MPI - Business Valuation Reports

Article: "ACCOUNTING STANDARDS AND VALUATION - STOCK OPTIONS "

Cases:
· McLendon (Court of Appeals No. 94-40584)
· Mandelbaum (T.C. Memo 1995-255)
· McCormick (T.C. Memo 1995-371)
· Frank (T.C. Memo 1995-132)
· Trenchard (T.C. Memo 1995-121)

Of Special Interest - AFHE Association Forms

ACCOUNTING STANDARDS AND VALUATION - STOCK OPTIONS

Valuation, currently recognized as an important element in estate planning, is now of prominence in accounting for stock options. For some time the Financial Accounting Standards Board has struggled with the proper way to give financial statement recognition to the compensation cost implicit in the granting of stock options. After extensive consideration of an exposure draft, in November 1995 the FASB issued its Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation."

SFAS No. 123 requires that the fair value of stock options granted to executives and employees be determined and that, at a minimum, the compensation cost of the stock options should be reflected in pro forma disclosures in statement footnotes. This requirement is less rigorous than the original exposure draft, which would have required that the option-related compensation cost be deducted in the computation of net income.

Under SFAS No. 123, the fair value of stock options is determined using an option-pricing model which takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, anticipated dividends and the risk-free interest rate over the expected life of the option. Option pricing models such as Black-Scholes, adjusted for dividends, and binomial models are recognized for use with SFAS No. 123. Guidelines are provided for making assumptions with respect to factors such as expected life. Non-public, closely held entities are permitted to exclude the volatility factor in determining the fair market value of their stock options.

SFAS No. 123 is effective for transactions which are entered into in fiscal years which begin after December 15, 1995. MPI's valuation professionals are experienced with option pricing models and the requisite software, and we have already helped our clients meet the accounting and valuation requirements of SFAS No. 123. Our knowledge of this subject is growing, even as legal and accounting professionals become familiar with it. We look forward to working with you and expanding that knowledge as we serve our clients.

RECENT VALUATION DECISIONS

Estate of Gordon B. McLendon, Petitioner-Appellant v. Commissioner, Respondent-Appellee, U.S. Court of Appeals, Fifth Circuit, December 28, 1995. No. 94-40584 (96-1 USTC PAR 60)

This Appeals Court decision may be of interest to those practitioners concerned about the applicability of IRS Section 2704(b)(2) in a family partnership context. Section 2704(b)(2) raises questions about the valuation significance of deemed "applicable restrictions." The 5th Circuit reversed the Tax Court Memorandum opinion and remanded the case, holding that if a partner assigns an interest and does not receive the consent required to make the assignee a partner, then the interest transferred is only an assignee interest. An assignee interest must be valued in view of its limited rights and not as a partnership interest.

In March 1986, Gordon R. McLendon, a fabled Texas broadcaster, transferred partnership interests in two family partnerships to his children in exchange for a private annuity. In the exchange, a 30% general partnership interest in Tri-State Theaters was valued at $9,500,000 and a 46% general partnership in McLendon Co. was valued at $4,200,000. Tri-State Theaters leased real estate for drive-in theaters. McLendon Co. held real estate, ancient coins and antiquities and money funds. Both partnerships prohibited the transfer of partnership interests without the consent of all partners. Under partnership amendments, each partner waived the right to dissolve and terminate the partnership. The valuation and taxation of the transferred interests turns on the characterization of those interests under Texas limited partnership law and on estimating McLendon's life expectancy.

McLendon was diagnosed with esophageal cancer in May 1985 but in February 1986, just prior to the date of the transfer, his doctor wrote that the cancer was in remission and that McLendon could plan for the future. Despite this prediction, Gordon died on September 5, 1986 from the cancer. The remainder interest in the transferred assets was valued after reference to the IRS tables (assuming a 15 year life expectancy). The annuity payments were established, and an initial deposit of $250,000 was made. The estate asserted that Gordon had received full and fair consideration for the assets transferred in the annuity transaction.

In the Tax Court the IRS disagreed, asserting that the Tri-State interest was worth $43,940,000 (not $9,500,000), that the McLendon Co. interest was worth $11,376,000 (not $4,200,000) and that a gift had been made. The estate argued that the IRS overvalued the transferred interests by treating them as partnership interests instead of mere "assignee" interests, because a transfer of a partnership interest was prohibited by state law without express consent of the other partners. The Tax Court found that the transfers were intrafamily, not at arm’s length, had testamentary objectives and that full partnership interests had been transferred. An additional $12,500,000 in estate and gift taxes was assessed.

