Winter 2006 Issue

The Business Valuation Specialist

ValueManagement

Inc.

Issues &

Updates

Value Management Inc. ● 758 Durham Road ● Newtown, PA 18940-9676 P (215)598-9310 ● F (215)598-0589 ● www.ValueManagementInc.com

Tax Court Gives 32.24 Percent Discount for FLP with Cash and CDs

IN THIS ISSUETax Court Gives 32.24 Percent Discount for FLP with Cash and CDs....................................page 1

Breach of Contract Supports both Lost Business Value and Lost Profits Damage.................page 2

Court Reverses Inclusion of Life Insurance Proceeds ...................................................page 3

VMI Highlights..........................................page 4

Continued to next page...

nies, the court found that the net asset value approach was most applicable, as NAV is best suited for valuing non-operating entities.

Minority DiscountThe court found that a minority discount was appro-

priate, and that such a discount could be determined by reference to general equity closed-end funds. ATI determined that KLLP would be most comparable to the closed-end funds in the fourth quartile (funds with least demand) with price-to-NAV discounts of 21.8 percent to 25.5 percent. It based its discount on KLLP’s size, and two studies by Partnership Profiles, Inc., which suggested that discounts for comparable publicly-reg-istered but non-traded partnerships should be in the 27-29 percent range.

Dr. Widmer calculated a minority discount of 12 per-cent by calculating an arithmetic mean of the entire data set for closed-end funds, not only the fourth quartile. Dr. Widmer determined that it is essential to use the whole array of closed-end funds, as this calculation will remove the marketability element in the discounts or premiums.

The court rejected ATI’s discount methodology, ruling instead that Dr. Widmer’s approach was better because shareholders in all closed-end funds lack control. The court also concluded that in using only the fourth quartile, ATI combined elements of the lack of market-ability discount with the minority discount because the funds in the fourth quartile had the lowest demand and, therefore, the highest marketability discount. Using this

Estate of Kelley v. Commissioner, T.C. Memo 2005-235; 2005 Tax Ct. Memo LEXIS 236, United States Tax Court (October 11, 2005). Judge Vasquez.

In April 1999, Webster Kelley and his daughter and son-in-law (“the Loudens”) formed Kelley-Louden Business Properties, LLC (“KLBP LLC”), and Kelley-Louden, Ltd., a family limited partnership (“KLLP”). Kelley contributed $1,101,475 cash and certificates of deposit to KLLP, and the Loudens contributed $50,000 cash. Kelley died in December 1999, at which time he owned 33.33 percent of KLBP LLC, and 94.83 percent of KLLP. On the date of death, KLLP held assets to-taling $1,226,421, which consisted of $807,271 cash and $419,150 in certificates of deposit, and had no liabilities.

The estate hired Appraisal Technologies, Inc. (“ATI”) to prepare a valuation of the decedent’s interests in these closely-held entities. ATI concluded that a 53.5 percent valuation discount was applicable. Accordingly, the estate filed estate tax returns reporting Kelley’s KLLP interest at a value of $521,565 and his interest in KLBP LLC at a value of $1,833.33. The IRS issued a notice

of deficiency, determining that the discounts claimed by the estate were too high and that lower discounts were appropriate, i.e., a 25.2 percent discount.

Valuation EvidenceAt issue was the fair market value of Kelley’s inter-

ests. ATI used both a net asset value (“NAV”) and an income approach, and gave 80 percent weight to the NAV approach and 20 percent weight to the income approach.

The IRS expert, Dr. Raymond Widmer, used the NAV approach and valued the interests using a 25.2 percent valuation discount. Applying this discount, Dr. Widmer determined a value of $869,970 for the 94.83 percent limited partner interest in KLLP and $3,055 for the one-third interest in KLBP LLC.

Holding and RationaleBecause the entities involved were investment compa-

the court held that a 12% minority discount was correct...(and) that a total DLOM of 23% applied”“

approach, the court held that a 12 percent minority discount was correct.

Discount for Lack of Marketability (“DLOM”)The court agreed that a discount for lack of market-

ability was appropriate in valuing the interests in KLLP, as there is not a ready market for partnership interests in a closely-held partnership. In determining the market-ability discount, ATI used the restricted stock approach. After considering numerous barriers to marketability of a limited partnership interest in KLLP, ATI determined that a 38 percent marketability discount should apply to KLLP. Dr. Widmer determined a 15 percent discount for lack of marketability on the basis of a study by Dr. Mukesh Bajaj.

The court, again, was not persuaded by ATI’s ap-proach. It found that the restricted stock studies ex-amined mostly operating companies, and that “there are fundamental differences between an investment company holding easily valued and liquid assets (cash

1 McCord v. Commissioner, 120 T.C. No. 13, 2003 U.S. Tax Ct. LEXIS 16, (May 14, 2003).2 Lappo v. Commissioner, T.C. Memo 2003-258 (September 3, 2003).

...continued from front page

Breach of Contract Supports both Lost Business Value and Lost Profits DamageVehicular Technologies Corp. v. Titan Wheel Inter-national, Inc., 2005 Cal. App. Unpub. LEXIS 5392 (June 22, 2005). Judge Armstrong.

