estate and gift valuation update presentation master

ESTATE AND GIFT

VALUATION UPDATE

R. Christopher Rosenthal, CPA/ABV/CFF, ASA, AEP

Zachary Reichenbach, CPA/ABV

December 18, 2014

Overview

• Valuation Overview and Basics

• Standard of Value – Fair Market Value

• Valuation Approaches

• Discounts

• Valuation Issues and Court Cases

• Issue #1 – Multi-Tier Discounting

• Issue #2 – Treatment of Management Projections

• Issue #3 – Subsequent Events

• Issue #4 – Personal Goodwill

• Issue #5 – Fractional Interests

Standard of Value

• U.S. Tax Court: Fair Market Value

• According to Internal Revenue Code Section

2031(a) and Regulation 20.2031-1(b), Fair

Market Value is defined as:

• “...the price at which property would change hands between a

willing seller and a willing buyer, neither being under any

compulsion to buy or to sell and both having reasonable knowledge

of relevant facts.”

• Can be on controlling and noncontrolling basis

• Discounts for lack of control and marketability

Valuation Approaches and Methods

Cost Approach

• Asset Accumulation Method (NAV Method)

Income

Approach

• Discounted Cash Flow Method (DCF Method)

• Capitalization of Earnings Methods

Market

Approach

• Guideline Merged and Acquired Company Method

• Guideline Publicly Traded Company Method

Application of Discounts

• Two Basic Discounts

• Discount for Lack of Control

• Discount for Lack of Marketability

• The application of discounts should always be taken in

the context of:

• The level of value the discount is applied to

• Legal documents that control the rights and restrictions of the

interest holder

• The ultimate rate of return produced for the investor

• Failure to consider these elements could often result in indications

of value which are overstated or understated.

Issue #1 – Multi-Tier Discounting

• Cases Allowing Multi-Tier Discounts

• Astleford v. Commissioner, T.C. Memo 2008-128 (May 5, 2008)

• Paulina Du Pont Dean and J. Simpson Dean v. Commissioner, T.C.

Memo 1960-54 (March 28, 1960)

• Edwin A. Gallun v. Commissioner, T.C. Memo 1974-284 (November

6, 1974)

• Gow v. Commissioner, T.C. Memo 2000-93 (March 20, 2000)

• Estate of Hjersted, 175 P.3d 810 (Kan. 2008)

• Kosman v. Commissioner, T.C. Memo 1996-112 (March 11, 1996)

• Estate of William T. Piper Sr. v. Commissioner, 72 T.C. 1062 (1979)

• Whittemore v. Fitzpatrick, 127 F. Supp. 710 (D. Conn. 1954)


• Cases Dismissing Multi-Tier Discounting

• Roy O. Martin, Jr. and Barbara M. Martin v. Commissioner, T.C.

Memo 1985-424 (August 14, 1985)

• Janda v. Commissioner, T.C. Memo 2001-24 (Feb. 2, 2001)

• Estate of J.E. O’Connell v. Commissioner, T.C. Memo 1978-191

(May 25, 1978)

• The Ringgold Telephone Company v. Commissioner, T.C. Memo

2010-103 (May 10, 2010)


• Valuation Takeaways

• Each level of value on each tier must be known

• Standard of value: willing buyer/willing seller

• Some tiers may only be affected by blockage issues

• Look at each asset and tier individually with respect to their own

asset type and risk profile

• Depends on the type of assets and the risks associated

• Interrelationship factors

• Asset Diversification factors

• Financial Condition factors

• Time Horizon factors

• Volatility factors


• Risks and Restrictions

• Depends on the operating agreement, bylaws or other legal

agreements – they may restrict the ability to give additional tier

discounts

• Contractual restrictions

• Distributions and allocations of profits and liquidation proceeds

• Management responsibilities

• Transferability restrictions

• Buy/Sell Agreements and Rights of First Refusal

• Double Discounting

• Pyramid discounting approach

• Bottom-Up Approach or Top-Down Approach

• Discounts should be reasonable and supported by market evidence

Issue #1 – Multi-Tier Discounting Example

Tier 3 Discounts: 5%



Tier 3 Value:

$56,525

Tier 2 Value:

$59,500

Tier 1 Value:

$70,000

Cumulative Discount: 43.4%

Indicated Value: $100,000

Issue #2 – Treatment of Management

Projections• Recent Cases

• S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co.

