Business valuation 2012 the state of things presentation

Business Valuation 2012: the State
of Things
17th Annual CalCPA East Bay Chapter
Estate Planning Symposium
L. Paul Hood, Jr.
© 2012 L. Paul Hood, Jr.

L. Paul Hood, Jr., JD, LLM

L. Paul Hood, Jr., JD, LLM
130 W. Kent Ave., Apt. 11
Missoula MT 59801
____________________
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L. Paul Hood, Jr. Is the Director of Gift Planning for The University of
Montana Foundation. He received his J.D. from Louisiana State University
Law Center in 1986 and Master of Laws in Taxation from Georgetown
University Law Center in 1988. Paul is a frequent speaker, is widely quoted
and his articles have appeared in a number of publications, including BNA
Tax Management Memorandum, CCH Journal of Practical Estate
Planning, Estate Planning, Valuation Strategies, BV Alert, Digest of Federal
Tax Articles, Loyola Law Review, Louisiana Bar Journal, Tax Ideas and
Charitable Gift Planning News.
He is also the co-author of A Reviewer’s Handbook to Business Valuation:
Practical Guidance on the Use and Abuse of a Business Appraisal (John
Wiley, 2011) with Timothy R. Lee, ASA of Mercer Capital., and Estate
Planning for the Blended Family (Self-Counsel Press 2012) with Emily
Bouchard.
He has spoken at programs sponsored by a number of law schools, including
Duke, Georgetown, NYU, Tulane, Loyola (N.O.) and LSU, as well as many
other professional organizations, including AICPA and NACVA.
From 1996-2004, Paul served on the Louisiana Board of Tax Appeals, a three
member board that has jurisdiction over all Louisiana state tax matters.

2

Business Valuation 2012:
the State of Things
In this presentation, we’ll discuss the state of
business valuation in 2012
• We’ll review selected recent court decisions with
a view toward spotting trends
• After having examined some recent valuation
court decisions, we’ll then consider the current
state of business valuation
• We’ll conclude with a review of some burning
issues in business valuation that impact BV
reports
©2012 L. Paul hood, Jr.

3

the State of Things
• We’ll review selected recent developments in
business valuation with a view toward
spotting trends
– Gallagher Est. v. Comr.
– Giustina Est. v. Comr.
– Boltar v. Comr.
– Jensen Est. v. Comr.
– The Ringgold Telephone Company v. Comr.
– IRS DLOM Job Aid

4

the State of Things
• We begin our analysis of recent developments in
business valuation with the decision of Tax Court
Judge Halpern in Gallagher Est. v. Comr., T.C.
Memo 2011-148
• The decision was appealable to the U.S. 11th
Circuit Court of Appeals, but won’t be appealed
• Prepare to be surprised by several of the Tax
Court’s findings and conclusions in this
case, which is one of the most remarkable
valuation cases in a long time for the richness of
its lessons

5

the State of Things
Gallagher Valuation Positions-Preliminary
Considerations:
• In preparation for the trial, the taxpayer
commissioned an independent appraisal of the
Paxton LLC (LLC) units versus the internally
produced valuation that was used in the Estate’s
original estate tax return filing
• The Tax Court also sidestepped the IRC Sec. 7491
burden of proof shift to the IRS by deciding the
case on the preponderance of
evidence, wrongfully in my view

6

the State of Things
Gallagher Valuation Positions-Preliminary
Considerations (cont.):
• The Tax Court noted that while the IRS
moderated its valuation position between the
time of deficiency notice (which was
quantified via an IRS engineering exercise) and
trial (where an independent appraisal was
presented), the estate’s position actually
decreased in value from the estate tax return
position

7

the State of Things
In Gallagher, the parties disagreed over the following
issues:
• the date of financial information relevant to a dateof-death valuation of the decedent’s units
• the appropriate adjustments to the LLC’s historical
financial statements
• the propriety of relying on a market-based valuation
approach (specifically, the guideline company
method) in valuing the units, and, if appropriate, the
proper manner of applying that method

8

the State of Things
In Gallagher, the parties disagreed over the
following issues (cont.):
• the application of the income approach
(specifically, the discounted cash flow
valuation method)
• the appropriate adjustments to the LLC’s
enterprise value
• the proper type and size of applicable
valuation discounts

9

the State of Things
Gallagher Case Per Unit Value Summary:
•

Return as Filed

$8,800 per unit

•

IRS Original

$12,469 per unit (Notice of proposed adjustment from IRS)

•

Taxpayer Appraisal 1 $6,702 per unit

(Schedrick, McGehee & Kohler (not used at trial))

•

Taxpayer Appraisal 2 $7,103 per unit

(AWC Advisors LLC (May Appraisal))

•

IRS Appraisal

(Prepared by David Paxton internally for options &
buy-sell agreement)

$10,293 per unit (Klaris Thomson & Schroeder, Inc. (Thomson

Appraisal))
•

Court’s Original

•
•

Court’s Corrected $9,008 per unit
Note that the “informal” appraisal performed by a non-business appraiser came closest to
the Tax Court’s corrected conclusion

$8,212 per unit


10

the State of Things
Relevant Financial Information in Gallagher
• The relevant valuation date was the date of the decedent’s death: July
5, 2004
• The issue was what financial statements should have been used
• The IRS appraiser (Thomson Report)
– Internal financials for 12 months ended June 27, 2004
– Guideline company financials as of quarter ending June 30, 2004
• The Estate’s appraiser (May Report)
– Internal financials for 12 months ended May 30, 2004
– Guideline company financials for quarter ending March 31, 2004 (June
financials not reported until after valuation date) arguing that the
hypothetical willing buyer and seller wouldn’t have known of the
latest financial statements

11

the State of Things
• The Tax Court sided with the IRS appraiser, reasoning that
the later financial statements better represented the
market conditions on the valuation date and that the
Estate alleged no intervening change in financial
condition of the LLC
• The Tax Court’s ruling on this issue totally ignored SEC
Regulation FD, which was adopted by the SEC on August
15, 2000 and became effective on October 23, 2000 and
which prohibits selective disclosure of material nonpublic information to certain parties, including
analysts, brokers, dealers, investment
advisers, investment companies and stockholders

12

the State of Things
In Gallagher, the parties disagreed over the appropriate
adjustments to the LLC’s historical financial statements;
specifically, a life insurance policy adjustment, a self-insured
health insurance adjustment and an overfunded defined
benefit plan
• The estate’s appraiser made all of the adjustments, while the
IRS appraiser did not
• The Tax Court agreed with the IRS appraiser, pointing out that
the estate’s appraiser failed to provide any explanation why
the gains in each instance were non-recurring
• Likewise, the Tax Court disregarded the other income
adjustments that the estate’s appraiser made, noting that the
court could not understand the rationale for the adjustments.