The Appellate Court found that the Tax Court had focused too heavily on the family relationships and had neglected to consider Texas partnership law. Significantly, there was no formal consent by all of the partners to the transfer of the partnership interests in the annuity transaction. Also, leaving relatively powerless assignee interests to his litigious daughters was consistent with McLendon’s estate plan.

The Appellate Court remanded the case, requesting that the Tax Court view the transferred interests as assignee interests.

COMMENT: In some state partnership statutes limited partners may have a withdrawal right, unless a definite term of years for the partnership is specified. If a transferred partnership interest is a mere assignee interest, it will not have a withdrawal right, a circumstance which could obviate the applicable restrictions issue presented by 2704(b)(2) for valuation purposes.

Bernard Mandelbaum, et al. v. Commissioner , T. C. Memo 1995-255. Filed June 12, 1995.

The issue here was the size of a discount for lack of marketability. The court's opinion is particularly useful because it methodically walks the reader through each factor considered in determining the size of the discount.

The case involved gift tax values of minority stock interests in Big M, an operator of women's apparel stores in six eastern states. The stock's freely traded value (its price as if publicly traded, which includes a minority interest discount) was stipulated by the parties. The company was entirely family owned and there were shareholder agreements in force during the 1986 to 1990 period when the gifts were made. The agreements, one in 1982 and another which replaced it in 1988, were clearly designed to keep Big M privately held and family controlled. They contained typical stock transferability restrictions, although right of first refusal language did not mention price or a pricing formula.

The IRS appraiser relied on published restricted stock studies to support a marketability discount. The studies compared the prices paid in private transactions of restricted stock of public companies with prices of the stock when publicly traded. He found that restricted stock generally sold for 30% to 35% less than unrestricted stock and concluded a 30% discount. He did not feel the shareholders' agreements affected marketability one way or the other.

The family argued that the discount should be much higher because Big M stock was "virtually illiquid." After using restricted stock studies (35%) and IPO studies which compared stock prices before and after their IPO's (45%) as a starting point, its expert placed heavy emphasis on the shareholders' agreements. He said an investor would require a 35% to 40% rate of return for an investment in Big M and assumed a holding period of 10 to 20 years for the investment to become liquid. Based on such holding periods and required rate of return, he calculated a range of 70% to 75% for a marketability discount.

The court decided that the discount should be 30%, the IRS number, but did so after finding many weaknesses in the arguments of both parties. The assertion that a willing buyer would demand a 35% to 40% return on his investment was unrealistic because the rate would not apply to all types of investors. On the other hand, the IRS had given too little weight to transferability restrictions in the shareholders' agreements and should not have relied solely on restricted stock studies.

The court analyzed a list of ten factors in arriving at a 30% discount for lack of marketability, including factors such as financial statement analysis, dividend policy, management and transferability restrictions. Big M's profitability, good growth potential, sound capitalization, diversification and strong management persuaded the court, and these characteristics were pivotal in the judge’s analysis.

COMMENT: If stock of a company as large and sound as Big M merits a 30% discount, should the discounts applicable to smaller or more speculative companies or partnerships be larger? The clear victor in this case is marketability discount valuation methodology. Both sides used an analysis of private placements of restricted stock to support marketability discounts and the court implicitly accepted the validity of this approach. At MPI, we have used and refined the restricted stock approach for many years and do our own proprietary research in this area.

Estate of Lucile McCormick v. Commissioner, T.C. Memo 1995-371. Filed August 7, 1995

A major concern in valuing a general partnership interest is whether the partner can force liquidation and get his or her pro rata share of the assets. This was a key issue in the McCormick case and its resolution in the family's favor allowed MPI to present successful expert testimony on valuation discounts through our President, Robert P. Oliver.

Two general partnerships held and developed tracts of land in Arizona and were engaged in the sale of developed but unimproved building lots. General partnership interests ranging from 1/2% to 14% had to be valued for both gift and estate tax purposes as of dates in 1986, 1987 and 1988. MPI had not prepared valuations for filing purposes but was retained after an IRS challenge to the filing values.

The partnership agreements did not contain dissolution provisions. However, North Dakota law allowed a partner to withdraw at will and, the IRS contended, thereby access "some form of liquidation value based on his percentage interest." The court said:

"We tend to agree with petitioners on this point because liquidation value in the setting of this case would not be readily available to a holder of a small percentage of these family partnerships. In that connection, it is less likely that a willing buyer would purchase any of the interests under consideration for the purpose of liquidating the underlying assets. It is more likely that a willing buyer would seek to invest in what appears to be a profit-making and ongoing business."

