than average• Judge picked average CEF for both portfolios

– Peracchio v. Commissioner: 9.6% held (equities)• Unclear as to what experts sought for equity portfolio• Judge used data provided for CEF’s, excluded outliers and came up with 9.6%

Discounts for FLPs—DLOCs cont…• Mixed Results for Real Estate

– Real Estate Limited Partnerships (RELPs)

– Real Estate Investment Trusts (REITs)

– Both have been used in court cases

– Both have high degree of subjectivity

Discounts for FLPs—DLOCs for Real Estate• Judges feel free to apply judgment

– McCord v. Commissioner: judge used REIT analysis but recalculated—23.3%

• REIT’s have a LOC discount but also have a liquidity premium because they are designed to allow investors to invest in illiquid investments—huh?

• “Using the same procedure as (IRS expert), but substituting an illiquidity discount of 18 percent for his 7-percent figure (note: the 18% was Judge’s number), we arrive at a liquidity premium (note: obverse of 18%) and therefore conclude that the minority discount imbedded in the 1.3-percent price-to-NAV discount selected from the REIT sample is 23.3 percent. . .”

– Lappo v. Commissioner: judge used REIT analysis but recalculated—18.4%, 16.1% (two gifts)

• Same type of adjustment

– Astleford v. Commissioner: judge used REIT analysis but recalculated—16.17% and 17.5% (two gifts)

• “To calculate the lack of control discount present in the REIT comparables we must eliminate (from the .1-percent median trading premium observed for the 1996 REIT comparables). . .this 16.27-percent liquidity premium. For 1996, we simply subtract .1 from the 16.27-percent liquidity premium to arrive at a lack of control discount of 16.17 percent.”

Discounts for FLPs—DLOCs for Real Estate cont...

• RELPs not used due to Petitioner’s experts– Astleford v. Commissioner: 45% DLOC sought– Lappo v. Commissioner: 35% and 30% sought (used

RELPs as reasonableness checks)

Summary of Valuation Lessons• Arguments must be case specific but must

address data/arguments used in court cases

• Document specific factors for DLOM

• Use available market data for FLP’s

• More complications coming (DLOC)