13

the State of Things
Adjustments to Subject Company Financial Statements:
•

The parties disagreed over the proper adjustments to the LLC’s financial
statements, specifically, a life insurance policy adjustment, a self-insured
health insurance adjustment and an overfunded defined benefit plan

•

Thomson and May Reports
– 2000 - Adjusted for gain on divested newspapers of $7.9 million

•

May Report
– 2003 – Eliminated $0.7 million gain on life insurance policy
– 2003 – Eliminate $1.1 million positive claim experience on Paxton’s selfinsured health insurance
– Each year – Eliminate income from overfunded defined benefit pension
plan (increasing income) and adding back to enterprise value
$11.7, amount of overfunding

14

the State of Things
• The Tax Court disregarded the adjustments in
the May Report “because we fail to
understand his adjustments”
• Likewise, the Tax Court disregarded the other
income adjustments made in the May
Report, noting that the court could not
understand the rationale for the adjustments


15

the State of Things
May Report (p. 26):
•

•

Net Pension Income (Expense).
– “The Company had an overfunded defined benefit plan, which in most
historical periods served to increase its reported net income. We have
adjusted this out in the previous schedule, to show how the Company
reported its EBITDA, but then we add the benefit from this overfunding back
in when calculating our adjusted EBITDA which we use for valuation purposes.
This is consistent with the treatment with the guideline companies (i.e., the
pension costs are included in their P&Ls).”
– Gain on Divested Newspapers “During fiscal 2003, the Company had a gain on
the divesture of newspapers. We have adjusted this out in the schedule above
as it is a non-recurring item.”
Positive Claim Experience from Company’s Self-Insured Health Insurance
– “During fiscal 2003, the Company had abnormally positive claim experience
from the Company’s self-insured health insurance. We have adjusted the
effects of this out in the schedule above as it is a non-recurring item.”

16

the State of Things
• In my judgment, the Tax Court’s position that it
couldn’t understand these adjustments was
disingenuous
• In my opinion, these adjustments could not have
been explained any better, and the court’s
conclusion that the May Report didn’t satisfactorily
explain why the items were non-recurring is
surprising to say the very least
• What else can be said about a non-recurring item
except that it is non-recurring?

17

the State of Things
• In Gallagher, the parties disagreed over the
propriety of relying on a market-based valuation
approach (specifically, the guideline company
method) in valuing the units, and, if
appropriate, the proper manner of applying that
approach
• The guideline public company method is one that
can be tricky for business appraisers because of
the size differential between most guideline
public companies and subject privately-held
companies

18

the State of Things
Guideline Company Method
•

•

•

The Thomson Report begins with 13 newspaper companies and selects four as guideline
companies:
– Journal Register Co. (11.1x EBITDA)
– Lee Enterprises, Inc. (12.4x)
– The McClatchey Co. (10.9x)
– Pulitzer, Inc. (12.6x)
The May Report selected seven newspaper companies as guideline companies:
– Gannett Co., Inc.
– The McClatchy Company
– Journal Register Co.
– The New York Times Company
– Knight-Ridder, Inc.
– Pulitzer Inc.
– Lee Enterprises Inc.
Notice that four of the guideline companies are the same, and they are in bold


19

the State of Things
Applicability of the Market Approach
• The Thomson report utilized the market approach and weighted its
indication of value 50%, while the May Report did not expressly
weight the market approach in its conclusion of value
• The Tax Court sided with the May Report, describing in detail a test
for comparability of guideline companies and finding there to be a
lack of “sufficiently similar” guideline companies (even though the
May Report identified pretty much the same guideline companies)
• However, and you wouldn’t know it from only reading the Tax Court
opinion, the May Report fully developed a market approach and
even used it to confirm its conclusion of value under the DCF
Approach

20

the State of Things
Issues with the Guideline Company Group - Thomson Report
• Size
– One third of the guideline group’s median revenue and onefourth of median assets
• Products
– Guideline companies are more diversified and have internet
components
• Other Differences
– More highly leveraged than the guideline companies
• Tax Court: “We find that Mr. Thomson improperly relied on the
guideline company method because the four guideline companies
alone were not similar enough to PMG to warrant its application.”
• This still doesn’t address the fact that the May Report fully
developed a market approach and used it to confirm value

21

the State of Things
• The May Report reached a per unit conclusion of value of
$6,293 in its Market Approach
• This is about $1,000 less per unit than its conclusion of
value under the DCF Approach
• This is about $5,000 less than the conclusion of value
that the Thomson Report reached in its Market Approach
• Why were the two reports so different on the Market
Approach?
• The May Report used an EBITDA multiple of 7.34, while
the Thomson Report had an EBITDA multiple of 10.6

22

the State of Things
In Gallagher, the parties disagreed over the application of the
income approach (specifically, the discounted cash flow
valuation method (DCF Approach))
• The Application of the DCF Method issues in dispute were:
–
–
–
–
–
–
–

Discounting the LLC’s net free cash flow
The LLC’s financial projections
Whether to tax-effect Paxton’s earnings
Cashflow adjustments
WACC
*Earnings+ adjustments to Paxton’s enterprise value
Appropriate minority interest and marketability discounts

23

the State of Things
In Gallagher, the parties disagreed over the LLC’s
financial projections
• The IRS argued that both of the appraisers should
have used the projections that a bank had prepared
in conjunction with a 2004 loan, so it argued against
its own trial appraiser in this instance
• Neither appraiser used those projections, so the Tax
Court disregarded them
• Each appraiser prepared his own projections

24

the State of Things
The Tax Court found the projections in the Thomson Report to be
more persuasive for the following reasons:
– The May Report used a growth rate that he admitted was
significantly higher than the LLC’s actual growth rate for
prior years
– Revenues from an acquisition that occurred after the
valuation date should have been included because the
acquisition was reasonably foreseeable on the valuation
date
– The May Report did not “adequately explain” its increasing
costs adjustment in its projections

25

the State of Things
Net Free Cash Flow, Tax Court?
• The Thomson Report discounts net EBITDA
– EBITDA minus projected Capital Expenditures (CapEx)
• The May Report discounts net free cash flow
– “…*C+ash *that+ is free to be paid back to the suppliers of
capital.” (Court quotes Quick MBA)
• Tax Court: “The parties have not distinguished between these two
economic benefits against which to apply the DCF method. We
shall derive the present value of PMG’s net free cashflow (net
cashflow)…..We shall construct our own operating income
projections in discounting PMG’s net cashflow.”
• The Tax Court actually projected and discounted EBITDA less
CapEx, not net cash flow, which was a mischaracterization, but the
Tax Court probably didn’t understand the difference

26

the State of Things
The Tax Court’s DCF Calculations:
Total Marketable Enterprise Value
Less Net Debt at Valuation Date
Plus Adj. for Overfunded Benefit Plans
Plus Cash Value of Life Insurance
Plus Excess Working Capital (Deficit)
Plus Tax Shield from Goodwill
Plus "Extra" Value for S Corp Benefits
Plus "Extra" Tax Shield from Higher Debt
Less In-the-Money Value of Options
Equals Marketable Minority Equity Value
Less: Minority Discount
Marketable Minority Value
Less: Marketability Discount
Nonmarketable Minority Value
Nonmarketable Minority Value Rounded
Units Outstanding (fully diluted)
Nonmarketable Minority Value Per Unit