• Hintman v. Fred Weber, Inc. (Chancery Court)


• Use of management projections in a DCF method

• Analyst needs to do their due diligence on the reasonableness and

quality of management projections

• Need to provide defensible support

• DCF Method needs to capture the appropriate level of risk

associated with the subject company

• This potentially means modifying

• Cost of capital

• Management prepared projections


Projections• Valuation Takeaways (cont.)

• Cost of Capital Modification - See Hintman v. Fred Weber, Inc.

(Chancery Court)

• Section of sources of equity-risk premium data (Supply side vs.

historical long-term risk premium)

• Section of cost of capital method (i.e. CAPM vs. Build Up)

• Specific Company risk

• Selection can depend on the availability of market data

• Availability of guideline public companies and transactions


Projections• Valuation Takeaways (cont.)

• Modification of Management Projections - See S. Muoio & Co. LLC

v. Hallmark Entertainment Investments Co.

• Most straightforward way to modify projected cash flow

• Could create friction with management and the company

• Pushback from management

• Difficulty in revising projections as of valuation date

• Do these projections capture any expected significant financial

situations in the future

• Exercising options, buyouts and/or liquidations

• Research in the business cycle and maturation of industry

• Comparison with value indications with market data

• Daubert Challenges

Issue #3 – Subsequent Events

• Overview

• Generally, a valuation analyst will disregard any data or event

occurring after the valuation date

• However, it can be different in tax court if the subsequent event

• Was reasonably foreseeable as of the valuation date

• Was relevant to establishing the amount that a willing buyer would have

paid a willing seller for the subject interest even if the event was

unforeseeable as of the valuation date

• Tax courts have been know to look at transactions after the

valuation date

• Treasury Regulation 20.2031-1(b)

• Adjustments may be required to subsequent events based on different

conditions


• Estate of Gallagher v. Commissioner, T.C. Memo 2011-

148

• Valuation Date: July 5, 2004 (Date of Death)

• IRS Expert used financial statement information as of June 27,

2004 and market data as of June 30, 2004

• Petitioner Expert’s used financial statement information as of May

30, 2004 and market data as of March 31, 2004

• Use of DCF and guideline public company method

• Court agreed with IRS Expert


• Petitioner’s Expert failed to object and disprove the use of May 2004

financial statements

• Petitioner’s Expert did not support use for March 2004 market data


• Estate of John Koons v. Commissioner, T.C. Memo 2013-

94

• Koons died on March 3, 2005 and was CEO of Central Investment

Corp. (CIC).

• March 3, 2005 was valuation date

• Koons owned 46.9% voting interest in CIC and 51.9% non-voting

interest in CIC

• Children owned a substantial portion of the remaining equity in CIC

• CIC sold to PepsiAmericas, Inc. (PAS) in January 2005

• Created CI, LLC to own assets not sold to PAS

• By February 2005, all four children accepted offer to sell their

ownership interests in CI, LLC at net book value.



94

• Subsequent Event Issue

• However, the agreement was not executed until after the valuation date.

• Upon completion, Koons interest in CI, LLC would be 70.93% and the

voting interest would increase from 46.9% to 70.4%.

• Koons gets a controlling interest in CI, LLC due to the redemption of the

children’s interests

• Estate Expert Position

• Ignored redemption agreement; irrelevant since subsequent to valuation

date

• Estate’s appraiser said subject interest had rights of 50% owner

• Considered subject interest a noncontrolling interest

• DLOM was 31.7%



94

• IRS’ Expert Position

• Considered redemption agreement, regardless of the fact it is

subsequent to valuation date

• IRS said subject interest had rights of 71% owner (i.e. control)

• DLOM was 7.5%

• Instead of using several factors like the estate’s expert and studies, IRS

determined 5-10% to be appropriate.


• Redemption offer is a binding contract regardless if it is a written

agreement; also need to consider the company documents

• DLOM should be addressed on a controlling basis

• Court agreed with IRS Expert


• Estate of Bernard Kessel v. Commissioner, T.C. Memo

2014-97

• Bernard Kessel held a personal pension plan with Bernard L.

Madoff Investment Securities, LLC

• Would a willing buyer of the Madoff Investments reasonable know

or foresee that Madoff was operating a Ponzi scheme?

• Date of Death: July 16, 2006

• Estate requested tax refund of $1.9 million after Madoff was

arrested and charged.

