business valuation 2012 the state of things presentation

Business Valuation 2012: the State of Things

17th Annual CalCPA East Bay Chapter Estate Planning Symposium

L. Paul Hood, Jr.© 2012 L. Paul Hood, Jr.

L. Paul Hood, Jr., JD, LLML. Paul Hood, Jr. Is the Director of Gift Planning for The University of Montana Foundation. He received his J.D. from Louisiana State University Law Center in 1986 and Master of Laws in Taxation from Georgetown University Law Center in 1988. Paul is a frequent speaker, is widely quoted and his articles have appeared in a number of publications, including BNA Tax Management Memorandum, CCH Journal of Practical Estate Planning, Estate Planning, Valuation Strategies, BV Alert, Digest of Federal Tax Articles, Loyola Law Review, Louisiana Bar Journal, Tax Ideas and Charitable Gift Planning News. He is also the co-author of A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal (John Wiley, 2011) with Timothy R. Lee, ASA of Mercer Capital., and Estate Planning for the Blended Family (Self-Counsel Press 2012) with Emily Bouchard.He has spoken at programs sponsored by a number of law schools, including Duke, Georgetown, NYU, Tulane, Loyola (N.O.) and LSU, as well as many other professional organizations, including AICPA and NACVA.From 1996-2004, Paul served on the Louisiana Board of Tax Appeals, a three member board that has jurisdiction over all Louisiana state tax matters.

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©2012 L. Paul hood, Jr. [email protected]

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Business Valuation 2012:the State of Things

In this presentation, we’ll discuss the state of business valuation in 2012

• We’ll review selected recent court decisions with a view toward spotting trends

• After having examined some recent valuation court decisions, we’ll then consider the current state of business valuation

• We’ll conclude with a review of some burning issues in business valuation that impact BV reports


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• We’ll review selected recent developments in business valuation with a view toward spotting trends– Gallagher Est. v. Comr.– Giustina Est. v. Comr.– Boltar v. Comr.– Jensen Est. v. Comr.– The Ringgold Telephone Company v. Comr.– IRS DLOM Job Aid


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• We begin our analysis of recent developments in business valuation with the decision of Tax Court Judge Halpern in Gallagher Est. v. Comr., T.C. Memo 2011-148

• The decision was appealable to the U.S. 11th Circuit Court of Appeals, but won’t be appealed

• Prepare to be surprised by several of the Tax Court’s findings and conclusions in this case, which is one of the most remarkable valuation cases in a long time for the richness of its lessons


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Gallagher Valuation Positions-Preliminary Considerations:• In preparation for the trial, the taxpayer commissioned

an independent appraisal of the Paxton LLC (LLC) units versus the internally produced valuation that was used in the Estate’s original estate tax return filing

• The Tax Court also sidestepped the IRC Sec. 7491 burden of proof shift to the IRS by deciding the case on the preponderance of evidence, wrongfully in my view


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Gallagher Valuation Positions-Preliminary Considerations (cont.):

• The Tax Court noted that while the IRS moderated its valuation position between the time of deficiency notice (which was quantified via an IRS engineering exercise) and trial (where an independent appraisal was presented), the estate’s position actually decreased in value from the estate tax return position


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In Gallagher, the parties disagreed over the following issues:

• the date of financial information relevant to a date-of-death valuation of the decedent’s units

• the appropriate adjustments to the LLC’s historical financial statements

• the propriety of relying on a market-based valuation approach (specifically, the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that method


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In Gallagher, the parties disagreed over the following issues (cont.):

• the application of the income approach (specifically, the discounted cash flow valuation method)

• the appropriate adjustments to the LLC’s enterprise value

• the proper type and size of applicable valuation discounts


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Gallagher Case Per Unit Value Summary:

• Return as Filed $8,800 per unit (Prepared by David Paxton internally for options & buy-sell agreement)

• IRS Original $12,469 per unit (Notice of proposed adjustment from IRS)

• Taxpayer Appraisal 1 $6,702 per unit (Schedrick, McGehee & Kohler (not used at trial))

• Taxpayer Appraisal 2 $7,103 per unit (AWC Advisors LLC (May Appraisal))

• IRS Appraisal $10,293 per unit (Klaris Thomson & Schroeder, Inc. (Thomson Appraisal))

• Court’s Original $8,212 per unit

• Court’s Corrected $9,008 per unit• Note that the “informal” appraisal performed by a non-business appraiser came closest to

the Tax Court’s corrected conclusion


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Relevant Financial Information in Gallagher• The relevant valuation date was the date of the decedent’s death: July 5,

2004 • The issue was what financial statements should have been used • The IRS appraiser (Thomson Report)

– Internal financials for 12 months ended June 27, 2004– Guideline company financials as of quarter ending June 30, 2004

• The Estate’s appraiser (May Report)– Internal financials for 12 months ended May 30, 2004– Guideline company financials for quarter ending March 31, 2004 (June

financials not reported until after valuation date) arguing that the hypothetical willing buyer and seller wouldn’t have known of the latest financial statements


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• The Tax Court sided with the IRS appraiser, reasoning that the later financial statements better represented the market conditions on the valuation date and that the Estate alleged no intervening change in financial condition of the LLC

• The Tax Court’s ruling on this issue totally ignored SEC Regulation FD, which was adopted by the SEC on August 15, 2000 and became effective on October 23, 2000 and which prohibits selective disclosure of material non-public information to certain parties, including analysts, brokers, dealers, investment advisers, investment companies and stockholders


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In Gallagher, the parties disagreed over the appropriate adjustments to the LLC’s historical financial statements; specifically, a life insurance policy adjustment, a self-insured health insurance adjustment and an overfunded defined benefit plan

• The estate’s appraiser made all of the adjustments, while the IRS appraiser did not

• The Tax Court agreed with the IRS appraiser, pointing out that the estate’s appraiser failed to provide any explanation why the gains in each instance were non-recurring

• Likewise, the Tax Court disregarded the other income adjustments that the estate’s appraiser made, noting that the court could not understand the rationale for the adjustments.


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Adjustments to Subject Company Financial Statements:

• The parties disagreed over the proper adjustments to the LLC’s financial statements, specifically, a life insurance policy adjustment, a self-insured health insurance adjustment and an overfunded defined benefit plan

• Thomson and May Reports– 2000 - Adjusted for gain on divested newspapers of $7.9 million

• May Report– 2003 – Eliminated $0.7 million gain on life insurance policy– 2003 – Eliminate $1.1 million positive claim experience on Paxton’s self-

insured health insurance– Each year – Eliminate income from overfunded defined benefit pension

plan (increasing income) and adding back to enterprise value $11.7, amount of overfunding


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• The Tax Court disregarded the adjustments in the May Report “because we fail to understand his adjustments”

• Likewise, the Tax Court disregarded the other income adjustments made in the May Report, noting that the court could not understand the rationale for the adjustments


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May Report (p. 26):• Net Pension Income (Expense).

– “The Company had an overfunded defined benefit plan, which in most historical periods served to increase its reported net income. We have adjusted this out in the previous schedule, to show how the Company reported its EBITDA, but then we add the benefit from this overfunding back in when calculating our adjusted EBITDA which we use for valuation purposes. This is consistent with the treatment with the guideline companies (i.e., the pension costs are included in their P&Ls).”

– Gain on Divested Newspapers “During fiscal 2003, the Company had a gain on the divesture of newspapers. We have adjusted this out in the schedule above as it is a non-recurring item.”