$709,258
(243,602)

709,314

The Court

(1)
23.0%
31.0%

(17,422)
$448,234
($103,094)
$345,140
($106,993)
$238,147
$238,147
26,439

$9,007

Units Owned by Estate
Value of Estate's Interest
Value of Estate's Interest (rounded)

448,290
345,183
0
238,176

9,008

3,970

35,759,431
$35,800,000

35,761,760
Actual

27

the State of Things
To Tax Effect or Not?
• The May Report tax effects earnings of LLC at 39% blended
federal/state rate in the DCF method. It used a 40% blended
federal/state rate in building up the WACC (see p. 63, May
Report for explanation of a blended tax rate)
– The Tax Court says: “Indeed, we are also unclear as to the
source of those income tax rates. In the year in issue,
2004, the highest marginal corporate tax rate was 35%,
with the highest individual tax rate set at 39.6 percent.”
– Unrealistic for the Tax Court not to understand blended
federal/state tax rates (and to miss the clear explanation in
the May Report)
– Was using 39% and 40% an issue with credibility?
• The Thomson Report did not tax affect

28

the State of Things
• The Tax Court denied tax affecting again and was critical
of the May Report, noting:
– “*Estate’s appraiser+ failed to explain his reasons for
tax affecting *the LLC’s+ earnings and discount rate
and for employing two different tax rates (39 percent
and 40 percent) in doing so. Absent an argument for
tax affecting *the LLC’s+ projected earnings and
discount rate, we decline to do so. … *Estate’s
appraiser] has advanced no reason for ignoring such a
[corporate tax] benefit, and we will not impose an
unjustified fictitious corporate tax rate burden on
*LLC’s+ future earnings.”

29

the State of Things

• Tax Court: “*Estate’s appraiser+ tax affected *LLC’s+
earnings by assuming a 39-percent income tax rate in
calculating the company’s future cashflows, before
discounting *LLC’s+ future earnings to their present
value. He also assumed a 40-percent marginal tax
rate in calculating the applicable discount rate. In
contrast, [IRS appraiser] disregarded shareholderlevel taxes in projecting both the *LLC’s+ cashflows
and computing the appropriate discount rate.”

30

the State of Things
• Tax Court: “*Estate’s appraiser+ failed to explain his reasons for tax
affecting *LLC’s+ earnings and discount rate and for employing two
different tax rates (39 percent and 40 percent) in doing so. Absent
an argument for tax affecting *LLC’s+ projected earnings and
discount rate, we decline to do so. As we *actually, “I”+ stated in
Gross v. Commissioner, T.C. Memo. 1999-254, the principal benefit
enjoyed by S corporation shareholders is the reduction in their total
tax burden, a benefit that should be considered when valuing an S
corporation. *Estate’s appraiser+ advanced no reason for ignoring
such a benefit, and we will not impose an unjustified fictitious
corporate tax rate burden on *LLC’s+ future earnings.”

31

the State of Things
• Notwithstanding the Tax Court’s comments, the
May Report was in the mainstream of valuation
theory and practice on tax-affecting
• As you will see in a few minutes, the Tax Court’s
remark about “ignoring” the corporate tax
benefit of S corporation status simply is wrong—
the May Report added back a benefit of S
corporation status and was consistent by
deducting the impact of the income tax at the
entity level

32

the State of Things
Adjustments to Cash Flow

• The appraisers disagreed on two adjustments to cash flow:
– capital expenditures
– working capital
• With respect to the capital expenditures, the Thomson Report
projected equal capital expenditures as a percentage of
revenue, while the May Report projected unequal, but
increasing, capital expenditures. The Tax Court again sided
with the Thomson Report, stating:
– “not only does *Estate appraiser+ fail to support his
projection, but *the LLC’s+ financial statements do not
justify his estimated increase in capital expenditures.”

33

the State of Things
Working Capital Issue

• Not surprisingly, the appraisers differed on the
projected level of working capital for the LLC
• The May Report based its projection on
fluctuating levels of working capital, while the
Thomson Report based its projection based
upon the past performance of the LLC


34

the State of Things
Working Capital Issue
• The Tax Court again sided with the Thomson Report, and provided:
– *Estate appraiser+ projected that *the LLC’s+ future investment in
working capital would fluctuate; however, he failed to explain
how he arrived at those estimates. *Estate appraiser’s+ only
explanation consisted of an appendix to his report containing his
projected income statement, balance sheet, and cash flow
statement for *the LLC+. We shall ignore *Estate appraiser’s+
working capital projections because of their complete lack of
support.
• Actually, the May Report provided a detailed projection analysis
with detailed assumptions, and it was disingenuous for the Tax
Court to say otherwise just because that analysis was in an
appendix rather than in the body of the report


35

the State of Things
Weighted Average Cost of Capital (WACC)
•

•

Despite taking issue with the use of a WACC in the valuation of a small, closely
held entity, the Tax Court stated:
– “We have previously held that WACC is an improper analytical tool to value a
‘small, closely held corporation with little possibility of going public.’ Estate of
Hendrickson v. Commissioner, T.C. Memo. 1999-278; cf. Gross v. Commissioner,
supra (allowing the use of WACC when the expert used the subject
corporation’s actual borrowing costs to calculate the cost of debt capital
component of the WACC formula). Neither party has indicated the likelihood
of [the LLC] becoming a publicly held company; however, because both
experts used WACC as the rate of return in their analyses, and neither party
otherwise raised the issue, we shall adopt it, although we do not set a general
rule in doing so.”
The appraisers disagreed in their determination of WACC based on three primary
issues:
– cost of equity capital
– cost of debt capital
– relative weights of debt and equity in calculating WACC

36

the State of Things
Cost of Equity Capital
•

•
•
•

The equity component of the Thomson Report’s WACC was developed using
an Ibbotson inspired build-up method, which employed:
– an after-tax cost of equity
– a premium for control (20%, effectively lowering the equity discount
rate), a company specific risk size/premium (4%, which increased the
equity discount rate), and
– an equity premium (2%) to recognize the potential loss of the company’s
favorable S corporation status in the event of a sale. Ultimately, the IRS
equity discount rate was 20%
The May Report utilized the capital asset pricing model (“CAPM”) to derive an
equity discount rate of 13.5%
The Tax Court again predominantly sided with the Thomson Report, criticizing
the May Report’s use of CAPM for a closely held entity, citing prior Tax Court
precedent
Why should what a court that has no valuation expertise says about a
valuation method be followed in subsequent cases?

