Article: "Estate Planning and Valuation "
Cases:
· Luton (T.C. Memo 1994-539)
· Lauder (T.C. Memo 1992-736)
· Meyer (U.S. Court of Appeals, Second Circuit, April 13, 1994, Nos. 676, 93-6171)
Estate Planning and Valuation
These are exciting times for tax planners. As we travel the nation, we see a renewed interest in estate planning for owners of private business interests. We see several forces driving this:
· The Revenue Reform Act of 1990 and Revenue Ruling 93-12 codified new ideas and removed any doubt about family attribution and minority discounts.
· Court decisions have consistently supported minority and marketability discounts.
· A massive generational transfer of business interests and wealth is underway.
· Articles in magazines such as Forbes about GRATs, FLPs and other vehicles have created the most knowledgeable group of clients we have seen in over 55 years in this business.
A key to much of today’s planning is sound valuation work. The role of valuation issues in the court decisions and TAMs in this report is ample evidence of the importance of defensible valuations.
We work with trust, estate and tax practitioners in all 50 states. As much of our valuation practice is involved in the estate and succession planning for private business interests, we are directly involved in the wide range of techniques available today. Gifts from family limited partnerships can take advantage of annual exclusions and the unified credit. Combined with GRATs for additional leverage, significant wealth can be transferred to family members. We see FLPs funded with portfolios of marketable securities, real estate, closely held stock and combinations thereof. Discounts in partnership contexts are well supported by capital market evidence and court decisions. Partnerships can also be used in estate freezing transactions. Recapitalizations with nonvoting stock can facilitate wealth transfer while maintaining control and addressing the needs of children in and out of the family businesses. Gifts of minority blocks of closely held stock, either outright or in conjunction with GRATs and FLPs, are commonly used.
Legal and valuation opinions are often intertwined. Appraisers may need legal guidance, for example, on Chapter 14 issues in partnership scenarios, particularly Section 2704(b) regarding applicable restrictions. Our experience with a wide variety of private business interests and planning techniques can be valuable to you and your clients. Please do not hesitate to contact us if we may be of assistance.
Recent Valuation Decisions
Estate of William F. Luton v. Commissioner, T.C. Memo 1994-539 Filed October
27, 1994
Mr. Luton owned common stock in two S corporations, 78% of a ranch and 33% of a duck
hunting preserve, both of which were located and incorporated in California. This decision
valued his shares for estate tax purposes as of October 27, 1987.
The valuation positions were as follows:
| 78% Interest in Ranch | 33% Interest In Preserve | |
| Estate Estate IRS Court |
$2,900,000 - $5,336,000 $4,493,000 |
$ 505,000 |
In both valuations, the appraisers and the court concluded that the starting point was net asset value based on appraisals of the underlying realty assets. The IRS and the estate hired independent business appraisers to address discounts and other valuation issues.
In valuing the 78% controlling interest in the ranch corporation, one of the estate’s business appraisers used a liquidation analysis because development of the property was restricted for at least 10 years. The appraiser subtracted transaction costs, state and federal capital gains taxes and a 40% marketability discount. The IRS appraiser deducted only a 5% marketability discount due to the powers of the controlling interest and asserted that the S status avoided potential capital gains taxes.
The court did not directly discount for potential gains taxes but concluded that, even with the S status, some recognition of potential taxes should be considered in the lack of marketability discount. The court indicated that closely held stock should be discounted for lack of marketability, and that the discount should reflect development restrictions on the land and that the assets of the company were not liquid. In valuing the 78% controlling interest, the court reduced net asset value by a 20% marketability discount.
In valuing the 33% minority position in the duck hunting preserve, one of the estate’s appraisers used a liquidation value approach and deducted transaction costs, capital gains taxes and a 35% minority interest discount. In reaching a value of $642,000, it is only revealed that the estate’s other appraiser used a comparable company approach. Although no details are provided, it can be determined that his conclusion represents a 60% discount from net asset value. In deducting a 10% minority discount, the IRS appraiser gave weight to the protections offered a one-third interest under California law. She did not deduct any discount for marketability or capital gains taxes.
After considering the expert testimony, the judge valued the 33% minority interest by deducting a 15% minority discount and a 20% marketability discount, for a combined discount of 35% form net asset value. Liquidation cost and capital gains tax discounts were rejected because a liquidation was not planned. The comparable approach was rejected because the comparables were not sufficiently similar to the subject company. Safeguards under California law reduced the size of the judge’s minority discount. The marketability discount was based on the expert reports and evidence submitted.