• Positive Claim Experience from Company’s Self-Insured Health Insurance– “During fiscal 2003, the Company had abnormally positive claim experience

from the Company’s self-insured health insurance. We have adjusted the effects of this out in the schedule above as it is a non-recurring item.”


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• In my judgment, the Tax Court’s position that it couldn’t understand these adjustments was disingenuous

• In my opinion, these adjustments could not have been explained any better, and the court’s conclusion that the May Report didn’t satisfactorily explain why the items were non-recurring is surprising to say the very least

• What else can be said about a non-recurring item except that it is non-recurring?


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• In Gallagher, the parties disagreed over the propriety of relying on a market-based valuation approach (specifically, the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that approach

• The guideline public company method is one that can be tricky for business appraisers because of the size differential between most guideline public companies and subject privately-held companies


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Guideline Company Method

• The Thomson Report begins with 13 newspaper companies and selects four as guideline companies:– Journal Register Co. (11.1x EBITDA)– Lee Enterprises, Inc. (12.4x)– The McClatchey Co. (10.9x)– Pulitzer, Inc. (12.6x)

• The May Report selected seven newspaper companies as guideline companies:– Gannett Co., Inc. – The McClatchy Company– Journal Register Co. – The New York Times Company– Knight-Ridder, Inc. – Pulitzer Inc.– Lee Enterprises Inc.

• Notice that four of the guideline companies are the same, and they are in bold


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Applicability of the Market Approach

• The Thomson report utilized the market approach and weighted its indication of value 50%, while the May Report did not expressly weight the market approach in its conclusion of value

• The Tax Court sided with the May Report, describing in detail a test for comparability of guideline companies and finding there to be a lack of “sufficiently similar” guideline companies (even though the May Report identified pretty much the same guideline companies)

• However, and you wouldn’t know it from only reading the Tax Court opinion, the May Report fully developed a market approach and even used it to confirm its conclusion of value under the DCF Approach


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Issues with the Guideline Company Group - Thomson Report• Size

– One third of the guideline group’s median revenue and one-fourth of median assets

• Products– Guideline companies are more diversified and have internet

components• Other Differences

– More highly leveraged than the guideline companies• Tax Court: “We find that Mr. Thomson improperly relied on the guideline

company method because the four guideline companies alone were not similar enough to PMG to warrant its application.”

• This still doesn’t address the fact that the May Report fully developed a market approach and used it to confirm value


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• The May Report reached a per unit conclusion of value of $6,293 in its Market Approach

• This is about $1,000 less per unit than its conclusion of value under the DCF Approach

• This is about $5,000 less than the conclusion of value that the Thomson Report reached in its Market Approach

• Why were the two reports so different on the Market Approach?

• The May Report used an EBITDA multiple of 7.34, while the Thomson Report had an EBITDA multiple of 10.6


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In Gallagher, the parties disagreed over the application of the income approach (specifically, the discounted cash flow valuation method (DCF Approach))

• The Application of the DCF Method issues in dispute were:

– Discounting the LLC’s net free cash flow– The LLC’s financial projections– Whether to tax-effect Paxton’s earnings– Cashflow adjustments– WACC– [Earnings] adjustments to Paxton’s enterprise value– Appropriate minority interest and marketability discounts


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In Gallagher, the parties disagreed over the LLC’s financial projections

• The IRS argued that both of the appraisers should have used the projections that a bank had prepared in conjunction with a 2004 loan, so it argued against its own trial appraiser in this instance

• Neither appraiser used those projections, so the Tax Court disregarded them

• Each appraiser prepared his own projections


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The Tax Court found the projections in the Thomson Report to be more persuasive for the following reasons: – The May Report used a growth rate that he admitted was

significantly higher than the LLC’s actual growth rate for prior years

– Revenues from an acquisition that occurred after the valuation date should have been included because the acquisition was reasonably foreseeable on the valuation date

– The May Report did not “adequately explain” its increasing costs adjustment in its projections


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Net Free Cash Flow, Tax Court?• The Thomson Report discounts net EBITDA

– EBITDA minus projected Capital Expenditures (CapEx)• The May Report discounts net free cash flow

– “…[C]ash [that] is free to be paid back to the suppliers of capital.” (Court quotes Quick MBA)

• Tax Court: “The parties have not distinguished between these two economic benefits against which to apply the DCF method. We shall derive the present value of PMG’s net free cashflow (net cashflow)…..We shall construct our own operating income projections in discounting PMG’s net cashflow.”

• The Tax Court actually projected and discounted EBITDA less CapEx, not net cash flow, which was a mischaracterization, but the Tax Court probably didn’t understand the difference


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The Tax Court’s DCF Calculations:Total Marketable Enterprise Value $709,258 709,314

Less Net Debt at Valuation Date (243,602)

Plus Adj. for Overfunded Benefit Plans

Plus Cash Value of Life Insurance

Plus Excess Working Capital (Deficit) The Court

Plus Tax Shield from Goodwill

Plus "Extra" Value for S Corp Benefits

Plus "Extra" Tax Shield from Higher Debt

Less In-the-Money Value of Options (1) (17,422)

Equals Marketable Minority Equity Value $448,234 448,290

Less: Minority Discount 23.0% ($103,094)

Marketable Minority Value $345,140 345,183

Less: Marketability Discount 31.0% ($106,993) 0

Nonmarketable Minority Value $238,147 238,176

Nonmarketable Minority Value Rounded $238,147

Units Outstanding (fully diluted) 26,439Nonmarketable Minority Value Per Unit $9,007 9,008

Units Owned by Estate 3,970Value of Estate's Interest 35,759,431 35,761,760

Value of Estate's Interest (rounded) $35,800,000 Actual


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To Tax Effect or Not?

• The May Report tax effects earnings of LLC at 39% blended federal/state rate in the DCF method. It used a 40% blended federal/state rate in building up the WACC (see p. 63, May Report for explanation of a blended tax rate)– The Tax Court says: “Indeed, we are also unclear as to the source of

those income tax rates. In the year in issue, 2004, the highest marginal corporate tax rate was 35%, with the highest individual tax rate set at 39.6 percent.”

– Unrealistic for the Tax Court not to understand blended federal/state tax rates (and to miss the clear explanation in the May Report)

– Was using 39% and 40% an issue with credibility? • The Thomson Report did not tax affect


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• The Tax Court denied tax affecting again and was critical of the May Report, noting:– “[Estate’s appraiser] failed to explain his reasons for tax

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


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• Tax Court: “[Estate’s appraiser] tax affected [LLC’s] earnings by assuming a 39-percent income tax rate in calculating the company’s future cashflows, before discounting [LLC’s] future earnings to their present value. He also assumed a 40-percent marginal tax rate in calculating the applicable discount rate. In contrast, [IRS appraiser] disregarded shareholder-level taxes in projecting both the [LLC’s] cashflows and computing the appropriate discount rate.”


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To Tax Effect or Not?• Tax Court: “[Estate’s appraiser] failed to explain his reasons for tax

affecting [LLC’s] earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting [LLC’s] projected earnings and discount rate, we decline to do so. As we [actually, “I”] stated in Gross v. Commissioner, T.C. Memo. 1999-254, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. [Estate’s appraiser] advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on [LLC’s] future earnings.”