37

the State of Things
Cost of Debt Capital
•
•

The Thomson Report calculated a pre-tax cost of debt of 6.6% (applying no tax
effect) versus the May Report’s after-tax cost of debt of 3.0% (5% pre-tax).
While the Tax Court was not convinced by the work of either appraiser, the Tax
Court again sided with the Thomson Report, in part because the higher
number was better for the Estate and in part because of the limited
explanation offered by the May Report:
– “In his expert report, *Estate appraiser+ calculated a 5-percent average
cost of debt. The entirety of his reasoning lies in a footnote: ‘Based on
*the LLC’s+ existing costs of debt and estimated costs of debt, given the
companies [sic] financial condition and the current interest rate
environment.’”
– The May Report used the LLC’s actual existing costs of debt and estimated
costs of debt in its analysis-what else could the May Report have said?

38

the State of Things
Relative Weights of Debt & Equity in Calculating WACC

• The Thomson Report basically employed the LLC’s
debt/equity ratio because he was valuing a minority
interest, reasoning that the minority owner could
exercise no influence to change the capital structure
• The May Report employed the guideline company
debt/equity ratio, despite failing to find any
comparable guideline company in its market
approach

39

the State of Things
Relative Weights of Debt & Equity in Calculating WACC
• The Tax Court called the May Report down for inconsistency,
pointing out:
– “In contrast, despite *Estate appraiser+ conclusion that the
guideline companies were not comparable under the guideline
company method, he declared that the same companies were
sufficiently comparable under the DCF method to justify using
their capital structures to calculate *LLC’s+ WACC. We lend no
weight to *Estate appraiser’s+ wavering stance and therefore use
*the LLC’s+ own capital structure at book value for purposes of
this case.”
• We have already established that the May Report actually
developed a market approach and used it to confirm its conclusion
of value under its DCF Approach


40

the State of Things
Adjustments to the LLC’s Enterprise Value
• The appraisers disagreed over the proper
adjustments to the LLC’s enterprise value, as
follows:
– long-term debt,
– working capital deficit,
– S corporation benefits, and
– stock options outstanding on the valuation
date

41

the State of Things
• With respect to the long-term debt issue, the appraisers were very close
together, with the only difference being the date of the financial
statements that each used. The Tax Court sided with the Thomson Report,
criticizing the May Report as follows:
– “Moreover, *Estate appraiser+ identified differing debt amounts
throughout his report. We will not rely on a consistently changing
number, especially one that *Estate appraiser+ fails to justify.”
•

The “consistently changing number?” Only by different dates for financial
statements; it was very disingenuous of the Tax Court to make this point
because you would expect to have different debt amounts on different
dates

42

the State of Things
•
•

On the working capital deficit issue, the May Report made an adjustment, while
the Thomson Report did not
Again, the Tax Court sided with the Thomson Report:
– “We do not find *Estate appraiser’s+ analysis to be persuasive. *Estate
appraiser] once again failed to explain why the public companies that he
deemed to be not comparable to [the LLC] under the guideline company
method provide a sufficient comparison upon which to base a working capital
adjustment. We lend little weight to his seemingly contradictory positions. In
addition, although explaining the need for a working capital adjustment under
the guideline company methodology, he failed to do so under the DCF method
despite applying the adjustment to the results under both methods. For these
reasons, we disregard his working capital deficit adjustment.”
– Again, it is disingenuous for the Tax Court to say that the May Report found no
guideline companies for the LLC; the May Report fully developed a market
approach and used it to confirm its conclusion of value under the DCF
approach


43

the State of Things
• The May Report made adjustments to reflect the S
corporation benefits, while the Thomson Report made no
such adjustments
• Because the May Report “failed to justify the adjustments,”
the Tax Court disregarded those adjustments
• Finally, the Tax Court accepted the adjustment made by the
May Report relative to the stock options outstanding as of the
valuation date because he assumed that all of the options
would be exercised
• This time, the Tax Court called down the Thomson Report for
failing to justify its position that the stock options would not
be exercised

44

the State of Things
S Corporation Benefits

• The May Report considered certain S corporation benefits
– $12.8 million to account for S shareholder tax savings on
all future distributions over tax distributions (present value
of benefit)
• This is a logical way to handle this, although the benefit
was calculated to perpetuity, when the investment in
the subject interest is for a finite expected holding
period
– $44.3 million to reflect future value of deductible goodwill
– $6.7 million to account for the extra marginal debt tax
shield (because of higher leverage in the LLC)

45

the State of Things
S Corporation Benefits

• Citing Gross, apparently as precedential guidance, the May
Report’s adjustments were ignored
• The result is that the May Report effectively lowered DLOM to
account for these potential benefits
– The Thomson Report ignores the benefit if S corporation
distributions are made at the shareholder level
– Tax Court also ignores these benefits too
• Why? Electing S has a benefit; if you are going to take the tax
expense into account, it is logical to add back the benefits of S
status

46

the State of Things
Minority Interest Discount
• Thomson Report applied a 17% discount due to a minority interest to the
DCF value based on an assumed 20% control premium that is somehow
applicable
– 1/(1+ CP) – 1
1/(1 + 20%) – 1 = 17% discount
• Implicit assumptions include:
– There are substantial synergies available to potential acquirers – not
indicated by the DCF analysis, which was entirely financial in
nature, not strategic or synergistic
– The DCF Approach provides a strategic control level of value
• Most authorities agree this is not so unless you adjust the cash
flows for potential synergies/strategic benefits are included in the
numerator (i.e., in the projected cash flows)

47

the State of Things
Minority Interest Discount
• Tax Court carries this a step further and
assumed a 30% control premium and
therefore, a 23% minority interest discount
– More favorable to the estate in a vacuum,
but it makes no economic sense
• The May Report appropriately did not apply a
minority interest discount to its DCF method

48

the State of Things
Discount for Lack of Marketability (DLOM)
• The Thomson Report develops DLOM of 31% based on examination of
seven dated restricted stock studies
– SEC Institutional Investor
Study, Gelman, Trout, Moroney, Maher, Silber and Management
Planning

• The May Report develops marketability discount of 30% based on the
same studies
– Effectively lowers DLOM with additions based on expected
shareholder level tax benefits

• Tax Court concludes marketability discount of 31%, since the Thomson
Report was a little higher in the way of DLOM and thus more favorable to
the estate

49

the State of Things
Concluding thoughts on Gallagher Est. v. Comr.
• Court opinions don’t tell the entire story, or even, in
this case, an accurate one
• Judges don’t make very good business appraisers
• Judge Halpern’s significant math error that led to the
revised judgment demonstrates how hard business
appraisal is
• It helps to be able to cite yourself as authority-Judge
Halpern wrote the Tax Court opinion in Gross, which
was a memorandum decision, and he cited Gross in his
Gallagher opinion

50

the State of Things
• The Tax Court’s failure to accept the use of the CAPM in
determining a discount rate for a closely held business is
just unacceptable. Again, the Tax Court must accept
general ly accepted appraisal principles and procedures
• It remains an ongoing astonishment that some valuation
practitioners and stakeholders view the build-up
approach and the CAPM as something other than highly
incestuous as a means to the same end
• Appraisers use the CAPM or some variant to develop a
discount rate every day. That they cannot do that in the
Tax Court only strains credulity

51

the State of Things
• The Tax Court’s failure to understand that if restricted
stock studies and the pre-IPO studies say anything, and
that is debatable, they should set a floor on DLOM
because it usually takes much longer to sell interests in
closely-held businesses than to sell restricted stock,
which is stock in public companies that is restricted for
now only six months before it can be sold
• Finally, Judge Halpern did not explain several of his
findings in significant detail. Query: Is he guilty himself
of the sin of failure to properly document that he
accused the estate appraiser of?

