Article: "Recession Discounts for Real Estate Companies "

Cases:
· Moore (T.C. Memo 1991-546)
· Campbell (T.C. Memo 191-615)
· Berg (T.C. Memo 1991-279)
· Feuchter (T.C. Memo 1992-97)
· Pillsbury (T.C. Memo 1992-245)
· Rapid-American/McCrory / Harris (603 A.2d 796 & 1992 WL 69614 (Del.Ch.))
· Mueller (T.C.Memo 1992-284)
· Friedberg (T.C.Memo 1992-31) 
· Ansan Tool and Mfg. Co. (T.C. Memo 1992-121)

Tax Planning Tip
MPI Delivering Valuation Studies Based on Chapter 14 Regulations

Recession Discounts for Real Estate Companies

The recent Tax Court acceptance of well supported business valuations comparing private real estate concerns to publicly traded real estate investment trust companies (REITs), coupled with the depressed value of real property and traded real estate stocks, provides privately held companies with an opportunity to take advantage of the prevailing recession discounts. Some cases illustrate the use of comparable companies and discounting in the real estate industry. Again, appropriate and supportable discounts were the focus of contention in these five decisions involving real estate interests.

John R. Moore and Viola K. Moore v. Commissioner, T.C. Memo. 1991-546

The issue in this case was the determination of the fair market value, for gift tax purposes, of minority partnerships interests (.2256% each) given by Mr. and Mrs. Moore to four of their children and grandchildren on April 13, 1984. The Moores valued the gifted partnership interests at a 40% discount from the net asset value of K&M Company, a Colorado general partnership which owned and operated twenty farm and ranch properties in northern Colorado.

The taxpayer and the IRS were in agreement as to the partnership’s net asset value. The taxpayer’s business appraiser testified that a total discount of as much as 50% for the factors of minority interest and lack of marketability should be applied for gift tax valuation purposes (30% for minority interest and 20% for lack of marketability). The IRS expert, also a business appraiser, testified to a 10% discount.

The reported case is difficult to evaluate because, in the case of the taxpayer’s appraiser, not much is disclosed about the empirical basis for the 50% discount. The report of the taxpayer’s appraiser apparently looked to discounts seen in the minority trading prices of publicly held companies. In his testimony he referred to evidence of discounts seen in secondary market transactions involving real estate partnership interests. The IRS valuation expert did not present any empirical capital market evidence regarding his discount conclusion.

The Court recognized that the determination of these valuation discounts is the job of a business appraiser, not a real estate appraiser, because the question presented was the valuation of a partnership interest, not the valuation of the real estate owned by the partnership. This is an important issue because, as noted in the case:

It is the withdrawing partner’s share in the partnership, not a proportionate percentage of partnership assets, that is to be valued, and

The critical factor is lack of control, be it as a minority partner or a minority shareholder.

Considerable attention was paid to the terms of the partnership agreement. A minority partner had no voice in selecting managers, no control over management policies or salaries, and no opportunity to influence asset acquisitions or dispositions. The court concluded that a combined discount of 35% for minority interest and lack of marketability should be used in valuing the minority partnership interests for gift tax purposes.

Estate of Catherine Campbell v. Commissioner, T.C. Memo. 1991-615

The court was asked to decide the fair market value, for estate tax purposes, of one-third of the common stock of Campbell Farming Corporation (CFC) as of July 2, 1982. CRC had substantial land holdings in Montana and New Mexico and was engaged in grain farming, cattle production, grain elevator operations and oil and fertilizer sales. CFC had a substantial net asset value, based mainly on land values, but earned a low 1% rate of return on net asset value.

As in the Moore case, real estate appraisers were used to determine the net asset value and business appraisers were retained by the taxpayer and the IRS to value the common stock. Unlike the Moore case, the reports and testimony of the valuation experts involved extensive analysis of capital market evidence.

The taxpayer’s appraiser valued the stock using two methods: 1) a comparable company approach which emphasized the corporation’s earnings and, 2) a net asset value approach which emphasized net asset value. The earnings-based value was given ten times the weight of the asset-based value to reflect the returns available to a minority investor in a going concern. The resultant weighted value was then discounted 35% for lack of marketability. The concluded fair market value represented a 90% discount from net asset value.