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To Tax Effect or Not?• Notwithstanding the Tax Court’s comments, the

May Report was in the mainstream of valuation theory and practice on tax-affecting

• As you will see in a few minutes, the Tax Court’s remark about “ignoring” the corporate tax benefit of S corporation status simply is wrong—the May Report added back a benefit of S corporation status and was consistent by deducting the impact of the income tax at the entity level


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Adjustments to Cash Flow

• The appraisers disagreed on two adjustments to cash flow: – capital expenditures– working capital

• With respect to the capital expenditures, the Thomson Report projected equal capital expenditures as a percentage of revenue, while the May Report projected unequal, but increasing, capital expenditures. The Tax Court again sided with the Thomson Report, stating:– “not only does [Estate appraiser] fail to support his

projection, but [the LLC’s] financial statements do not justify his estimated increase in capital expenditures.”


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Working Capital Issue

• Not surprisingly, the appraisers differed on the projected level of working capital for the LLC

• The May Report based its projection on fluctuating levels of working capital, while the Thomson Report based its projection based upon the past performance of the LLC


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Working Capital Issue

• The Tax Court again sided with the Thomson Report, and provided:– [Estate appraiser] projected that [the LLC’s] future investment in

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

• Actually, the May Report provided a detailed projection analysis with detailed assumptions, and it was disingenuous for the Tax Court to say otherwise just because that analysis was in an appendix rather than in the body of the report


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Weighted Average Cost of Capital (WACC)

• Despite taking issue with the use of a WACC in the valuation of a small, closely held entity, the Tax Court stated:– “We have previously held that WACC is an improper analytical tool to value a ‘small,

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

• The appraisers disagreed in their determination of WACC based on three primary issues: – cost of equity capital – cost of debt capital – relative weights of debt and equity in calculating WACC


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Cost of Equity Capital

• The equity component of the Thomson Report’s WACC was developed using an Ibbotson inspired build-up method, which employed: – an after-tax cost of equity – a premium for control (20%, effectively lowering the equity discount rate), a

company specific risk size/premium (4%, which increased the equity discount rate), and

– an equity premium (2%) to recognize the potential loss of the company’s favorable S corporation status in the event of a sale. Ultimately, the IRS equity discount rate was 20%

• The May Report utilized the capital asset pricing model (“CAPM”) to derive an equity discount rate of 13.5%

• The Tax Court again predominantly sided with the Thomson Report, criticizing the May Report’s use of CAPM for a closely held entity, citing prior Tax Court precedent

• Why should what a court that has no valuation expertise says about a valuation method be followed in subsequent cases?


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Cost of Debt Capital

• The Thomson Report calculated a pre-tax cost of debt of 6.6% (applying no tax effect) versus the May Report’s after-tax cost of debt of 3.0% (5% pre-tax).

• While the Tax Court was not convinced by the work of either appraiser, the Tax Court again sided with the Thomson Report, in part because the higher number was better for the Estate and in part because of the limited explanation offered by the May Report:– “In his expert report, [Estate appraiser] calculated a 5-percent average

cost of debt. The entirety of his reasoning lies in a footnote: ‘Based on [the LLC’s] existing costs of debt and estimated costs of debt, given the companies [sic] financial condition and the current interest rate environment.’”

– The May Report used the LLC’s actual existing costs of debt and estimated costs of debt in its analysis-what else could the May Report have said?


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Relative Weights of Debt & Equity in Calculating WACC

• The Thomson Report basically employed the LLC’s debt/equity ratio because he was valuing a minority interest, reasoning that the minority owner could exercise no influence to change the capital structure

• The May Report employed the guideline company debt/equity ratio, despite failing to find any comparable guideline company in its market approach


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Relative Weights of Debt & Equity in Calculating WACC

• The Tax Court called the May Report down for inconsistency, pointing out:– “In contrast, despite [Estate appraiser] conclusion that the

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

• We have already established that the May Report actually developed a market approach and used it to confirm its conclusion of value under its DCF Approach


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Adjustments to the LLC’s Enterprise Value• The appraisers disagreed over the proper

adjustments to the LLC’s enterprise value, as follows: – long-term debt, – working capital deficit, – S corporation benefits, and – stock options outstanding on the valuation

date


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Adjustments to the LLC’s Enterprise Value

• With respect to the long-term debt issue, the appraisers were very close together, with the only difference being the date of the financial statements that each used. The Tax Court sided with the Thomson Report, criticizing the May Report as follows:

– “Moreover, [Estate appraiser] identified differing debt amounts throughout his report. We will not rely on a consistently changing number, especially one that [Estate appraiser] fails to justify.”

• The “consistently changing number?” Only by different dates for financial statements; it was very disingenuous of the Tax Court to make this point because you would expect to have different debt amounts on different dates


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Adjustments to the LLC’s Enterprise Value

• On the working capital deficit issue, the May Report made an adjustment, while the Thomson Report did not

• Again, the Tax Court sided with the Thomson Report:– “We do not find [Estate appraiser’s] analysis to be persuasive. [Estate appraiser]

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

– Again, it is disingenuous for the Tax Court to say that the May Report found no guideline companies for the LLC; the May Report fully developed a market approach and used it to confirm its conclusion of value under the DCF approach


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Adjustments to the LLC’s Enterprise Value• The May Report made adjustments to reflect the S corporation

benefits, while the Thomson Report made no such adjustments • Because the May Report “failed to justify the adjustments,” the

Tax Court disregarded those adjustments• Finally, the Tax Court accepted the adjustment made by the May

Report relative to the stock options outstanding as of the valuation date because he assumed that all of the options would be exercised

• This time, the Tax Court called down the Thomson Report for failing to justify its position that the stock options would not be exercised


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S Corporation Benefits

• The May Report considered certain S corporation benefits– $12.8 million to account for S shareholder tax savings on

all future distributions over tax distributions (present value of benefit)

• This is a logical way to handle this, although the benefit was calculated to perpetuity, when the investment in the subject interest is for a finite expected holding period

– $44.3 million to reflect future value of deductible goodwill– $6.7 million to account for the extra marginal debt tax

shield (because of higher leverage in the LLC)


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S Corporation Benefits

• Citing Gross, apparently as precedential guidance, the May Report’s adjustments were ignored

• The result is that the May Report effectively lowered DLOM to account for these potential benefits– The Thomson Report ignores the benefit if S corporation

distributions are made at the shareholder level– Tax Court also ignores these benefits too

• Why? Electing S has a benefit; if you are going to take the tax expense into account, it is logical to add back the benefits of S status


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Minority Interest Discount• Thomson Report applied a 17% discount due to a minority interest to the

DCF value based on an assumed 20% control premium that is somehow applicable– 1/(1+ CP) – 1 1/(1 + 20%) – 1 = 17% discount

• Implicit assumptions include:– There are substantial synergies available to potential acquirers – not

indicated by the DCF analysis, which was entirely financial in nature, not strategic or synergistic

– The DCF Approach provides a strategic control level of value• Most authorities agree this is not so unless you adjust the cash

flows for potential synergies/strategic benefits are included in the numerator (i.e., in the projected cash flows)


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Minority Interest Discount• Tax Court carries this a step further and

assumed a 30% control premium and therefore, a 23% minority interest discount– More favorable to the estate in a vacuum,

but it makes no economic sense• The May Report appropriately did not apply a

minority interest discount to its DCF method


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Discount for Lack of Marketability (DLOM)• The Thomson Report develops DLOM of 31% based on examination of

seven dated restricted stock studies– SEC Institutional Investor Study, Gelman, Trout, Moroney, Maher,

Silber and Management Planning• The May Report develops marketability discount of 30% based on the

same studies– Effectively lowers DLOM with additions based on expected

shareholder level tax benefits• Tax Court concludes marketability discount of 31%, since the Thomson

Report was a little higher in the way of DLOM and thus more favorable to the estate


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Concluding thoughts on Gallagher Est. v. Comr.