52

the State of Things
Giustina Est. v. Comr., T.C. Memo 2011-141 (Judge
Morrison)
• At the time of his death, the decedent, through his
revocable trust, owned 41.128% limited partnership
interest in an Oregon limited partnership that owned
approximately 48,000 acres of timber land. The
result was a substantial victory for the IRS. The case
is appealable to the U.S. 9th Circuit Court of
Appeals, and the estate did appeal in June of 2012

53

the State of Things
Giustina Est. v. Comr., T.C. Memo 2011-141 (Judge Morrison)
• The valuation positions of the parties and how the Tax Court came
out are as follows:
Position
Estate
IRS
Tax Court
Estate Tax Return
$12,678,117
Estate Litigation Value $12,995,000
IRS Notice of Deficiency Value
IRS Litigation Value
Tax Court Conclusion of Value

$35,710,000
$33,515,000


$27,454,115

54

the State of Things
Giustina Est. v. Comr., T.C. Memo 2011-141
(Judge Morrison)
• The Tax Court noted that both parties
moderated their valuation positions between
the time of filing the return/deficiency notice
and trial
• The Tax Court again sidestepped IRC Sec. 7491
burden of proof shift to the IRS by deciding
the case on the preponderance of evidence

55

the State of Things

• With respect to the cash flow method, the Tax Court found
problems with the work of both appraisers. The Tax Court
called down the IRS appraiser for using only one year’s worth
of cash flow; the estate’s appraiser used five consecutive
years of cash flows. Additionally, the IRS appraiser assumed
3% growth and flat expenses, which the Tax Court said was
wrong. In the end, the Tax Court wholly disregarded the cash
flow approach work of the IRS appraiser
• However, the Tax Court also found fault with the work of the
estate’s appraiser, disregarding the 25% discount for income
taxes that the estate’s appraiser took, reasoning that the
appraiser used a pre-tax, not a post-tax, capitalization rate,
citing Gross v. Comr

56

the State of Things
• In determining DLOM, both experts relied upon a benchmark
analysis based upon the restricted stock studies and the pre-IPO
studies. However, the IRS appraiser gave more reliance to the
restricted stock studies, specifically, the SEC Institutional Investors
Study, while the estate’s appraiser relied more upon the pre-IPO
studies
• The IRS appraiser testified that the pre-IPO studies overstated the
DLOM, and, according to the Tax Court, the estate’s appraiser failed
to rebut that point. Thus, the Tax Court upheld the DLOM
conclusion that the IRS appraiser reached
• The Tax Court’s decision that the Pre-IPO studies overstate DLOM is
ridiculous and without any support
• If Pre-IPO studies do anything at all, and that is debatable, they set
a floor for DLOM of closely-held entity interests

57

the State of Things
Morrison)
• The Tax Court disregarded three valuation methods that
the estate’s appraiser employed, totaling 70% of that
appraiser’s conclusions: the asset accumulation method,
the capitalization of distributions method and the market
approach (that the IRS appraiser also employed)
• The Tax Court disregarded the capitalization of
distribution method because it found that the cash flow
method was more accurate and that the two methods
were duplicative because both assume continued
operations

58

the State of Things
Morrison)
• The Tax Court disregarded the asset accumulation
approach, again because the Tax Court believed that
the method was duplicative of the asset approach
• The Tax Court disregarded the market approach that
both appraisers employed because the court
believed that the selected guideline companies were
substantially different from the subject company and
because the court noted that neither appraiser
“appropriately” considered those differences

59

the State of Things
• This is a very interesting valuation case because the Tax Court
primarily relied upon a valuation method (cash flow method)
substantially more than the experts for both sides did. Query
whether this gives the estate any grounds for appeal?
• The Tax Court employed a unique proportionality method in
that the court assumed a 75% chance that the subject
company would continue its timber operations as is and a
25% chance that the limited partners would force the
liquidation of the subject company
• The Tax Court seemed to come up with those percentages out
of thin air. I can’t recall another case or situation where such
a method was used. Could that be attacked on appeal?

60

the State of Things
Morrison)
• Some of the mistakes that the appraisers made seem to
have emanated from the valuation positions that the
respective parties espoused, which often is a problem.
Using a pre-tax discount rate with a tax adjustment
seems to be wrong at first glance. Query how that got
out of the appraiser’s office other than because it made
the numbers come out close to the return position?
• Given that there is a lot of money involved here, I suspect
that we haven’t heard the last of this matter. I expected
the estate to appeal, and they have appealed to the
Ninth Circuit

61

the State of Things
Boltar, LLC v. Comr., 136 T.C. 326 (2011) (Judge Cohen)
• In this federal income tax case, the Tax Court, in a
reviewed opinion, excluded the appraisal report of the
taxpayer’s appraiser on Daubert grounds and upheld the
IRS’s position in the valuation of a conservation
easement
• The case was appealable to the U.S. Tenth Circuit Court
of Appeals, but it wasn’t appealed
• At issue was the correct value of a 2003 income tax
charitable contribution deduction for a conservation
easement

62

the State of Things

• The relevant value positions of the litigants and that
ultimately reached by the entire Tax Court are as follows:
• Taxpayer’s Return Position: $3,245,000
• IRS Audit/Deficiency Notice Position: $42,400
• IRS Expert’s Position: $31,280
• 1999 Acquisition Price: $10,000 per acre
• Highest and Best Use per the Taxpayer’s Expert: Condominium
development
• Highest and Best Use per the IRS Appraiser: Delayed singlefamily detached homes

63

the State of Things

Problems with the taxpayer’s appraisal report:
• Based appraisal on a draft of the conservation easement
rather than on the final conservation easement
• It failed to determine the value of the easement area
before and after the placement of the easement on the
property, as required by Treas. Reg. Sec. 1.170A14(h)(3)(i)
• Failure to apply realistic or objective assumptions
• Erroneous assumptions about city placement of the
property and the zoning

64

the State of Things

• Failure to consider prospects for annexation into the
city of Hobart and rezoning to permit the
condominium project that the appraisers argued was
the highest and best use of the property
• Failure to suggest adjustments or corrections to
calculations that were obviously wrong except to
assert that the original report was correct even with
the factual errors

