Article: "Family Limited Partnerships and Valuation "
Cases:
· Ford (T.C. Memo 1993-580)
· Hutchens (T.C. Memo 1993-60)
· Jung (101 T.C. No. 28)
· Reich ("Kroy")(89-CIV-8361, SDNY)
· Newman/Shay, "Pacific Architects and Engineers" (District Court Central District of California, No. CD91-145 DT)
Family Limited Partnerships and Valuation
Family limited partnerships are one of the hottest estate planning tools in use today. Revenue Ruling 93-12 removed any lingering question as to family attribution of minority, fractional interests and many estate planning professionals are creating family partnerships where real estate, securities and cash are the underlying assets. Minority limited partnership interest, when gifted, can be valued at significant discounts from underlying net asset value. The valuation support for these discounts involves proven valuation techniques which Management Planning has successfully used and defended for many years.
As with the transfer of any closely owned, noncontrolling interest in an enterprise, the basis for discounting transferred minority interests is that they are worth less than their pro rata share of the entire asset, or enterprise. Minority interest positions have limited powers and lack marketability. The sequential application of minority and marketability discounts to limited partnership interests is well supported and well accepted.
Valuation in a family limited partnership context requires consideration of many factors. Minority interest discounts are affected by cash distributions, size, financial leverage, portfolio diversification, management depth and quality, investment performance, types of assets held and rates of return. MPI’s ongoing, proprietary study of private placements of restricted stocks (SEC Rule 144) provides strong support for marketability discounts. Marketability discounts in FLPs are affected by transferability restrictions, withdrawal rights and other partnership terms as well as by capital market evidence.
In many family limited partnership agreements we see, limited partners have:
No participation in management,
No ability to force liquidation,
No ability to get their pro rata share of net asset value,
No ability to control cash distributions, and
A right to the fair market value of their partnership interest based on the withdrawal or repurchase provisions of the agreement.
In order to value interests in a family limited partnership, an appraiser would need a beginning balance sheet, the market value of the assets, pro forma income statements, a draft of the partnership agreement, and access to management/owners for the purpose of conducting due diligence interviews.
Based on our vast experience in valuing real estate partnerships, asset holding companies and FLPs, we have a solid understanding of the discounts which can be supported. These discounts depend on the structure of the partnership and the underlying assets. In creating a family limited partnership, it is important to understand the valuation parameters in the initial stages. A well considered and properly structured family limited partnership can be a very effective gift and estate planning tool.
Recent Valuation Decisions
Estate of Ray A. Ford, Deceased, Jack F. Ford and Richard A. Ford, Personal Representatives v. Commissioner T.C. Memo. 1993-580, Filed December 8, 1993
The primary valuation issue in this case was the estate tax value of the decedent’s interest in five closely held companies. Decedent died on April 3, 1988 and was a resident of Omaha, Nebraska. At the time of his death, he owned the following three minority and two controlling stock interests:
| The Companies | Ownership Percentage |
| Ford’s Mercantile Warehouses Co. Ford Bros. Real Estate Company R.A. Ford Dodge Real Estate Co. Ford Bros. Van and Storage Co. Ford Storage and Moving Co. |
6.80% 36.41% 41.42% 92.41% 74.56% |
The first four companies were primarily asset holding companies (cash and real estate). Ford Storage and Moving Co. had substantial nonoperating assets and intercompany ownership. It operated a household and commercial goods storage and distribution business. The assets of all the companies were in Omaha.
In reaching a decision, the judge concluded that primary consideration should be given to earnings when valuing operating companies and that asset values (adjusted to fair market value) should be given the greatest weight in valuing the stock of a holding company. The court also understood the difference between minority and marketability discounts and concluded that they should both be deducted in the valuation of minority interests in these closely held holding companies.
The petitioner’s expert valuation was prepared by a college finance professor and was based on the book values of the companies and a multiple of their earnings. The Court found it to be carelessly prepared and flawed and did not accept it.
The valuation expert hired by the IRS computed the net asset value of each company after considering the fair market values of the underlying assets. A 20% minority discount and a 10% marketability discount were then deducted in valuing the minority stock interests. The decision does not explain the methodologies employed to support these discounts. The IRS expert allowed no discount in valuing the controlling interests.