One IRS expert considered the minority interest factor, stock restrictions, low earnings, dividend payments, lack of marketability, and a publicly traded comparable company. He valued the stock at a 33% discount from net asset value. A second IRS appraiser applied a minority interest discount of 18% and a lack of marketability discount of 30% for a combined discount of 43% from net asset value.

In its decision, the court observed that the company had the characteristics of both an operating company and an investment or real estate holding company and did not focus on earnings to the virtual exclusion of net asset value. The court also considered the company’s low earnings, dividends, operations during its 60 year history and its likely manner of operation in the future. The court’s valuation conclusion represented a combined discount of 57% for minority interest and lack of marketability.

Estate of Edgar A. Berg v. Commissioner, T.C. Memo. 1991-279

At issue was the fair market value of a 26.92% interest in the common stock of Vaberg, Inc., a North Dakota real estate holding company which owned, operated and managed commercial and undeveloped real estate in North Dakota. The date of death was June 6, 1985. The court had to decide the appropriate discounts for minority interest and lack of marketability.

The taxpayer and the IRS agreed on the net asset value of Vaberg based on real estate appraisals discussed in the reported case. Based on previous court decisions, a discount of 60% for minority interest and lack of marketability was used for the estate filing. At trial, the IRS expert determined that discounts of 20% for minority interest and 10% for lack of marketability, or a total of 30%, should be used.

The court agreed that the discount from net asset value seen in the publicly traded prices of REITs arises because investors are acquiring a minority interest position. The court was persuaded by the strength of the IRS expert’s appraisal and gave weight to his greater experience and education as an appraiser. The court concluded that for minority interest and lack of marketability a 20% and 10% discount should be applied. The court also indicated that the taxpayer had failed to offer any evidence showing that a marketability discount greater than 10% would be warranted and relied upon the 10% discount of the IRS expert.

Note: In Berg, the IRS expert’s methodology for determining the valuation discounts was Management Planning’s long-standing approach to real estate holding company valuations as prescribed in an article by Robert P. Oliver of  Management Planning, Inc., "Valuing Fractional Interests in Closely Held Real Estate Holding Companies," Real Estate Review, Spring 1986 .

Estate of Harriet L. Feuchter v. Commissioner, T.C. Memo. 1992-97
Estate of Eleanor O. Pillsbury v. Commissioner, T.C. Memo. 1992-245

The major issue in both of these cases was the size of the discount to be allowed in the valuation of undivided interests in real property. In the Feuchter case, the decedent (valuation date August 27, 1986) owned 57.13% of a partnership which owned several tracts of land. The partnership had undivided 50% interest in three of the tracts. In the Pillsbury case, the decedent (valuation date December 12, 1987) owned an undivided 77% interest in one property and an undivided interest in another.

In each case, the taxpayer retained a real estate appraiser who testified that the value of an undivided interest should be discounted because of the legal and appraisal expenses of a partition action, the lack of general control, the lack of marketability and the lack of liquidity of undivided interests. The real estate expert in Feuchter believed that the discount should be 25% based on discussions over 10 years with auctioneers, farmers and land purchasers. He did not have comparable sales data. The Pillsbury appraiser had no comparable sales data although he had searched for it. He argued for a 20% discount. In both cases, the IRS argued that no discount should be allowed because there was no factual data to support a discount.

The court noted that comparable sales data would have been very desirable if the taxpayer wanted to support higher discounts. Nonetheless, the court recognized the difficulties in selling undivided real estate interests. In both cases, the court noted that the IRS did not present any evidence that a discount should not be allowed. In both cases, the court agreed that a 15% discount should be applied.

Note: The Feuchter case involved a 57.13% partnership interest. The case never discussed the terms of the partnership agreement. Depending on the rights of the partner, discounts for lack of control and lack of marketability may also have been supportable as they were in the partnership valued in the Moore case.

Real Estate Case Analyses

With many similarities existing among these cases, it may be of interest to consider the differences:

The discount of 57% in Campbell exceeds the 35% discount in Moore even though the companies have similar investment characteristics. The major difference between the two cases is the much greater weight given to capital market evidence by the valuation experts, particularly the taxpayer’s expert, in the Campbell case.

In the Berg case, the court did not accept the taxpayer’s reliance on discounts from other cases because discounts must be based on the specific, relevant facts and circumstances of the particular case at hand. The court opened the door for a higher lack of marketability discount but could not use a discount higher than 10% because of the taxpayer’s failure to present credible market evidence.