65

the State of Things

• Failure to address the argument that the proposed
project would not fit on the eased property in the
form drawn except by a “bald and unpersuasive
assertion that the project ‘will fit, it just won’t fit as
drawn’ in the site plan”
• Failure to adequately consider the hypothetical
willing buyer

66

the State of Things

• The taxpayer’s arguments against a Daubert exclusion:
– Daubert really only applies to jury trials and not to judge
trials because a judge can weigh the evidence
– The appraisal report must be accepted since the IRS
previously accepted the methodology in the appraisal
report and in fact stipulated that it was a qualified
appraisal
– Tax Court Rule 143(g) mandates receipt of the appraisal
report into evidence
– The IRS complaints about the appraisal report don’t affect
admissibility of the report into evidence

67

the State of Things
• The Tax Court refuted every argument of the taxpayer
against a Daubert exclusion, noting:
• In most cases, as in this one, there is no dispute about the
qualifications of the appraisers. The problem is created
by their willingness to use their resumes and their skills to
advocate the position of the party who employs them
without regard to objective and relevant facts, contrary
to their professional obligations.
• Justice is frequently portrayed as blindfolded to symbolize
impartiality, but we need not blindly admit absurd
expert opinions.[emphasis added]

68

the State of Things
The Tax Court went on:
• After decades of warnings regarding the standards to be applied, we may
fairly reject the burden on the parties and on the Court created by
unreasonable, unreliable, and irrelevant expert testimony. In addition, the
cottage industry of experts who function primarily in the market for tax
benefits should be discouraged. Each case, of course, will involve exercise
of the discretion of the trial judge to admit or exclude evidence. In this
case, in the view of the trial judge, the expert report is so far beyond the
realm of usefulness that admission is inappropriate and exclusion serves
salutary purposes.[emphasis added]
• We are not inclined to guess at how their valuation should be reduced by
reason of their erroneous factual assumptions. Their report as a whole is
too speculative and unreliable to be useful.

69

the State of Things
The Tax Court concluded:
• If the report and their testimony were admitted into
evidence, we would decide that their opinions were not
credible. The assertion that the Eased Parcel had a fair
market value exceeding $3.3 million on December 29,
2003, before donation of the easement, i.e., that it would
attract a hypothetical purchaser and exchange hands at
that price, defies reason and common sense.[emphasis
added]


70

the State of Things

What are some of the takeaway lessons from Boltar?
• It is critical that the appraiser be objective and
reasonable. How do you know when your appraiser is not
being objective and reasonable? It requires you to be
objective and reasonable as well, even when you are
zealously advocating your client’s position
• Co-opting your appraiser into being an advocate is the
absolutely wrong approach. This is one of the reasons why
I believe that a trial appraiser should not also serve as a
rebuttal expert. I believe that simultaneously serving in
both capacities compromises the expert in the eyes of the
court

71

the State of Things

• On balance, reviews are suggested every time that
there are large differences between the conclusions
of value of qualified appraisers. True, this adds
expense that the client may not go for, but it’s so
important in my opinion that you should go on record
in writing as having suggested it so that if your
appraiser is wrong, you at least can say “I told you to
get a review.”

72

the State of Things
• It is imperative that your appraiser immediately correct
errors and carefully consider how the errors affected the
conclusion of value. Appraisers are human too and do
make mistakes from time to time
• Errors can easily be made, and in appraisal reports, errors
can cascade into bigger errors as they factor themselves in
at each level of the analysis, throwing the conclusion of
value off even further
• In Boltar, the appraisers apparently didn’t consider how
their errors affected their analysis, which the Tax Court
termed “fatal”

73

the State of Things
• Where an appraiser is not following a required
valuation approach format, such as that for
conservation easements, or the appraiser desires to
use a technique that is “cutting edge” and hasn’t been
vetted with the appraiser’s peers, warning bells
should go off! I normally wouldn’t permit my clients to
be guinea pigs unless they understood that and were
nevertheless willing to do so. I strongly encourage
appraisers who are “inventive” to publish articles and
speak about their technique first to their peers

74

the State of Things
Jensen Est. v. Comr., T.C. Memo 2010-182 (Judge Vasquez)
• In this federal estate tax case, the Tax Court determined
the discount for built-in capital gain for an 82% interest in
a New Hampshire C corporation, which owned, as its
principal asset, a 94 acre waterfront parcel on which it
operated a girls’ summer camp
• The effect of the result was a complete victory for the
estate
• The case was appealable to the 2nd Circuit Court of
Appeals, but it wasn’t appealed

75

the State of Things
Jensen Est. v. Comr., T.C. Memo 2010-182 (Judge
Vasquez)
The valuation positions of the parties and how the Tax
Court came out are as follows:
Position
Estate
IRS
Tax Court
Value
$2,554,317 $3,268,465
$2,554,317
Discount
$1,133,283 $490,383
$1,133,283


76

the State of Things

The Appraisers’ Methodology
• The estate’s appraiser simply computed the amount of
the built-in capital gain (fair market value less adjusted
basis) and deducted that sum dollar for dollar from the
fair market value of the property
• The IRS’s appraiser took a more complex route in its
determination. That appraiser used closed-end funds to
assist in the determination of the proper level of discount
for built-in capital gain

77

the State of Things

The Appraisers’ Methodology
• Interestingly, that appraiser concluded that there was no
“direct correlation between exposure to built-in capital gains
and discounts from net asset value at levels of exposure of
41.5 percent or less…” *which was the highest percentage of
built-in gains among the six closed-funds that he examined]
• As a result, it only recognized the built-in gain above 41.5%,
which was 24.5% since the amount of built-in gain in Wa-Klo
was 66%. However, as to this excess, he permitted a dollarfor-dollar discount for built-in capital gains

78

the State of Things
• However, as to the IRS appraiser’s use of closed-end funds to assist
in the determination of the proper level of discount for built-in
capital gain, Judge Vasquez ruled against the IRS, noting that he
didn’t feel that the funds were comparable in any way to the
subject parcel
• Moreover, he noted that closed-end funds invest indirectly in real
estate through REIT’s and further that “discounts from a closed-end
fund’s net asset value are attributable to several factors including
supply and demand, manager or fund performance, investor
confidence, or liquidity.” Judge Vasquez also expressly noted that
the “studies on the effect of unrealized capital gains on the
discounts from a closed-end fund’s net asset value are inconclusive”

79

the State of Things
Vasquez)
• Judge Vasquez went on to assume a 17 year
holding period as no party had offered
evidence of holding period
• After making his calculations, Judge Vasquez
determined that the estate was entitled to at
least that discount it claimed

80

the State of Things
Vasquez)
• All I could do was shake my head when I read the
opinion’s description of the IRS appraiser’s
analysis. It struck me as voodoo economics, and
Judge Vasquez wasn’t buying it either
• The IRS appraiser’s approach has no basis in any of
the valuation literature to the best of my
knowledge, and probably should have been
challenged on Daubert grounds