The judge agrees with the 20% minority and 10% marketability discount of the IRS expert because the expert "explained how these discounts were derived and set forth the factors considered in developing them."
Note: The minority discount of 20% does not seem unreasonable considering publicly traded guideline company market relationships prevailing in 1988. The 10% marketability discount seems far too low in view of capital market evidence available to support such discounts. The petitioner’s expert offered a 33% marketability discount but did not explain his support for the discount to the satisfaction of the judge.
The judge disagreed wit the notion that a marketability discount should not be deducted in valuing the two controlling interests. He found that there was no market for the shares of the two companies. Given the size of the companies, their quality and the relationships among the companies, he concluded that a 10% marketability discount should be deducted.
Note: In another recent tax court decision (Estate of Charles Russell Bennett, Deceased, Eva F. Bennett and Don R. Paxson, Co-Executors v. Commissioner T.C. Memo. 1993-34), a 15% marketability discount was deducted in the valuation of a 100% controlling interest in a real estate holding company.
We have yet to see a court decision though, which considers a capital gain discount in valuing a controlling interest in a holding company with appreciated assets. The economic arguments for such a discount are compelling.
COMMENT: Appraisal credentials continue to receive recognition by judges. In Ford, the independent fee appraisers hired by the IRS were professional appraisers and credentialed members of appraisal societies. The petitioner’s expert did not have the credentials normally seen among valuation experts. As a college professor, he did not belong to a professional appraisal society and was not a full-time business appraiser.
Lewis G. Hutchens Non-marital Trust v. Commissioner, T.C. Memo. 1993-60, Filed December 16, 1993.
The estate, income and gift taxes due on a classic preferred stock freeze are the valuation questions in the Hutchens case.
1. Was a gift made in exchange of common stock for preferred stock in a 1982 estate freeze transaction?
2. Were gifts made by decedent and spouse to common stockholders because preferred stock dividends were not paid?
3. Under 2036, was the date of death value of the 83% interest held before the recapitalization includable in the gross estate?
4. Was the fair market value of preferred stock in the estate equal to the redemption price paid nine months after death? Did the redemption from the surviving spouse’s trust result in a gift to their son, the sole remaining stockholder?
In answering these questions the IRS claimed deficiencies in income, estate and gift taxes and penalties of $44,239,000. The preferred stock recapitalization occurred on September 27, 1982. The date of death was March 1, 1985.
These same issues were the subject of much discussion in the legal and appraisal professions in the heyday of the preferred stock freeze. The facts presented suggest that the IRS was correct in its challenge and its assessment of taxes and penalties. The judge, however, found for the taxpayer.
COMMENT: While generally disregarded today in corporate contexts, we have found that estate freezes have applicability in certain partnership situations. This very detailed case provides important lessons in preferred stock recapitalizations. Those with an interest in using freezes today should study the Hutchens decision. Those who implemented preferred stock freezes for their clients in years past must study the Hutchens case.
Estate of Mildred Herschede Jung, Deceased, Ruth J. Conway,
Executrix v. Commissioner, 101 T.C. No. 28
The question in this case was the value of a 20.83% interest in Jung Corporation on October 9, 1984, the decedent’s date of death.
Since most of the company’s assets had been sold in a series of transactions in 1986, the decedent’s estate received more than $13 million from the sales. The court determined that the sales of assets were not foreseeable in 1984 when Mrs. Jung dies. After hearing the testimony of business valuation experts, the Court valued her shares at $4.4 million, after allowing a 35% discount for lack of marketability. The Court did not allow a minority interest discount because it was concluded, after extensive testimony, that the specific discounted cash flow technique which has been employed produced a minority interest basis value. Accordingly, only a discount for lack of marketability needed to be deducted.
The Court also disallowed a significant penalty for undervaluation under IRC Sec. 6660 since the IRS had overvalued by an even greater percentage.
Reich v. Valley National Bank of Arizona, 89-CIV-8361, SDNY "Kroy Case"
Reich v. Valley National Bank, known as the Kroy case in the ESOP and valuation communities, involves an action brought against the bank as a result of the bank’s responsibilities as trustee for the ESOP of Kroy, Inc. In part, the court determined that Valley National failed to perform proper due diligence, did not determine if the price to be paid for the Kroy stock was in excess of the fair market value of the underlying stock, and failed to determine if the transaction was fair to the ESOP participants.