In Feuchter and Pillsbury, the court decided that a discount of 15% was appropriate even though comparable sales data had not been presented. The court noted, however, the importance and desirability of comparable sales data in support of valuation discounts. The difficulty in finding sales data supporting discounts for undivided interests in real property is well known, but convincing evidence is available to support reasonable discounts when valuing business ownership interests in real estate holding companies.

In today’s depressed real estate market, evidence supports combined minority interest and marketability discounts of 60% and 70% depending on the facts of each particular case. In recent settlements, IRS has accepted combined discounts of this magnitude based on Management Planning valuations. Real estate owners should act now because time may be running out on recession discounts.

Conglomerate Shareholders Awarded 333% Premium

Rapid-American Corp. and McCrory Parten Corp. v. David Harris, et. al., 603 A.2d 796
David Harris, et. al. V. Rapid-American Corp. and McCrory Parent Corp., 1992 WL 69614 (Del. Ch.)

Question: Should a holding company, Rapid-American, that owns three distinct operating subsidiary companies, be valued in a statutory appraisal action on a consolidated basis, or should it be valued on a "segmented basis" with each subsidiary valued separately by a comparative company valuation analysis? Secondly, should a control premium be added to the publicly traded equity value of each of the subsidiaries in determining the fair value of 1.2% of the holding company, Rapid-American? And finally, should the holding company’s debt be subtracted at market value or its higher book value?

Chancery Court Initially Held: Prior to the merger, Rapid-American advisors rendered a fairness opinion of $28 per share using a "consolidated basis" valuation approach. This approach was rejected by the court. The court decided that the segmented valuation basis best mirrored economic reality, in that the company’s value is best found in the sum of its parts, and that the segmented approach was not an attempt to ascertain Rapid-American’s liquidation value. The valuation of debt at market value, and not at its higher book value, also reflected the realities of the marketplace. No control premium should be applied at the subsidiary level. The court valued the stock of $51 per share.

On Appeal: The Supreme Court of Delaware affirmed the Chancery Court’s positions on all but the control premium issue. It found that the exclusion of a control premium would artificially and unrealistically treat Rapid-American as a minority shareholder in its three subsidiaries and would place disproportionate emphasis on market value. The case was remanded to the Chancery Court on that issue.

On Remand: Court of Chancery then held that a control premium of $22.29 should be added to the $51 from the original proceeding, for a fair value of $73.29 per share.

Note: These decisions represent a further evolution in legal and valuation thought regarding the concept of fair value in a statutory appraisal proceeding. Here, major emphasis was placed on enterprise or control values as opposed to minority values. To appreciate the magnitude of these decisions, the $73.29 per share value should be compared to the $17 publicly traded price of Rapid-American’s stock prior to the merger transaction. The decisions, in effect, placed a premium of 331% on the stock.

In recent fairness opinion work, Management Planning was retained by a closely owned business to help in pricing a tender offer to non-family shareholders. The company wanted to consolidate ownership and settle succession issues with family members active in the business and management of the corporation. The Board of Directors was advised by counsel to obtain a fairness opinion. MPI was selected based on our knowledge of the client’s industry and the quality of work that we had previously delivered to them. We have worked closely with many public and private corporations and their legal counsel in rendering fairness opinions.

Recent Valuation Decisions

Estate of Bessie I. Mueller v. Commissioner, T.C Memo. 1992-284

Question: What is the fair market value of common stock for estate tax purposes when a cash merger offer has been made to the company, but not yet accepted by it, three days prior to death?

Tax Court Held: Offered merger price is the starting point in determining estate tax value per share. That price is to be discontinued to reflect the associated risks of nonconsummation of the merger, threatened lawsuits from other shareholders and lack of liquidity. Total discount was set at 21%.

Note: As seen before, the Judge reiterated the position of the Tax Court on valuation questions. "We once again intone our warning to parties before this Court that we need not reconcile or average the opinions of experts. We may choose one approach over another, resulting in a windfall for one party and a disaster for the other." See Buffalo Tool and Die Mfg. Co. v. Comm., 74 TCM 441, 452 (1980).

See Tax Planning Tip for extraordinary condemnation of the IRS expert witness by the judge.