COMMENT: The court’s valuation conclusions are closer to the IRS positions than to those of the taxpayers and this case looks like a win for the IRS. The IRS lost on the discount issues, though, because a 20% marketability discount was allowed on a controlling interest and both minority and marketability discounts were allowed in valuing the minority interest. The facts of the case do not seem to support the taxpayer’s liquidation cost and tax discounts. The judge’s position on those issues seems fair in this instance but in other circumstances a capital gains discount can be justified.
Estate of Joseph H. Lauder v. Commissioner, T.C. Memo. 1992-736. Filed December 30, 1992.
This decision was the third in a series of three concerning the estate tax valuation of Joseph H. Lauder’s 20% common stock interest in EJL Corporation as of the date of his death, January 16, 1983. EJL Corporation, a holding company with Estee Lauder, Inc. and other subsidiaries, is a major producer of cosmetics and fragrances.
In the second Lauder case (T.C. Memo 1990-530) a mandatory buy-sell agreement and its book value-based pricing formula was found to be testamentary in intent and to be disregarded for estate tax purposes. This decision set the stage for the third trial, at which the fair market value of the estate’s shares was determined. The estate’s appraiser used ten guideline companies to develop a price-earnings ratio for valuing EJL. After detailed consideration of the investment characteristics of EJL versus each of the public companies, the appraiser concluded that a multiple of 12 times recent earnings should be used. A 50% marketability discount was deducted due to lack of a public market, unavailability of detailed financials, the desire to keep the company private, no regular dividends and inherent potential for corporate structure conflicts of interest.
Even though the pricing formula of the buy-sell had been deemed irrelevant in the second trial, the estate’s appraiser presented valuation testimony which considered the agreements and aspects of it. Testimony from a buy-out firm indicated a value of 2.5 times recent earnings. Testimony from a college professor supported a marketability discount of 90%. All of these supplemental approaches were ultimately disregarded by the judge.
The appraiser hired by the IRS primarily relied on a publicly held guideline company valuation approach but also utilized initial public offering and merger and acquisition analysis valuation approaches. The IRS appraiser arrived at a multiple of about 18.0 times earnings to derive a value which was then reduced by a 40% marketability discount. No weight was given to the shareholder agreement.
What did Judge Hamblen decide? Among other things, he reiterated his previous conclusion that the shareholder agreement had a testamentary purpose. He disregarded the book value pricing formula of the agreement for estate tax purposes. He did note, though, that the agreement confirmed the family’s commitment to keep the company private and that this should be considered in setting the size of the marketability discount.
The judge found that the "comparative valuation approach, emphasizing the price/earnings ratios of comparable companies within the industry, provides the most objective and reliable basis for determining the fair market value of the stock in question." After considering positive and negative aspects of EJL compared to the guideline companies, the judge picked a multiple of 12.2 times earnings. The court disagreed with the up to 90% marketability discounts of the estate’s appraisers because EJL represented a sound and not a speculative investment. The judge decided to use a 40% marketability discount.
COMMENT: The use of the comparable or guideline approach and the use of price-earnings ratios for valuation purposes was certainly endorsed by this decision. The 40% marketability discount is at the top end of the range normally seen in court decisions, particularly in view of the size and stature of the subject company, but is in line with a trend of larger marketability discounts in tax court decisions.
Estate of Eugene Meyer, III, v. U.S.A., U.S. Court of Appeals, Second Circuit, April 13, 1994, Nos. 676, 93-6171.
At issue in this case was the estate tax value of 743,500 shares of Class B common stock of the Washington Post Company. The valuation date of death was February 24, 1982.
Meyer was a member of the board of directors of the Washington Post Company, which publishes newspapers and magazines including the Washington Post and Newsweek. The estate held about 6.5% of the outstanding Class B shares. SEC Rule 144 limited the methods by which the bulk of the estate’s shares could be sold.
In May and June of 1982 the estate sold 211,000 Class B shares under Rule 144 under a registration exemption which allows the sale of a limited number of shares. The shares were sold at about $35.00 per share.
To dispose of the remaining shares the executors decided that an underwritten secondary offering would yield the highest price. In July 1982 an additional 422,500 shares were sold by Salomon Brothers for $14 million, or $34.00 per share. The expenses of the offering were $213,000 (accounting fees, legal fees, printing fees, etc., but not underwriting fees). As compensation, Salomon was allowed to keep possession of the proceeds of the sale until 90 days following the sale.