The court found that Valley National’s actions caused the ESOP to overpay for its shares in the highly leveraged buyout. This was based on the facts regarding the trust department’s conduct rather than on questioning any particular valuation techniques used.
The court found that Valley National had breached its fiduciary duties and had not protected the interests of the ESOP participants. In particular, they had failed to conduct an investigation in connection with the leveraged buyout, led by Kroy management, to take the company private.
This decision seems to suggest that financial advisors have a responsibility to look beyond the projections of an organization when assessing the value of a transaction and must make their own projections based on information they have gathered. As a practical mater, this can be very difficult. The case also seems to suggest that advisors need to also consider factors outside the subject organization, such as status of the industry in which the business operates.
Unfortunately, the Court gives little guidance on some major ESOP questions, such as:
1. Equity allocation in multi-investor deals,
2. What constitutes control and appropriate control premiums, and 3. Clarification of valuation standards in ESOP leveraged buy-outs.
Newman, Howard, et al, Plaintiffs v. Edward A. Shay et al Defendants, Filed 9/15/93, District Court Central District of California No. CD91-145 DT. "Pacific Architects and Engineers"
At issue in this case was whether or not the trustees of the ESOP had breached their fiduciary duties. It is of interest from a valuation point of view because the court upheld an 83% total combined discount on a 39% block of stock being sold by the ESOP to a Shay family trust.
Pacific Architects and Engineers provided architectural and maintenance services for U.S. Government installations on a worldwide basis. Started in Japan by Edward A. Shay, the company owned real estate in the U.S. and Japan and a joint venture interest in real estate in Japan. These holdings were substantial as compared to the operating segments of the business.
In the 1970s, 38% of the company’s stock was sold to an ESOP. By the 1980s, many participants had retired but still owned their shares. Members of the ESOP administrative committee were concerned about the availability of liquidity to ultimately get cash to the ESOP participants.
In November 1988, the ESOP administrative committee voted to sell the 38% ESOP block to an irrevocable trust of which Allan Shay, Edward’s son, was the sole beneficiary. This created a situation whereby a control stockholder was buying back stock from the ESOP. Plaintiffs for the ESOP beneficiaries alleged a series of breaches of fiduciary duty on behalf of Shay and company executives who were members of the ESOP administrative committee.
The valuation issue was mainly over the minority and marketability discounts determined and applied by the ESOP appraiser. The plaintiffs did not dispute or offer an evidence regarding the values of the underlying assets.
The gross value of the assets was $83,000,000 and the net value of all the common stock after minority and marketability discounts was $14.4 million, for an 83% discount. The appraiser indicated that the use of the valuation approach and related discounts were necessary "to induce an outside third party purchaser under a willing buyer and willing seller test." In reaching a decision, the court accepted the appraiser’s minority discounts but was troubled by the 50% marketability discount because there was a specific buyer, The Shay Trust, standing ready to provide liquidity.
A supplemental appraiser testified that the approach and methodology of the ESOP appraiser complied with normal standards of appraisal practice in using minority and marketability discounts. He supported the 50% discount by saying that a marketability discount of at least 35% should be used for restricted stock of publicly traded corporations, and that an additional discount of 15% should be warranted because there was no mandatory put option: Without a put and in the absence of funding by Pacific Architects and Engineers, beneficiaries would be left holding "paper certificates." He further testified that a 50% discount was justified by:
1. Lack of dividends due to insignificant historical earnings,
2. PAE’s return equity was under 1%, and
3. Cash flow of PAE.
The court could not find that the discounts taken by the ESOP appraiser were improper or excessive and concluded that the appraisal presented a fair valuation to the plan fiduciaries and that the ESOP appraiser used met the criteria for an independent appraiser spelled out in the Internal Revenue Code.
By relying on the independent appraisal, the fiduciaries did not breach their fiduciary duties. Donovan v. Cunningham, 716 F.2d 1455, 1465 (5th Cir. 1983) was noted, which said that the fiduciaries do not have to be valuation experts because they can rely on the expertise of others.
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