• Court opinions don’t tell the entire story, or even, in this case, an accurate one

• Judges don’t make very good business appraisers• Judge Halpern’s significant math error that led to the

revised judgment demonstrates how hard business appraisal is

• It helps to be able to cite yourself as authority-Judge Halpern wrote the Tax Court opinion in Gross, which was a memorandum decision, and he cited Gross in his Gallagher opinion


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Concluding thoughts on Gallagher Est. v. Comr.• The Tax Court’s failure to accept the use of the CAPM in

determining a discount rate for a closely held business is just unacceptable. Again, the Tax Court must accept general ly accepted appraisal principles and procedures

• It remains an ongoing astonishment that some valuation practitioners and stakeholders view the build-up approach and the CAPM as something other than highly incestuous as a means to the same end

• Appraisers use the CAPM or some variant to develop a discount rate every day. That they cannot do that in the Tax Court only strains credulity


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Concluding thoughts on Gallagher Est. v. Comr.• The Tax Court’s failure to understand that if restricted stock

studies and the pre-IPO studies say anything, and that is debatable, they should set a floor on DLOM because it usually takes much longer to sell interests in closely-held businesses than to sell restricted stock, which is stock in public companies that is restricted for now only six months before it can be sold

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


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Giustina Est. v. Comr., T.C. Memo 2011-141 (Judge Morrison)

• At the time of his death, the decedent, through his revocable trust, owned 41.128% limited partnership interest in an Oregon limited partnership that owned approximately 48,000 acres of timber land. The result was a substantial victory for the IRS. The case is appealable to the U.S. 9th Circuit Court of Appeals, and the estate did appeal in June of 2012


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• The valuation positions of the parties and how the Tax Court came out are as follows:

Position Estate IRS Tax Court Estate Tax Return $12,678,117Estate Litigation Value $12,995,000IRS Notice of Deficiency Value $35,710,000IRS Litigation Value $33,515,000Tax Court Conclusion of Value

$27,454,115


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• The Tax Court noted that both parties moderated their valuation positions between the time of filing the return/deficiency notice and trial

• The Tax Court again sidestepped IRC Sec. 7491 burden of proof shift to the IRS by deciding the case on the preponderance of evidence


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Giustina Est. v. Comr., T.C. Memo 2011-141 (Judge Morrison)• With respect to the cash flow method, the Tax Court found

problems with the work of both appraisers. The Tax Court called down the IRS appraiser for using only one year’s worth of cash flow; the estate’s appraiser used five consecutive years of cash flows. Additionally, the IRS appraiser assumed 3% growth and flat expenses, which the Tax Court said was wrong. In the end, the Tax Court wholly disregarded the cash flow approach work of the IRS appraiser

• However, the Tax Court also found fault with the work of the estate’s appraiser, disregarding the 25% discount for income taxes that the estate’s appraiser took, reasoning that the appraiser used a pre-tax, not a post-tax, capitalization rate, citing Gross v. Comr


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• In determining DLOM, both experts relied upon a benchmark analysis based upon the restricted stock studies and the pre-IPO studies. However, the IRS appraiser gave more reliance to the restricted stock studies, specifically, the SEC Institutional Investors Study, while the estate’s appraiser relied more upon the pre-IPO studies

• The IRS appraiser testified that the pre-IPO studies overstated the DLOM, and, according to the Tax Court, the estate’s appraiser failed to rebut that point. Thus, the Tax Court upheld the DLOM conclusion that the IRS appraiser reached

• The Tax Court’s decision that the Pre-IPO studies overstate DLOM is ridiculous and without any support

• If Pre-IPO studies do anything at all, and that is debatable, they set a floor for DLOM of closely-held entity interests


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• The Tax Court disregarded three valuation methods that the estate’s appraiser employed, totaling 70% of that appraiser’s conclusions: the asset accumulation method, the capitalization of distributions method and the market approach (that the IRS appraiser also employed)

• The Tax Court disregarded the capitalization of distribution method because it found that the cash flow method was more accurate and that the two methods were duplicative because both assume continued operations


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• The Tax Court disregarded the asset accumulation approach, again because the Tax Court believed that the method was duplicative of the asset approach

• The Tax Court disregarded the market approach that both appraisers employed because the court believed that the selected guideline companies were substantially different from the subject company and because the court noted that neither appraiser “appropriately” considered those differences


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• This is a very interesting valuation case because the Tax Court primarily relied upon a valuation method (cash flow method) substantially more than the experts for both sides did. Query whether this gives the estate any grounds for appeal?

• The Tax Court employed a unique proportionality method in that the court assumed a 75% chance that the subject company would continue its timber operations as is and a 25% chance that the limited partners would force the liquidation of the subject company

• The Tax Court seemed to come up with those percentages out of thin air. I can’t recall another case or situation where such a method was used. Could that be attacked on appeal?


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• Some of the mistakes that the appraisers made seem to have emanated from the valuation positions that the respective parties espoused, which often is a problem. Using a pre-tax discount rate with a tax adjustment seems to be wrong at first glance. Query how that got out of the appraiser’s office other than because it made the numbers come out close to the return position?

• Given that there is a lot of money involved here, I suspect that we haven’t heard the last of this matter. I expected the estate to appeal, and they have appealed to the Ninth Circuit


62


Boltar, LLC v. Comr., 136 T.C. 326 (2011) (Judge Cohen)• In this federal income tax case, the Tax Court, in a

reviewed opinion, excluded the appraisal report of the taxpayer’s appraiser on Daubert grounds and upheld the IRS’s position in the valuation of a conservation easement

• The case was appealable to the U.S. Tenth Circuit Court of Appeals, but it wasn’t appealed

• At issue was the correct value of a 2003 income tax charitable contribution deduction for a conservation easement


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Boltar, LLC v. Comr., 136 T.C. 326 (2011) (Judge Cohen)

• The relevant value positions of the litigants and that ultimately reached by the entire Tax Court are as follows:

• Taxpayer’s Return Position: $3,245,000• IRS Audit/Deficiency Notice Position: $42,400• IRS Expert’s Position: $31,280• 1999 Acquisition Price: $10,000 per acre• Highest and Best Use per the Taxpayer’s Expert:

Condominium development• Highest and Best Use per the IRS Appraiser: Delayed single-

family detached homes


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Problems with the taxpayer’s appraisal report:• Based appraisal on a draft of the conservation easement

rather than on the final conservation easement• It failed to determine the value of the easement area

before and after the placement of the easement on the property, as required by Treas. Reg. Sec. 1.170A-14(h)(3)(i)

• Failure to apply realistic or objective assumptions• Erroneous assumptions about city placement of the

property and the zoning


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Problems with the taxpayer’s appraisal report:• Failure to consider prospects for annexation into the

city of Hobart and rezoning to permit the condominium project that the appraisers argued was the highest and best use of the property

• Failure to suggest adjustments or corrections to calculations that were obviously wrong except to assert that the original report was correct even with the factual errors


66



Problems with the taxpayer’s appraisal report:• Failure to address the argument that the proposed

project would not fit on the eased property in the form drawn except by a “bald and unpersuasive assertion that the project ‘will fit, it just won’t fit as drawn’ in the site plan”

• Failure to adequately consider the hypothetical willing buyer


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• The taxpayer’s arguments against a Daubert exclusion:– Daubert really only applies to jury trials and not to judge

trials because a judge can weigh the evidence– The appraisal report must be accepted since the IRS

previously accepted the methodology in the appraisal report and in fact stipulated that it was a qualified appraisal

– Tax Court Rule 143(g) mandates receipt of the appraisal report into evidence

– The IRS complaints about the appraisal report don’t affect admissibility of the report into evidence


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• The Tax Court refuted every argument of the taxpayer against a Daubert exclusion, noting:

• In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.