In this breach of contract action, the issues pertained to the appropriate measure of contract damages.

Vehicular Technologies (“Vehicular”) sued Titan Wheel International, Inc. and Dyneer Corporation dba Tractech (“Tractech”) for breach of contract and other causes of action. Before Vehicular started selling the Lock-Right automo-tive locker (an automotive locker is a device that can be put on car or truck axles to add traction for difficult driving conditions, such as off-road driving), Tractech dominated the locker market with a device called the Detroit Locker. The Lock-Right was a superior product in every way. It was just as durable as the Detroit Locker, but much cheaper, and it also worked better and was much easier to install.

Allegedly, Tractech CEO Ralph McGee contacted Vehicular, ostensibly to discuss a licensing or other busi- Continued to next page...

Court Case Updatesand certificates of deposit), such as KLLP, and operating companies.” However, it was also not persuaded by Dr. Widmer’s discount, saying that his conclusion based on the Bajaj study “is not entirely accurate.”

Because it declined to use either party’s DLOM, the court conducted its own DLOM analysis, finding that a 20 percent initial marketability discount was appropri-ate. The court based this discount on the approach used in McCord v. Commissioner1, where the court focused on the Bajaj study and found that a 20 percent marketability discount was appropriate for interests in an FLP classified as an investment company. It further found that an upward adjustment of 3 percent was proper, based on the approach used in Lappo v. Com-missioner2, to incorporate characteristics specific to the partnership, thus concluding that a total DLOM of 23 percent applied.

ness arrangement between the two companies. During the negotiations, McGee requested confidential manu-facturing and business information, promising not to use it except for purposes of the negotiation. McGee also promised not to copy the Lock-Right (and concealed the fact that Tractech was already doing just that) or to sell a Lock-Right copy. In reliance on McGee’s promise, Vehicular divulged confidential information on all as-pects of its business, including materials, manufacturing techniques, production costs, sales, and profits.

McGee’s promise not to copy or use confidential information was knowingly false. Trachtech put out a locker identical to the Lock-Right, the EZ Locker, with the goal of “burying” Vehicular

through misleading marketing and price undercutting; Trachtech succeeded. Ultimately, another company acquired all of Vehicular’s operations, including its prod-ucts, patents, inventory, designs, and trademarks.

Lost Profits At trial, Vehicular presented proof on lost profits as

well as on lost business value. On damages, Vehicular presented evidence about its sales, growth, projected growth and sales, profits, debts, and business and

...a valuation of a business is by definition all about the future... ”“

financial plans from 1993 to the buy-out in 2002. Dam-ages expert Marc Margulis testified that (as a minimum, based on modest estimates) Vehicular lost $8.5 million in profits on the Lock-Right and $12.8 million in prof-its on the Performance Locker (another locker it had developed). He calculated these figures by estimating the number of sales Vehicular could have expected, capping those sales at a conservative number, deter-mining Vehicular’s cost per unit and its actual sales. Margulis testified that the profits were lower than would have been expected because competition from the EZ Locker caused confusion in the marketplace and forced Vehicular to lower its prices, so that Vehicular had less money “to be out there with advertising, with promotion” or for research and development, and was left “undercapitalized to achieve its goals.”

Lost Business Value He also opined that the value of the business on sale

was diminished by about $17 million, $4 million of which was attributable to the Lock-Right and $13 million of which was attributable to the Performance Locker. A jury found in Vehicular’s favor and awarded $16.3 million.

Holding and Rationale On appeal, Trachtech challenged the damages as in-

supportably high, and also argued that the lost business value damages were improper, but the appellate court disagreed. Tractech’s theory of Vehicular’s damages was that loss of sales due to disparaging advertising had to be ignored, so that the only sales Vehicular lost were the sales Tractech made ($2.89 million at most). The court rejected this argument as an oversimplifica-tion, given that Trachtech did not want to sell EZ Lock-ers, but instead was protecting its flagship product, the Detroit Locker.

The court also rejected Trachtech’s argument that, to the extent that the jury awarded damages for lost busi-ness value, those damages were duplicative of the lost profits damages. The court found persuasive Margulis’ testimony that “a valuation of a business is by definition all about the future,” and that Vehicular would have had over $20 million in lost profits and $17 million in lost business value at the time of the sale. The court found that this was substantial evidence that the damages were not duplicative, but would actually compensate Vehicular for the harm caused by Tractech’s torts.

Finally, the court found Margulis’ testimony was not speculative, but was based on Vehicular’s financial records and reliable projections.

...continued from previous page Court Reverses Inclusion of Life Insurance Proceeds Estate of Blount v. Commissioner, United States Court of Appeals for the Eleventh Circuit, No. 04-15013 (October 31, 2005). Circuit Judges Birch, Carnes and Fay.

Blount Construction Company (“BCC”) was in the busi-ness of construction and street repair for various clients. When Blount died in September 1997, he owned roughly 83 percent of BCC. In 1996, the decedent discovered that he was terminally ill with cancer, which prompted him to update a 1981 buy-sell agreement with BCC.