81

the State of Things

• With respect to the built-in capital gains tax issue, this may
appear to be another 100% of the tax on the appreciation
case, as we’ve seen recently for C corporations as in Dunn Est.
v. Comr. and Jelke Est. v. Comr. However, there’s a twist, and it
is the holding period assumption, which the Tax Court also
employed in Borgatello v. Comr.
• I agree with Judge Vasquez’s analysis. As I have said before,
the dollar-for-dollar reduction, while certainly simple, strikes
me as arbitrary. I predict that you’ll see more of this type of
analysis except in the Fifth and Eleventh Circuits

82

the State of Things
The Ringgold Telephone Company v. Comr., T.C. Memo
2010-103 (Judge Wells)
• The taxpayer corporation elected to be treated as an
S corporation effective as of January 1, 2000. At that
time, it held a 25% limited partnership interest in an
entity that in turn owned a 29.54% limited
partnership interest in another limited partnership.
The principal asset in the parent limited partnership
was a cellular license

83

the State of Things
The Ringgold Telephone Company v. Comr., T.C. Memo 2010-103 (Judge
Wells)
• The valuation numbers are as follows:
– Value per income tax return: $2,600,000
– Original valuation: $4,600,000
– Revised valuation: $2,600,000
– Value per taxpayer’s appraiser-trial: $2,980,000
– IRS determination of value-notice of deficiency: $5,243,602
– IRS determination of value per IRS’s appraiser-trial: $5,155,000
– Tax Court determination of proper value: $3,727,142


84

the State of Things
Wells)
• Less than one year after electing to be an S corporation, the
taxpayer sold its limited partnership interest for $5,220,423. For
purposes of computing its built-in gain, the taxpayer reported the
value of the limited partnership interest per its revised appraisal:
$2,600,000. On audit, the IRS asserted that the value should have
been determined by the subsequent sales price
• Predictably, it boiled down to a war between the appraisers. The
taxpayer utilized an appraiser who has an ABV from AICPA and who
had significant experience in valuing telecommunications entities.
Contrast this with the IRS appraiser, who had no valuation
credentials and who had never valued a telecommunications entity

85

the State of Things
The Ringgold Telephone Company v. Comr., T.C.
Memo 2010-103 (Judge Wells)
• The taxpayer’s appraiser weighted his indications
of value in arriving at his conclusion of value of
the parent limited partnership:
• Capitalization of income-50%
• Discounted future income-30%
• Guideline company approach-10%
• Guideline transaction approach-10%

86

the State of Things
Wells)
• Once he arrived at the value of the parent limited partnership, the
taxpayer’s appraiser then attacked the valuation of the taxpayer’s
limited partnership interest
• He used two methods to determine this value: a distribution yield
analysis and a business enterprise analysis, the latter of which was
simply to apply a 5% DLOM to the taxpayer’s proportionate share of
the parent limited partnership
• In his distribution yield analysis, and this is very important, the
taxpayer’s appraiser used after-tax dollars. He weighted these two
approaches equally in arriving at his ultimate conclusion of value on
the limited partnership interest


87

the State of Things
• Contrast this with the weightings that the IRS
appraiser employed in valuing the parent limited
partnership interest:
–
–
–
–

Discounted cashflow-50%
Merger and acquisition-50%
Guideline company approach-0%
The IRS appraiser did not employ a distribution yield
analysis and gave no DLOM

88

the State of Things
The Ringgold Telephone Company v. Comr., T.C. Memo 2010-103
(Judge Wells)
• The Tax Court first considered the IRS argument that the
actual distributions made was irrelevant pursuant to Rev. Rul.
59-60. Citing prior Tax Court precedent in Barnes v. Comr., the
Tax Court found that the distribution yield analysis was
appropriate for valuing a non-controlling interest
• The Tax Court then tackled the taxpayer’s arguments that the
subsequent sale of the limited partnership interest
approximately six months after the valuation date was
irrelevant, and, if relevant, must be significantly adjusted to
reflect that BellSouth’s purchase of the taxpayer’s interest was
a strategic purchase, i.e., above fair market value

89

the State of Things
• The Tax Court determined that the sale should
have been considered as it was within a
reasonable period of time after the valuation
date and further that the sale was at arm’s
length. However, the Tax Court agreed that it
“should consider the unique characteristics of
the buyer, seller, and transaction.”

90

the State of Things
Wells)
• However, the Tax Court found that nothing in the record supported
the taxpayer’s assertion that the transaction included a control
premium, citing the taxpayer’s own appraiser, who testified that in
his opinion, since BellSouth already controlled the parent limited
partnership, it had no reason to enter into the transaction
• Nevertheless, the Tax Court agreed with the taxpayer that BellSouth
had made a strategic acquisition, relying upon the testimony of the
taxpayer’s appraiser to the effect that BellSouth had a practice of
making higher bids than it would have ordinarily made to
discourage exercise of the right of first refusal

91

the State of Things
• The Tax Court accepted the conclusions of
value that the taxpayer’s appraiser reached in
his distribution yield analysis and in his
business enterprise analysis
• However, to these approaches, the Tax Court
equally weighted the subsequent sales price in
arriving at its value determination

92

the State of Things
• Perhaps most importantly, and this is not readily
apparent in the opinion, it is noteworthy that
both appraisers tax effected the earnings
• The opinion is important because it illustrates the
importance of hiring accredited appraisers who
have experience in valuing companies that are
similar to the subject company
• The case was appealable to the Eleventh
Circuit, but it wasn’t appealed

93

the State of Things
The Ringgold Telephone Company v. Comr., T.C. Memo
2010-103 (Judge Wells)
• The opinion also demonstrates an understanding by
the Tax Court of the commonly accepted levels of
value, i.e., that strategic value is higher than fair
market value
• Should the existence of strategic buyers be considered
in the determination of fair market value?
• My position is that strategic buyers should not be
considered in determining fair market value because
they will always out pay a financial buyer, who buys at
fair market value

94

the State of Things
IRS DLOM Job Aid
• The IRS has released to the public a 107 page
document entitled “Discount for Lack of
Marketability Job Aid for IRS Valuation
Professionals”
• This document summarizes and evaluates
most, but not all, of the methods that are
currently in use for determining DLOM

95

the State of Things
IRS DLOM Job Aid
•

At the beginning of the DLOM Job Aid, the IRS makes clear what its alleged
intentions are with respect to its issuance:
– It is not meant to provide a cookbook approach to evaluating a marketability
discount as proposed by a taxpayer or to setting a proposed marketability
discount in the case of an independent governmental appraisal. It is
emphasized that, all background and existing practices aside, the
establishment of a Discount for Lack of Marketability is a factually intensive
endeavor that is heavily dependent upon the experience and capability of
the valuator. By bringing the included material together in one document, we
are striving to make the job of the IRS valuation analyst easier. We do not
mean to provide guidance as to reasonable levels of marketability discounts
that would prevail in all situational contexts or to imply that the IRS has any
policy per se in the evaluation or the determination of such discounts
[emphasis added]

96

the State of Things
IRS DLOM Job Aid
• The DLOM Job Aid divides DLOM approaches into
four categories: benchmark approaches, securitiesbased approaches, analytical approaches and other
approaches
• According to the IRS: This Job Aid is meant to provide a
background and context for the Discount for Lack of
Marketability as such is commonly applied in business
valuation analyses and reports. It reviews past and
existing practices and attempts to provide insight into
the strengths and weaknesses of these practices.