• Justice is frequently portrayed as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions.[emphasis added]


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Boltar, LLC v. Comr., 136 T.C. 326 (2011) (Judge Cohen)The Tax Court went on:

• After decades of warnings regarding the standards to be applied, we may fairly reject the burden on the parties and on the Court created by unreasonable, unreliable, and irrelevant expert testimony. In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.[emphasis added]

• We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions. Their report as a whole is too speculative and unreliable to be useful.


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Boltar, LLC v. Comr., 136 T.C. 326 (2011) (Judge Cohen)The Tax Court concluded:

• If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense.[emphasis added]


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What are some of the takeaway lessons from Boltar?• It is critical that the appraiser be objective and reasonable.

How do you know when your appraiser is not being objective and reasonable? It requires you to be objective and reasonable as well, even when you are zealously advocating your client’s position

• Co-opting your appraiser into being an advocate is the absolutely wrong approach. This is one of the reasons why I believe that a trial appraiser should not also serve as a rebuttal expert. I believe that simultaneously serving in both capacities compromises the expert in the eyes of the court


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What are some of the takeaway lessons from Boltar?• On balance, reviews are suggested every time that

there are large differences between the conclusions of value of qualified appraisers. True, this adds expense that the client may not go for, but it’s so important in my opinion that you should go on record in writing as having suggested it so that if your appraiser is wrong, you at least can say “I told you to get a review.”


73



What are some of the takeaway lessons from Boltar?• It is imperative that your appraiser immediately correct errors

and carefully consider how the errors affected the conclusion of value. Appraisers are human too and do make mistakes from time to time

• Errors can easily be made, and in appraisal reports, errors can cascade into bigger errors as they factor themselves in at each level of the analysis, throwing the conclusion of value off even further

• In Boltar, the appraisers apparently didn’t consider how their errors affected their analysis, which the Tax Court termed “fatal”


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What are some of the takeaway lessons from Boltar?• Where an appraiser is not following a required valuation

approach format, such as that for conservation easements, or the appraiser desires to use a technique that is “cutting edge” and hasn’t been vetted with the appraiser’s peers, warning bells should go off! I normally wouldn’t permit my clients to be guinea pigs unless they understood that and were nevertheless willing to do so. I strongly encourage appraisers who are “inventive” to publish articles and speak about their technique first to their peers


75


Jensen Est. v. Comr., T.C. Memo 2010-182 (Judge Vasquez)• In this federal estate tax case, the Tax Court

determined the discount for built-in capital gain for an 82% interest in a New Hampshire C corporation, which owned, as its principal asset, a 94 acre waterfront parcel on which it operated a girls’ summer camp

• The effect of the result was a complete victory for the estate

• The case was appealable to the 2nd Circuit Court of Appeals, but it wasn’t appealed


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Jensen Est. v. Comr., T.C. Memo 2010-182 (Judge Vasquez)

The valuation positions of the parties and how the Tax Court came out are as follows:

Position Estate IRS Tax Court Value $2,554,317 $3,268,465

$2,554,317Discount $1,133,283 $490,383

$1,133,283


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The Appraisers’ Methodology• The estate’s appraiser simply computed the amount of

the built-in capital gain (fair market value less adjusted basis) and deducted that sum dollar for dollar from the fair market value of the property

• The IRS’s appraiser took a more complex route in its determination. That appraiser used closed-end funds to assist in the determination of the proper level of discount for built-in capital gain


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The Appraisers’ Methodology• Interestingly, that appraiser concluded that there was no

“direct correlation between exposure to built-in capital gains and discounts from net asset value at levels of exposure of 41.5 percent or less…” [which was the highest percentage of built-in gains among the six closed-funds that he examined]

• As a result, it only recognized the built-in gain above 41.5%, which was 24.5% since the amount of built-in gain in Wa-Klo was 66%. However, as to this excess, he permitted a dollar-for-dollar discount for built-in capital gains


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• However, as to the IRS appraiser’s use of closed-end funds to assist in the determination of the proper level of discount for built-in capital gain, Judge Vasquez ruled against the IRS, noting that he didn’t feel that the funds were comparable in any way to the subject parcel

• Moreover, he noted that closed-end funds invest indirectly in real estate through REIT’s and further that “discounts from a closed-end fund’s net asset value are attributable to several factors including supply and demand, manager or fund performance, investor confidence, or liquidity.” Judge Vasquez also expressly noted that the “studies on the effect of unrealized capital gains on the discounts from a closed-end fund’s net asset value are inconclusive”


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• Judge Vasquez went on to assume a 17 year holding period as no party had offered evidence of holding period

• After making his calculations, Judge Vasquez determined that the estate was entitled to at least that discount it claimed


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• All I could do was shake my head when I read the opinion’s description of the IRS appraiser’s analysis. It struck me as voodoo economics, and Judge Vasquez wasn’t buying it either

• The IRS appraiser’s approach has no basis in any of the valuation literature to the best of my knowledge, and probably should have been challenged on Daubert grounds


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• With respect to the built-in capital gains tax issue, this may appear to be another 100% of the tax on the appreciation case, as we’ve seen recently for C corporations as in Dunn Est. v. Comr. and Jelke Est. v. Comr. However, there’s a twist, and it is the holding period assumption, which the Tax Court also employed in Borgatello v. Comr.

• I agree with Judge Vasquez’s analysis. As I have said before, the dollar-for-dollar reduction, while certainly simple, strikes me as arbitrary. I predict that you’ll see more of this type of analysis except in the Fifth and Eleventh Circuits


83


The Ringgold Telephone Company v. Comr., T.C. Memo 2010-103 (Judge Wells)

• The taxpayer corporation elected to be treated as an S corporation effective as of January 1, 2000. At that time, it held a 25% limited partnership interest in an entity that in turn owned a 29.54% limited partnership interest in another limited partnership. The principal asset in the parent limited partnership was a cellular license


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• The valuation numbers are as follows:– Value per income tax return: $2,600,000– Original valuation: $4,600,000– Revised valuation: $2,600,000– Value per taxpayer’s appraiser-trial: $2,980,000– IRS determination of value-notice of deficiency: $5,243,602– IRS determination of value per IRS’s appraiser-trial:

$5,155,000– Tax Court determination of proper value: $3,727,142


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• Less than one year after electing to be an S corporation, the taxpayer sold its limited partnership interest for $5,220,423. For purposes of computing its built-in gain, the taxpayer reported the value of the limited partnership interest per its revised appraisal: $2,600,000. On audit, the IRS asserted that the value should have been determined by the subsequent sales price

• Predictably, it boiled down to a war between the appraisers. The taxpayer utilized an appraiser who has an ABV from AICPA and who had significant experience in valuing telecommunications entities. Contrast this with the IRS appraiser, who had no valuation credentials and who had never valued a telecommunications entity


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• The taxpayer’s appraiser weighted his indications of value in arriving at his conclusion of value of the parent limited partnership:

• Capitalization of income-50%• Discounted future income-30%• Guideline company approach-10%• Guideline transaction approach-10%