The new agreement was operative only upon his death and set a fixed, lump-sum purchase price of $4 million. The estate of Blount was required to sell Blount’s shares when he died, and BCC owned an insurance policy to ensure that it would have sufficient liquidity to accom-plish the contractual buyout. After Mr. Blount died, BCC paid $4 million to his estate “in accordance with the November 11, 1996 Shareholders’ Agreement.”

In 1997, the Taxpayer filed a return declaring $4 million as the value of the shares, and the IRS filed a notice of deficiency claiming that the stock was worth $7.9 million. Implicit in this valuation of Blount’s shares is a claim that BCC’s fair market value exceeded $9.5 million.

The Tax Court held that the 1981 agreement, as modi-fied by the 1996 amendment, was to be disregarded for the purpose of determining the value of the shares. (Estate of Blount v. Commissoner, 87 T.C.M. 1303, 1312 (2004).) The court also held that the amount of tax should have been calculated by adding the insurance proceeds to the other assets of BCC in order to arrive at the fair market value of the corporation.

In explaining the Court of Appeals opinion, Circuit Judge Birch stated,

We AFFIRM the Tax Court’s determination that the stock-purchase agreement does not fall within the statutory exception, which would allow the parties to conclusively establish the value of the corporation for taxation purposes at an agreed upon purchase price. Because the Tax Court should not have added the insurance proceeds to the value of the corporation when calculating its fair market value, we REVERSE the court’s computation of that value.

Court Case Updates

If you would like to receive a copy of any of the aforementioned court cases or to discuss a

particular business valuation issue, please feel free to contact Andrew Wilusz, ASA, at (215) 598-9310

or amw@valuemanagementinc.com.

©2006 Business Valuation Resources, LLC. No part of this newsletter may be reproduced or redistributed without the express written permission of the copyright holder. Although the information in this newsletter has been obtained from sources we believe to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This

newsletter is intended for information purposes only, and it is not intended as financial, investment, legal or consulting advice.

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ABOUT VALUE MANAGEMENT INC. VMI is a financial consulting firm specializing in valuing businesses, corporate securities and professional practices. Our firm is built on the performance of more than 4,000 valuations. Appraisals are rendered for estate tax planning, litigation support, and many other situations requiring independent appraisal. Our newsletter is published quarterly and does not constitute legal or financial consulting advice. It is offered as an information service to VMI’s clients and friends. Those interested in specific guidance for legal and accounting matters should seek competent professional advice. Inquiries on specific valuation matters are welcomed.

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VMI HIGHLIGHTSValue Management Inc. welcomes Jennifer D.

Dillon as our newest financial analyst. Jennifer will be responsible for providing research and performing financial and economic analysis for the valuation of closely held enterprises, professional practices and publicly traded securities. Her prior work experience includes actuarial and financial analysis. Jennifer graduated in the top one percent of her class from Cedar Crest College with a B.S. in Accounting. Wel-come Jennifer!

Tricia McMullen, a Candidate for membership in the American Society of Appraisers, has moved closer to achieving the designation of Accredited Senior Ap-praiser (“ASA”). The American Society of Appraisers, which originated in 1936, is the oldest and only major appraisal organization representing all of the disciplines of appraisal specialists. To qualify for the ASA designa-tion, an individual must prove a minimum of five years full-time equivalent appraisal experience, pass a series of intensive written examinations, including a test on the Uniform Standards of Professional Appraisal Practice (“USPAP”), and undergo peer review of actual appraisal reports. To date, Tricia has successfully completed the first three Advanced Business Valuation Courses and has passed the written examinations for each. You’re almost there, Trish!

Joseph M. Egler, CFA, a VMI senior analyst, pre-

sented the topic of “The Effective Litigation Team” to the Pennsylvania Institute of Certified Public Accountants Divorce Conference on October 28, 2005. Joe pre-sented with Catherine McFadden, Esq. of the law firm of Schnader, Harrison, Segal & Lewis and Stacy Preston Collins, CPA, ABV of Financial Research Associates.

Andrew Wilusz, ASA, VMI’s Director of Mergers & Acquisitions, recently gave presentations on “Business Valuations as Part of the Estate Planning Process” to the Executive Committee of the Corporate Fiduciaries of Philadelphia (November 10, 2005) and to the Society of Financial Service Professionals Delaware Chapter (November 15, 2005). Andrew also gave a presenta-tion on “What Every Estate Lawyer Should Know about Business Valuations” in conjunction with Howard W. Switkay, IRS Appeals Officer, at the Pennsylvania Bar Institute’s 12th Annual Estate Law Institute held at the Convention Center in Philadelphia on January 26/27, 2006.

Ed Wilusz, ASA, CFA, VMI President, was recently named Pearl S. Buck International’s (“PSBI”) Board Member of the Year. PSBI is a private, non-profit or-ganization with the mission of improving the quality of life and expanding opportunities for children, promoting and understanding the values and attributes of other cultures, the injustice of prejudice, and the need for humanitarianism throughout the world.