The court did not agree with the family's values for the partnerships' underlying assets and increased them substantially. This made the application of valuation discounts all the more critical.

MPI's traditional approach to developing minority discounts by analyzing market value to net asset value relationships of publicly traded REITs was accepted. Furthermore, combined minority and marketability discounts of up to 47% were sustained for valuation dates when prevailing minority discounts in the real estate industry were much lower than those seen in today’s market.

COMMENT: Since the McCormick case involved general partnerships, it is a favorable decision for clients with plans to establish family real estate limited partnerships, in which somewhat higher discounts are usually supportable.

Estate of Anthony Frank v. Commissioner, T.C. Memo 1995-132. Filed March 28, 1995

The Frank case is more about the validity of a death-bed gift than about valuation. Such a gift reduced the donor from a control to a minority shareholder in Magton, Inc., a family company. This case may encourage the idea that it is never too late to make a valid gift for estate planning purposes. The advantage in this instance was the resulting ability to use a minority discount and probably a higher marketability discount in valuing the shares.

Anthony Frank died October 26, 1988. His son, acting pursuant to a power of attorney, withdrew stock from Mr. Frank's revocable trust and transferred it to Mrs. Frank two days before death. The gift to mom lowered dad's percentage ownership from 50.2% to 32.1%. Mrs. Frank, a minority shareholder even after the gift, died November 10, 1988. Accordingly, the two estates held minority interests and valuation discounts were available in both estates. The IRS argued, among other things, that the transfer "was made solely to obtain a minority discount in the valuation of Magton stock for estate tax purposes", while the estate denied a tax avoidance plan. Because the power of attorney specifically authorized the withdrawal of trust principal and making of gifts, the court found it unnecessary to introduce the question of motive for the transfer.

Magton, Inc. owned and operated three seaside motels in Ocean City, New Jersey and had management contracts with condominium owners in a building near one of the motels. The court decided a net asset value approach was the appropriate way to value Magton stock and then deducted minority and marketability discounts of 20% and 30%, respectively. The court's opinion does not reveal the methodology used to support the discounts.

COMMENT: Both the IRS and the taxpayer’s appraisers deducted a 20% minority discount but the IRS appraiser a marketability discount of 35%, a higher discount than the 30% used by the taxpayer. As noted above in McCormick, real estate minority discounts in today’s market exceed those of 1988.

Estate of Helen M. Trenchard, T.C. Memo 1995-121. Filed March 22, 1995

The Trenchard case tells the story of a failed attempt at a preferred stock recapitalization. The decision seems so predictable that it is surprising the matter made it all the way to Tax Court.

Three generations of the Trenchard family transferred farmland to a newly formed corporation in exchange for non-cumulative preferred stock, debentures and common stock in 1977. The senior Trenchards took back preferred stock (with voting control and liquidation preferences) and debentures while their child and grandchildren received preferred stock, debentures and all of the common stock. The IRS questioned this 1977 transaction after Mr. and Mrs. Trenchard died in 1985 and 1992, respectively, contending that they had given up more than they received and the difference was a gift to common shareholders. After rejecting somewhat shallow arguments about the family's good faith and business reasons for forming the corporation, the court resorted to its "Solomon-like" powers to determine the excess value of the property transferred over what the preferred stock and debentures were worth. The Trenchards' main hope was their expert's opinion that a 138% control premium should be added to the preferred stock's value but the court said the premium was "exorbitant." After stating that the use of voting control to force liquidation or set one's own compensation would be inconsistent with a duty of loyalty to minority shareholders, the court reviewed control premiums in past cases and reduced the premium to 40%.

Needless to say, the IRS won the case handily and the court's decision is a good lesson for families who believe that transactions between related parties are not looked at carefully. Mr. and Mrs. Trenchard were found to have transferred property valued at $2,952,748 and received securities worth only $1,281,951, resulting in a gift to common shareholders of $1,670,797. The total amount of gift tax deficiencies and penalties was over $2,500,000 which must have been devastating to the family.

COMMENT: Trenchard differs from Hutchens (T.C. Memo 1993-600, Filed December 16, 1993) in that the taxpayer lost. Given the large number of preferred stock freezes done some years ago, we expect to see more freeze cases. Because they are primarily appraisal battles, the side with the best appraisal will win.

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