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• Once he arrived at the value of the parent limited partnership, the taxpayer’s appraiser then attacked the valuation of the taxpayer’s limited partnership interest

• He used two methods to determine this value: a distribution yield analysis and a business enterprise analysis, the latter of which was simply to apply a 5% DLOM to the taxpayer’s proportionate share of the parent limited partnership

• In his distribution yield analysis, and this is very important, the taxpayer’s appraiser used after-tax dollars. He weighted these two approaches equally in arriving at his ultimate conclusion of value on the limited partnership interest


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• Contrast this with the weightings that the IRS appraiser employed in valuing the parent limited partnership interest:– Discounted cashflow-50%– Merger and acquisition-50%– Guideline company approach-0%– The IRS appraiser did not employ a distribution yield

analysis and gave no DLOM


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• The Tax Court first considered the IRS argument that the actual distributions made was irrelevant pursuant to Rev. Rul. 59-60. Citing prior Tax Court precedent in Barnes v. Comr., the Tax Court found that the distribution yield analysis was appropriate for valuing a non-controlling interest

• The Tax Court then tackled the taxpayer’s arguments that the subsequent sale of the limited partnership interest approximately six months after the valuation date was irrelevant, and, if relevant, must be significantly adjusted to reflect that BellSouth’s purchase of the taxpayer’s interest was a strategic purchase, i.e., above fair market value


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• The Tax Court determined that the sale should have been considered as it was within a reasonable period of time after the valuation date and further that the sale was at arm’s length. However, the Tax Court agreed that it “should consider the unique characteristics of the buyer, seller, and transaction.”


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• However, the Tax Court found that nothing in the record supported the taxpayer’s assertion that the transaction included a control premium, citing the taxpayer’s own appraiser, who testified that in his opinion, since BellSouth already controlled the parent limited partnership, it had no reason to enter into the transaction

• Nevertheless, the Tax Court agreed with the taxpayer that BellSouth had made a strategic acquisition, relying upon the testimony of the taxpayer’s appraiser to the effect that BellSouth had a practice of making higher bids than it would have ordinarily made to discourage exercise of the right of first refusal


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• The Tax Court accepted the conclusions of value that the taxpayer’s appraiser reached in his distribution yield analysis and in his business enterprise analysis

• However, to these approaches, the Tax Court equally weighted the subsequent sales price in arriving at its value determination


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• Perhaps most importantly, and this is not readily apparent in the opinion, it is noteworthy that both appraisers tax effected the earnings

• The opinion is important because it illustrates the importance of hiring accredited appraisers who have experience in valuing companies that are similar to the subject company

• The case was appealable to the Eleventh Circuit, but it wasn’t appealed


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• The opinion also demonstrates an understanding by the Tax Court of the commonly accepted levels of value, i.e., that strategic value is higher than fair market value

• Should the existence of strategic buyers be considered in the determination of fair market value?

• My position is that strategic buyers should not be considered in determining fair market value because they will always out pay a financial buyer, who buys at fair market value


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IRS DLOM Job Aid• The IRS has released to the public a 107 page

document entitled “Discount for Lack of Marketability Job Aid for IRS Valuation Professionals”

• This document summarizes and evaluates most, but not all, of the methods that are currently in use for determining DLOM


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IRS DLOM Job Aid

• At the beginning of the DLOM Job Aid, the IRS makes clear what its alleged intentions are with respect to its issuance:– It is not meant to provide a cookbook approach to evaluating a marketability

discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal. It is emphasized that, all background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator. By bringing the included material together in one document, we are striving to make the job of the IRS valuation analyst easier. We do not mean to provide guidance as to reasonable levels of marketability discounts that would prevail in all situational contexts or to imply that the IRS has any policy per se in the evaluation or the determination of such discounts [emphasis added]


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IRS DLOM Job Aid• The DLOM Job Aid divides DLOM approaches into four

categories: benchmark approaches, securities-based approaches, analytical approaches and other approaches

• According to the IRS: This Job Aid is meant to provide a background and context for the Discount for Lack of Marketability as such is commonly applied in business valuation analyses and reports. It reviews past and existing practices and attempts to provide insight into the strengths and weaknesses of these practices.


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IRS DLOM Job Aid

The following quote is very instructive of the IRS general attitude regarding DLOM:

• If you are approaching the question of DLOM fresh, either as a reviewer confronted with an unreasonable taxpayer position based on invalid approaches or as a valuator charged with making your own valuation discount decisions, it is often helpful to start with a basic question as relates to DLOM. That question is: “Under the prevailing facts and circumstances and considering the nature of the interest to be valued why is the DLOM not zero?” [emphasis added]


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The state of business valuation: Let’s take the trends discussed in the recent developments to look at what the courts need to do

• Increase the number of Daubert exclusions. The United States Supreme Court made courts the “gatekeepers” of expert witness evidence. However, this did not mean that judges are now also experts who, but for their hallowed robes, would also be passing through the same gate

• To date, although there are some signs recently that this is changing, at least in the Tax Court, courts generally have done a poor job of gatekeeping in business valuation cases, opting instead to take on the cloak of “super appraiser,” divining between theories and conclusions reached by the appraisers to arrive at their own valuation conclusions, usually cherry-picked from bits and pieces of the work of the opposing appraisers, understandably because they don’t have the education or training to be appraisers


100


The state of business valuation: What the courts need to do• If the appraisers for both sides do something one way, that way might

be supportable. Say what you will about business appraisers, but, in my humble opinion, the quality of business appraisal work has increased by leaps and bounds over the past 20 years. During that time period, business appraisal standards have proliferated, and practices have begun to coalesce. Therefore, help nurture them along

• When appraisers for BOTH sides do something a certain way, like tax-affect earnings, courts should think long and hard before they simply dismiss it out of hand, especially if their reason is prior court jurisprudence

• Just because some non-appraiser judge in the past either didn’t understand or didn’t care for the way that the method was used by one appraiser in one situation is no reason to reject the method


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The state of business valuation: What the courts need to do• Prior court precedent is no way to set business valuation

practice rules. For example, in the area of tax-affecting S corporations, this is routinely done in business transactions every day. However, tax-affecting has a black eye, at least in the Tax Court, because of two cases, Gross and Heck, in which tax-affecting was probably inappropriate under those facts

• However, the Tax Court blew it in the Dallas case by not permitting tax-affecting in a case in which it was clearly advisable, solely because it wasn’t done in the two prior cases in which tax-affecting wasn’t appropriate. That doesn’t make any sense


102


The state of business valuation: What the courts need to do• Resist simplicity in some situations. While I normally support

the notion that simple is better, it doesn’t always work• For example, the “bright line” test that the Fifth Circuit

enunciated in Dunn and followed by the Eleventh Circuit in Jelke regarding the dollar-for-dollar reduction in valuation for the tax on built-in capital gains is simply too good to be true, makes little sense and violates the fair market value standard

• Courts are effectively forcing appraisers to do something, i.e., deduct the projected capital gains tax liability dollar-for-dollar, that they know is contrary to generally accepted business appraisal practices, which is just wrong


103


• We conclude our work today by considering a series of burning issues that are presently hot in business valuation

• I represent we consumers of tax valuation reports• There is a huge disconnect between the knowledge possessed

by business appraisers and the knowledge possessed by us• This is a source of consternation for us and our clients

because we must blindly rely upon these reports• For a detailed discussion of most of these burning issues, see

Chapter 19 of A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal


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Where You Stand On An Issue Depends On Where You Sit!