• IRS denied refund and issued a deficiency

• Argued that a Ponzi scheme is not reasonable knowable or foreseeable

until it is discovered and collapses


• Estate of Bernard Kessel v. Commissioner, T.C. Memo

2014-97


• Fair Market Value…”willing buyer, willing seller are ‘knowledgeable’”

• Case is moved to trial court

• Argument could be that this element of Fair Market Value was not met

• Could this scheme have been detected with enough due diligence


• Estate of Helen M. Noble v. Commissioner T.C Memo.

2005-2


• Tax court determined that a subsequent 3rd party sale of an ownership

interest in an identical closely held business as owned by the petitioner

was appropriate to be used to set the Fair Market Value for the interest

in this matter

• Relevant and identical transactions to the subject interest/subject

business should be considered in the valuation

• Regardless of the fact that they are after the valuation date

Issue #4 – Personal Goodwill

• Personal goodwill is an intangible assets that is tied to the

person as opposed to the business.

• Examples:

• Owner’s name

• Personal relationships or reputation

• Personal goodwill exists when the shareholder or owner’s

reputation, expertise or contacts contribute significantly to

the company’s value and income stream

• Typically seen in businesses that are technical,

specialized or professional or have few

customers/suppliers


Value Breakdown

Tangible Value

Customer Lists

Trained and AssembledWorkforce

Personal Goodwill


• Factors to consider

• Non-compete agreements

• Business is highly dependent on personal relationships and skills

• Individual’s service is important to sales

• Few, high volume customers

• Companies that are highly technical, specialized and engaged in

professional services

• Companies that have contracts that are terminable at will

• High percentage of total asset value being intangible

• Loss of individual would negatively impact the revenue/profitability

of the business


• Bross Trucking, Inc. v. Commissioner, T.C. No. 7710-11,

T.C. Memo 2014-107

• Bross had close relationships with company’s primary customers

• No non-compete agreement

• Value of Company’s licenses was not significant (easy to get new

licenses)

• The Company had been under investment by Department of

Transportation, received significant negative publicity from audits

• Negative publicity caused Bross’ kids to form new company without

the Bross name

• No significant, unique supplier relationships

• Significant use of independent contractors

• Children’s employees were only 50% of Bross employees


• Bross Trucking, Inc. v. Commissioner, T.C. No. 7710-11,

T.C. Memo 2014-107

• Court concluded that the company had:

• No trade name value

• No value to licenses

• No unique supplier relationships

• No valuable assembled work force

• No non-compete agreement


• Bross had personal relationships and the majority of intangible value of

the company was related to Bross (i.e. personal goodwill)

• Strong customer relationships

• No evidence that indicated any business goodwill

Issue #5 – Fractional Interests

• Estate of James A. Elkins, Jr. v. Commissioner, 140 T.C.

No. 5

• Overview

• From the U.S. Appeals Court (5th Circuit)

• Decedent owned a fractional interest in 64 original works of art

• Some art in a grantor retained income trust (GRIT); other art owned

individually in house, office, children’s house, etc..

• FMV of art not a dispute – agreed by all parties

• Issue of the case:

• Is the Estate taxable on decedent’s undiscounted pro rata share of the FMV or

it is taxable on only the FMV reduced by the fractional-ownership discounts

• Facts of the Case (Tax Court)

• Decedent’s experts determine a fractional ownership interest discount of

44.75%


• Estate of James A. Elkins, Jr. v. Commissioner, 140 T.C.

No. 5

• Facts of the Case (IRS)

• Commissioner determined that no-fractional ownership discount was

allowable

• Did not offer any affirmative evidence (factual or expert) as to the

quantitative calculation of a fractional ownership interest discount

• IRS issued a estate tax deficiency of $9,068,266.

• Facts of the Case (Tax Court)

• Tax court disagreed with Commissioner and determined that a 10%

discount was appropriate

• Applied the Willing Buyer/Willing Seller “test”


• Estate of James A. Elkins, Jr. v. Commissioner, 140 T.C. No. 5 • Appeals Court Analysis

• A fractional ownership discount may be applied

• 10% fractional ownership interest determined by Tax Court unsupported and without basis

• The 44.75% fractional ownership discount from decedent’s expert is supported

• Estate will be refunded taxes overpaid in amount of $14,359,508


• Qualitative and quantitative support needed for discounts

• Discounts should be determined for each asset separately – different factors and characteristics

• Willing buyer / Willing seller assumption under Fair Market Value

• Fair Market Value assumes hypothetical sale

• Get a qualified appraiser

Questions?

estate and gift valuation update presentation master

Documents

multitier discountingcases

multitier discountingissue

multitier discountingrisks

multitier discountingroy

multitier discountsastleford

knownstandard of value

indications of value

tax court