For estate tax valuation purposes the estate also retained Salomon. Salomon considered the price, expense and yield that could have been obtained in a secondary offering immediately after death. In an opinion rendered in November 1982, Salomon reached a conclusion that an offering would have netted $25.3725 per share, as follows:
| Mean Open Market Price Less: Blockage Discount Underwriting Fee Other Expenses |
$28.3750 |
| Net Yield | $25.3725 |
The estate used the Salomon conclusion for estate tax purposes. The estate also claimed $213,142 as a deduction, those being expenses incurred in the July 1982 offering. The estate did not claim a deduction for underwriting fees in connection with the offering.
The IRS claimed that the estate’s shares should have been valued at $28.375 per share, the mean open market price, and issued a notice of deficiency of $1,100,000 plus interest of $600,000.
The court concluded that underwriting fees and other expenses should be excluded from the computation of the fair market value of the stock for estate purposes and that the value of the shares was $27.125 per share. Only the blockage discount was allowed by the court. To allow underwriting fees and expenses as valuation discounts would result in a "double deduction," as in this estate such expenses were deducted on the estate return.
COMMENT: In this situation, the blockage discount appears to have been relevant in the first place because the secondary offering was a realistic way of maximizing the value of the shares. In other cases and court decisions a private placement, and not a secondary offering, was a realistic alternative and valuation experts and the courts have looked to private placement discounts which can range upwards of 30% to 35%.
Recent Technical Advice Memorandums
Technical Advice Memorandum 9436005, Published September 9, 1994
In this TAM the IRS asks if the "swing vote" attributes of each of three 30% blocks of stock should be considered in determining the fair market value of the stock for gift tax purposes.
In the facts presented, a donor owned 100% of the stock of a corporation and made three 30% gifts to each of three children and a 5% gift to a spouse. After the gifts, the donor owned 5% of the outstanding shares. The shares were valued at $50.00 per share (the net asset value of the stock) less a 25% discount for minority interest and marketability.
Revenue Ruling 93-12 is noted, in which a donor transferred all of his stock in simultaneous 20% gifts to five children. The ruling noted that the factor of corporate control in the family is not considered in valuing each gift for gift tax purposes and that a minority discount will not be disallowed.
Referring to the Estate of Winkler v. Commissioner, T.C. Memo. 1989-232, the TAM cites the fact that 10% of the voting stock had special "swing vote" characteristics because the remaining shares were in 40% and 50% blocks held by different families. By joining with the 40% block, a 10% block could block corporate action while joining with the 50% block could provide the minority 10% shareholder with a share in control over the corporation.
In the TAM, the IRS concludes that each 30% block has "swing vote" characteristics and that the extent to which the "swing vote" enhances value is a factual determination. The IRS concedes that relevant factors include the minority nature of each block, the lack of marketability of each block and the "swing vote" potential. These and all other factors should be taken into account in valuing each block.
COMMENT: The logic in this TAM is appealing but weak. The value attributable to a "swing vote," if it exists, is highly speculative. For a willing buyer to pay any "swing vote" premium he would need the assurance of continual cooperation with the other 30% owner. This might not occur. The ability of any controlling stockholder or group of stockholders to control a corporation is seriously restricted by fiduciary obligations to other minority stockholders. A combined 60% block might only represent working control and not absolute control in states where two-thirds of the votes are required for complete control.
TAX TIP: Owen Fiore, a noted estate tax commentator from San Jose, California, suggests a way around the swing vote issue. By doing a recapitalization of the company and gifting nonvoting common stock you avoid any conflict with this issue. In short, "You can’t swing if you don’t vote."
Technical Advice Memorandum 9432001, Published August 12, 1994
Here, the IRS asks if the value of a 49% block of stock is to be determined without reference to a 51% block of stock that is owned by the decedent’s son and to whom the 49% block is bequeathed for estate tax purposes.
After citing Revenue Ruling 93-12 and cases such as Bright, Propstra, Lee and Zaiger, the TAM concludes that the key to valuing closely held stock for estate tax purposes is to determine the price that a willing buyer would pay a willing seller for those particular shares. The relationship of the legatee and the number of legatees to which the shares are to pass are not relevant in valuing the shares in the estate. The factor of corporate control in the legatee after the decedent’s death is not considered in valuing the gross estate.
Having said this, the TAM notes that the size of the minority interest held by the estate may affect the amount of the discount placed on the shares.
COMMENT: Any ruling which reinforces the notion that minority interest discounts can be applied for estate tax purposes is welcomed. This TAM properly recognizes the importance and long standing acceptance of the hypothetical willing buyer and willing seller test in the valuation of minority blocks of stock. We will let the reader decide if this TAM is in conflict with the "swing vote" TAM discussed above.
back to library