• That’s a little Southern wisdom• Business appraisers make numerous judgment calls

on these very issues each and every time they write an appraisal report

• Most business appraisers rarely ever explain these choices in the appraisal report, or explain why another position is not preferable or even tenable


105


Little Did We Know …• That business appraisers argue so much amongst themselves

on such key doctrinal issues• We, users of business appraisal reports, blithely assume that

all matters in a valuation report used “generally accepted appraisal principles”

• The IRS says, until further notice, USPAP is it. Notice 2006-96• But USPAP is silent on virtually all of these issues• So where does this leave us?• You guessed it. We’re on our own and must learn about

business appraisal to protect ourselves and our clients


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So Many Issues, So Little Time …• Each of the burning issues mentioned here could, by

themselves, take up an entire continuing education program• We’re not going to solve anything here today, however…• My purpose is to give you food for thought about how business

appraisers present these issues when they write business appraisal reports

• It is important to remember that the six most important words in Rev. Rul. 59-60 are common sense, informed judgment and reasonableness

• You can’t say these words too often-forget them to your peril-and that of your client


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Inherent Problems With “Fair Market Value” as a Standard

• Hypothetical buyers and sellers• Res tantum valet quantum vendi potest• Valuation is perhaps best expressed by a range, yet the

tax system requires one number• Are judges qualified to appraise? No, but they do anyway• The appraiser’s task is a tough one• Good advisors prepare clients for it


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Generally Accepted Appraisal Principles, Anyone?• Frighteningly little is out there on an accepted way

to deal with most appraisal substantive issues

• The various appraisal standards promulgated to date certainly do not do so

• Given the various turf battles that rage within the business appraisal industry, on both a professional level and on a substantive level, I see little chance of this happening


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Burning Issue No. 1: Discount for Lack of Marketability (DLOM)


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Burning Issue No. 1: Discount for Lack of MarketabilityDLOM Approaches• Numerous and growing like weeds• The pros and cons of the selected DLOM approach

(and why another DLOM approach was not used) are rarely, if ever, discussed in a business appraisal report

• There are an awful lot of turf battles in this arena. Everyone seems to have something to sell, like a methodology or a proprietary data base


111


Burning Issue No. 1: Discount for Lack of MarketabilityDLOM Approaches (in no order of preference or importance)

• Pre-IPO Studies (Willamette, Valuation Advisors and Emory)• Restricted Stock Studies (Stout Risius Ross, FMV Opinions, Management Planning, Silber, Willamette, Institutional Investor Study,

Gelman, Trout, Moroney, Maher, LiquiStat and Standard Research Associates)• Black-Scholes Option Pricing Method (Chaffe application)• QMDM (Mercer)• Longstaff• Private Placement Method (Bajaj)• LEAP (Trout/Seaman)• Practical Scoring Method (Curtiss)• Bid-Ask Spread (Chipalkatti)• Time Model (Stockdale)• Finnerty• Meulbroek• Tabak• Mandelbaum (Judge Laro’s ten factor test)• Abrams• Wruck• Hertzel and Smith• MBVG (Abbott)• NICE (Frazier)• Partnership Spectrum• MergerStat


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Burning Issue No. 1: Discount for Lack of Marketability

To me, DLOM methods essentially break down into four categories, which is different from the way that the DLOM Job Aid categorized them:

• Market Approach methods• Income Approach methods• Quantitative methods• Qualitative methods


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Burning Issue No. 1: Discount for Lack of MarketabilityAn example:• I recently received a business appraisal report that computed

DLOM using the following weights:— Pre-1990 restricted stock studies-30% (when the holding

period was two years)— Pre-IPO studies-35%— LEAP-35%– Then factored through some additional factors

• How could this be justified or explained to the satisfaction of a court?


114


Burning Issue No. 1: Discount for Lack of MarketabilityAnother example:• I recently received a report that computed DLOM using the

following weights:— Option Methods-50%— Restricted Stock Studies-35%— LEAP-15%

• How could this be justified or explained to the satisfaction of a court?

• Again, it beats me• No explanation of either why other methods either weren’t used or

used even for a sanity check


115


Burning Issue No. 1: Discount for Lack of Marketability• The IRS recently weighed in on DLOM, making public and

issuing its DLOM Job Aid, in which it critiqued many, but not all, of the DLOM methods

• The IRS didn’t really prefer a DLOM method, as it pointed out the strengths and weaknesses of each method that it reviewed

• The DLOM Job Aid saved quite a bit of venom for one particular approach, the FMV Opinions Restricted Stock Study, which I can only explain by saying that they must be seeing quite a bit of it

• However, I’ve never seen it in use after having read several hundred business valuation reports


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Burning Issue No. 1: Discount for Lack of MarketabilityDaubert Considerations• Can so many different DLOM approaches ever give rise to a

truly successful compliance with Daubert and its progeny for any of these methods? Peer review anyone?

• In light of the disparate positions within the appraisal community, the answer arguably is “no,” yet a few of these approaches seemingly have passed muster under the Daubert test

• Daubert challenges are on the rise too-See the Tax Court opinion in Boltar v. Comr., which we discussed earlier


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Burning Issue No. 1: Discount for Lack of MarketabilityWhat’s coming next?• Examining the entrails of a chicken?• Seriously, folks, what will the next DLOM approach

be?• No doubt that it will be published soon• Where do you find these new DLOM approaches?

Business Valuation Review, a business appraiser publication, and esoteric finance journals


118


Burning Issue No. 2: DLOM applied to a controlling interest• Case law clearly has permitted this• But is this position correct from the standpoint of

valuation theory?• Appraisers significantly disagree here• Some business appraisers argue that a controlling owner

has access to all of the cash flows until sale, thereby negating DLOM

• How large should this discount be relative to DLOM for a controlling interest-probably small, in my view


119


Burning Issue No. 3: Discount for Built-In Capital Gains• Disparity between what the Tax Court is doing and

the “bright line” test enunciated by the two courts of appeals (5th and 11th) that have dealt with this-Supreme Court didn’t take the case in Jelke (11th Circuit).

• Is the bright line test too good to be true?• What should the rule be?• Could the appraisal community agree?• Doubtful


120


Burning Issue No. 3: Discount for Built-In Capital Gains• In Jensen Est. v. Comr., the Tax Court allowed 100% of

the discount for imbedded gains that the taxpayer claimed, but it did not simply take off 100% of the inherent tax. The court determined that a 17 year holding period was appropriate. T.C. Memo 2010-182.

• I suspect that a holding period analysis will ultimately prevail-it makes the most sense


121


Burning Issue No. 4: Looking for Private Comps• Under the market approach, one of the methods involves

finding so-called publicly traded guideline companies that are comparable to the subject privately held company

• This method is blessed in Rev. Rul. 59-60 Sec. 4.01(h) and in Treas. Reg. Sec. 20.2031-2(f)(2) (flush language)

• The problem inherent in any guideline public company approach is the size and qualitative differences between those publicly traded companies deemed to be sufficiently comparable to the subject company

• Could private company transactions be used?


122


Burning Issue No. 4: Looking for Private Comps• Databases of private company transactions are being aggressively

marketed-for example, BIZCOMPS®, DONEDEALS®, IBA Market Database and Pratt’s Stats®

• There is scant tax case law, which makes me nervous due to a lack of public track record

• There are significant criticisms in the appraisal literature of each of the private databases

• There is something attractively appealing to using private company data, but the lack of guidance and the criticisms give me heartburn

• Even though some business appraisers will disagree with me, I don’t think that these databases are ready for primetime


123


Burning Issue No. 5: What is the “Small Firm Effect,” if any?