Estate of Sidney M. Friedberg v. Commissioner, T.C. Memo. 1992-31

Question: What is the estate tax value of shares of restricted stock in a publicly held company? What discount should be applied to a large block of shares?

Tax Court Held: After rejecting the IRS report, the court found substantial agreement among the other experts and was persuaded that the value of the shares fell within the range established but could not pick an exact figure within the range. The court was unable to conclude the shares were worth less than the greatest reasonable estimate provided and so accepted the $9,193,510 of one of the reports which was a 30% discount from the NASDAQ market price.

Note: Generally, the market price of an actively traded, publicly held stock is the best evidence of its fair market value. However, in the case of a large block of restricted shares, some discount is in order. Events subsequent to death are not considered in fixing the fair market value except to the extent they were reasonably foreseeable at the date of evaluation. See Estate of Gilford v. Comm., 88 TCM 38, 52 (1989) in which MPI provided credible expert testimony on the size of restricted stock discounts.

Ansan Tool and Mfg. Co. v. Commissioner, T.C. Memo. 1992-121

Question: For income tax deduction purposes, is part of the payment made to a 50% shareholder to purchase his interest in a corporation allocable to his covenant not to compete? If so, what is the value of this covenant?

Tax Court Held: The Court accepted the expert whose opinion most "fully reflected the economic reality" of the situation and allowed the deductions of $876,908 which had been claimed by the taxpayer. The value of the covenant was amortizable over 5 years, the duration of the noncompetition period. The Court agreed that a valuation premium could be placed on the covenant because there was a clause in a promissory noted due to the shareholder that would force the company to default if it did not meet minimum credit guidelines and there was substantial risk of such default if the shareholder was free to compete.

Tax Planning Tip

Estate tax planners should take notice that in many recently decided cases the Tax Court is stressing its position that "the Court need not reconcile or average the opinions of experts. We may choose one approach over another, resulting in windfall for one party and a disaster for the other." Both the Mueller and Ansan Tool cases quoted Messing v. Comm. 48 TCM 502, 512 (1967) which said in part that valuation questions are "capable of resolution only by Solomon-like pronouncement." More than ever, the courts are rejecting valuation opinions based on assertions rather than proof. To avoid an unfavorable settlement or decision in the future, transactions should be based on sound, supportable business valuations prepared by an independent expert.

The Mueller case illustrates the value of strong, independent expert witnesses. In that case, the judge leveled severe criticism at the IRS expert witness. In his decision the judge called the witness a "results-oriented" "shill," whose report and testimony lacked the objectivity endorsed in Estate of Halas v. Comm., 94 TC 570 (1990). This extraordinary criticism reminds us that the best interests of each party are protected when the independence and integrity of the expert is protected and maintained.

MPI Delivering Valuation Studies Based on Chapter 14 Regulations

The Internal Revenue Service has issued its final regulations (and a set of technical corrections to these regulations) under Chapter 14 of the Internal Revenue Code. These regulations clarify many questions which were left unanswered by the statutory provisions but they also introduce a level of detail which will make most transactions fairly complex. In the case of estate freezing corporations or partnerships, the final regulations specify intricate rules for determining what interests and transactions are subject to Chapter 14 and for allocating value among the different equity interests in a corporation or partnership when Chapter 14 applies.

Application of the specified allocation procedure will often require a number of intermediate steps and preliminary valuations. These include such things as the application of special rules to determine various types of direct and attributed ownership; valuation of the corporation or partnership on an enterprise basis (even though all gifts were of minority interests); valuation of some preferred equity holdings under special rules which permit only limited attitudes (e.g. voting rights) or portions of the holdings (e.g. amounts exceeding the family interest percentage) to be considered for Chapter 14 valuation purposes; and determination of appropriate minority interest and lack of marketability valuation discounts.

Now that the final regulations have been issued, more and more individuals and their professional advisors are considering the creation of new estate freezing corporations or partnerships and transfers of interests in existing freeze entities. There has been particular interest in estate freezing transactions on the part of individuals with real estate holdings. The depressed value of much real estate makes this an especially suitable asset for estate freezing at the present time.

Management Planning has a long history of structuring successful estate freeze transactions for our clients and with the publication of the Chapter 14 regulations we can help business owners and their professional advisors determine whether or not Chapter 14 estate freezing is desirable for them. MPI has already provided valuation consulting services and delivered Chapter 14 valuations for a number of clients in connection with such transactions.

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