• The small firm effect provides that smaller cap firms out perform larger cap firms, but at greater risk

• There are two schools of thought-no small firm element of additional risk or a small firm element of additional risk (which reduces value)

• This added increment of risk usually is added without any discussion in the appraisal report, which I like to see

• Klauss v. Comr. held in favor of the small firm effect


124


Burning Issue No. 6: Are Synergistic Buyers Properly Included Within the Definition of “Hypothetical Buyer?”

• Judge Laro says yes. Is he correct?• I think not, but who in the Sam Hill am I?• If synergistic buyers were included within the

hypothetical willing buyer, then lots of potential willing buyers would be excluded because they wouldn’t pay what a synergistic buyer would pay, which would in my opinion violate the “hypothetical” nature of the “willing buyer”


125


Burning Issue No. 7: The Levels of Value• Appraisers disagree over the levels of value charts

that end up in appraisal reports, although there are majority and minority schools of thought

• Where your appraiser stands on this issue could mean a huge difference in a conclusion of value

• This is rarely, if ever, discussed in appraisal reports• It impacts the discount for lack of control (DLOC)• An example will illustrate how the levels of value

work


126


Burning Issue No. 7: The Levels of Value• Suppose that there is a closely-held operating

company that is reflecting net income of $250,000• However, on closer examination, the controlling

shareholder is taking out $500,000 per year more in salary than that would be paid to a third party manager

• Moreover, there is a lease to the company by the controlling shareholder that calls for rent that exceeds fair market value by approximately $100,000 per year


127


Burning Issue No. 7: The Levels of Value• Additionally, the controlling shareholder’s spouse is on the

payroll to the tune of $60,000 per year, and all indications are that the spouse is not even reporting for work

• A potential control buyer could save $50,000 per year by decreasing inventory turns and by providing additional operating capital

• A synergistic/strategic buyer of the company could eliminate the accounts payable and accounts receivable departments of the subject company, together with certain executive positions, for a total proposed savings of $300,000 per year


128


Burning Issue No. 7: The Levels of Value• Assume a price-to-earnings multiple of 5.• From the standpoint of the levels of value: • The unadjusted value of the company is $250,000 x 5=$1,250,000• Normalizing adjustments could be made to the marketable

minority level as follows: $250,000 (net income as reported) + $500,000 (excess compensation) + $60,000 (spouse compensation) + $100,000 (excess lease payments) = $910,000 x 5=$4,550,000

• Additional adjustments could be made at the control level of $50,000, bringing the value of the company to $4,800,000 (4,550,000 + 250,000)


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Burning Issue No. 7: The Levels of Value• At the strategic level of value, an additional adjustment of $300,000 per year

for reduction of expenses of another owned entity due to duplication that could bring the value of the company to $6,300,000 ($4,800,000 + $1,500,000).

• Summary of valuation indications: • As reported: $1,250,000• Marketable minority level of value: $4,550,000• Control Level of Value: $4,800,000• Strategic Level of Value: $6,300,000.• As you should be able to readily see, the values go up with each increasing

level of value• There actually might be a higher level of value-the price that an irrational

buyer might pay-think about that-dot coms, anyone?


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Burning Issue No. 7: The Levels of Value


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Burning Issue No. 8: To Tax-Effect or Not S Corporations• Disparity between what most appraisers seem to be doing and what the

Tax Court is doing! The appraisers are right, and the Tax Court is acting like a flat earth society, although there is a minority school of appraisers who agree with the Tax Court

• Again, too much “my model is better and your method ain’t worth a damn”-several models

• There seems to be no way to reconcile the differences of opinion here per Shannon Pratt

• Very little discussion of competing approaches in appraisal reports• Demand this discussion be included in the appraisal report• It may make more sense for a business appraiser to address this issue

indirectly through adjustments to multiples or in some other way


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Burning Issue No. 8: To Tax-Effect or Not S Corporations• There are five main recognized approaches in the tax-affecting

of S corporations: Grabowski, Fannon, Van Vleet’s SEAM, Mercer and Treharne

• I prefer to see all of the five methods illustrated in the appraisal report so that I can see the differences, even if the business appraiser ultimately relies only on one approach

• There will be differences depending upon a number of factors, including the size of the subject interest (control versus minority), the cash flows to shares presently being paid out or projected to be paid out in the future and the universe of potential buyers of the subject interest


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Burning Issue No. 9: Financial Statement Adjustments to Be Made When Valuing a Non-Controlling Interest

• These adjustments usually are material

• There are two schools of thought on this issue– One school says always make the adjustments because

one should assume a well-run company– The other school says that if the minority shareholder

can’t force the adjustment, then don’t make it

• This is rarely discussed in appraisal reports, but should be-demand to see it discussed


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Burning Issue No. 9: Financial Statement Adjustments to Be Made When Valuing a Non-Controlling Interest

An example:• Suppose the controlling shareholder overpays himself by

$100,000 annually, and takes out other perks worth $250,000• One school would say to adjust out the excesses even when

valuing a noncontrolling interest because of fiduciary duty and that these shareholders have the right to expect a well run company

• The other school says no because the minority shareholder is powerless to stop the majority shareholder, but is this true?

• I agree with the first school-make the adjustments


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Burning Issue No. 10: Validity of CAPM in Valuing Closely Held Companies

• The Capital Asset Pricing Model (CAPM) method forms the basis for a lot of appraisers’ estimation of the proper risk level

• It apparently is difficult to explain to courts, or courts have just been resistant to it

• In Gallagher v. Comr., T.C. Memo 2011-148, Judge Halpern expressed a favoring of a build-up method over the CAPM

• The problem is that the build-up method is a variant of CAPM

• CAPM also has some doctrinal difficulty in its application to closely held businesses

• I’ve never seen the caveats associated with this method discussed in an appraisal report-but they should be


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Bonus Burning Issue: Company Specific Risk Premium and Total Beta

• There is an emerging movement in business valuation that attempts to quantify a company specific risk premium utilizing a concept called “total beta”

• Currently, there are two basic ways that business appraisers develop a discount-CAPM, which uses beta) and a build-up method, which computes a discount rate by adding up the following elements: (1) a risk-free rate (usually the U.S. 20 year treasury bond rate), (2) an equity risk premium (for the extra risk of holding an equity security, as opposed to a bond), (3) small size risk premium and (4) a company-specific risk premium (which represents unsystematic risk)

• With respect to the last item, unsystematic risk, a new concept, called “total beta,” has come out


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Bonus Burning Issue: Company Specific Risk Premium and Total Beta• Total Beta of a particular publicly traded stock is the product of the standard

deviation of the returns of that particular stock divided by the standard deviation of the returns of the market (often represented by the S&P 500)

• Total Cost of Equity, the historically accepted view, is comprised of the sum of the risk-free rate plus total beta times the excess return premium

• There is something new called the Butler-Pinkerton Calculator (“BPC”), which attempts to extend the total beta concept to privately-held companies through the use of Total Beta for comparable (or guideline) public companies

• The BPC has passed a Daubert challenge, but it is still very controversial among business appraisers

• The jury is still out for me on the BPC, but I think that they may be on to something


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• I appreciate your attention today! Thank you!• If you have any comments or questions, I’d

love to take them, either now or later• You can e-mail or call me:

– 504.452.7574– [email protected]– [email protected]

mailto:[email protected]

mailto:[email protected]

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