97

the State of Things
IRS DLOM Job Aid
The following quote is very instructive of the IRS general
attitude regarding DLOM:
• If you are approaching the question of DLOM fresh,
either as a reviewer confronted with an unreasonable
taxpayer position based on invalid approaches or as a
valuator charged with making your own valuation
discount decisions, it is often helpful to start with a
basic question as relates to DLOM. That question is:
“Under the prevailing facts and circumstances and
considering the nature of the interest to be valued why
is the DLOM not zero?” [emphasis added]

98

the State of Things
The state of business valuation: Let’s take the trends discussed in the
recent developments to look at what the courts need to do
• Increase the number of Daubert exclusions. The United States
Supreme Court made courts the “gatekeepers” of expert witness
evidence. However, this did not mean that judges are now also
experts who, but for their hallowed robes, would also be passing
through the same gate
• To date, although there are some signs recently that this is
changing, at least in the Tax Court, courts generally have done a
poor job of gatekeeping in business valuation cases, opting instead
to take on the cloak of “super appraiser,” divining between theories
and conclusions reached by the appraisers to arrive at their own
valuation conclusions, usually cherry-picked from bits and pieces of
the work of the opposing appraisers, understandably because they
don’t have the education or training to be appraisers

99

the State of Things
The state of business valuation: What the courts need to do
• If the appraisers for both sides do something one way, that way
might be supportable. Say what you will about business
appraisers, but, in my humble opinion, the quality of business
appraisal work has increased by leaps and bounds over the past 20
years. During that time period, business appraisal standards have
proliferated, and practices have begun to coalesce. Therefore, help
nurture them along
• When appraisers for BOTH sides do something a certain way, like
tax-affect earnings, courts should think long and hard before they
simply dismiss it out of hand, especially if their reason is prior court
jurisprudence
• Just because some non-appraiser judge in the past either didn’t
understand or didn’t care for the way that the method was used by
one appraiser in one situation is no reason to reject the method

100

the State of Things
• Prior court precedent is no way to set business valuation
practice rules. For example, in the area of tax-affecting S
corporations, this is routinely done in business transactions
every day. However, tax-affecting has a black eye, at least in
the Tax Court, because of two cases, Gross and Heck, in which
tax-affecting was probably inappropriate under those facts
• However, the Tax Court blew it in the Dallas case by not
permitting tax-affecting in a case in which it was clearly
advisable, solely because it wasn’t done in the two prior cases
in which tax-affecting wasn’t appropriate. That doesn’t make
any sense

101

the State of Things
• Resist simplicity in some situations. While I normally support
the notion that simple is better, it doesn’t always work
• For example, the “bright line” test that the Fifth Circuit
enunciated in Dunn and followed by the Eleventh Circuit in
Jelke regarding the dollar-for-dollar reduction in valuation for
the tax on built-in capital gains is simply too good to be true,
makes little sense and violates the fair market value standard
• Courts are effectively forcing appraisers to do something, i.e.,
deduct the projected capital gains tax liability dollar-for-dollar,
that they know is contrary to generally accepted business
appraisal practices, which is just wrong

102

the State of Things
• We conclude our work today by considering a series of
burning issues that are presently hot in business valuation
• I represent we consumers of tax valuation reports
• There is a huge disconnect between the knowledge
possessed by business appraisers and the knowledge
possessed by us
• This is a source of consternation for us and our clients
because we must blindly rely upon these reports
• For a detailed discussion of most of these burning
issues, see Chapter 19 of A Reviewer’s Handbook to
Business Valuation: Practical Guidance on the Use and
Abuse of a Business Appraisal

103

the State of Things
Where You Stand On An Issue Depends On Where You
Sit!
• That’s a little Southern wisdom
• Business appraisers make numerous judgment calls
on these very issues each and every time they write
an appraisal report
• Most business appraisers rarely ever explain these
choices in the appraisal report, or explain why
another position is not preferable or even tenable

104

the State of Things
Little Did We Know …
• That business appraisers argue so much amongst
themselves on such key doctrinal issues
• We, users of business appraisal reports, blithely assume
that all matters in a valuation report used “generally
accepted appraisal principles”
• The IRS says, until further notice, USPAP is it. Notice
2006-96
• But USPAP is silent on virtually all of these issues
• So where does this leave us?
• You guessed it. We’re on our own and must learn about
business appraisal to protect ourselves and our clients

105

the State of Things
So Many Issues, So Little Time …
• Each of the burning issues mentioned here could, by
themselves, take up an entire continuing education program
• We’re not going to solve anything here today, however…
• My purpose is to give you food for thought about how
business appraisers present these issues when they write
business appraisal reports
• It is important to remember that the six most important
words in Rev. Rul. 59-60 are common sense, informed
judgment and reasonableness
• You can’t say these words too often-forget them to your periland that of your client

106

the State of Things
Inherent Problems With “Fair Market Value” as a
Standard
• Hypothetical buyers and sellers
• Res tantum valet quantum vendi potest
• Valuation is perhaps best expressed by a range, yet the
tax system requires one number
• Are judges qualified to appraise? No, but they do
anyway
• The appraiser’s task is a tough one
• Good advisors prepare clients for it

107

the State of Things
Generally Accepted Appraisal Principles, Anyone?
• Frighteningly little is out there on an accepted
way to deal with most appraisal substantive
issues
• The various appraisal standards promulgated to
date certainly do not do so
• Given the various turf battles that rage within the
business appraisal industry, on both a
professional level and on a substantive level, I see
little chance of this happening

108

the State of Things
Burning Issue No. 1: Discount for Lack of
Marketability (DLOM)


109

the State of Things
Burning Issue No. 1: Discount for Lack of Marketability
DLOM Approaches
• Numerous and growing like weeds
• The pros and cons of the selected DLOM approach
(and why another DLOM approach was not used) are
rarely, if ever, discussed in a business appraisal report
• There are an awful lot of turf battles in this arena.
Everyone seems to have something to sell, like a
methodology or a proprietary data base

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the State of Things
DLOM Approaches (in no order of preference or importance)
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•

Pre-IPO Studies (Willamette, Valuation Advisors and Emory)
Restricted Stock Studies (Stout Risius Ross, FMV Opinions, Management
Planning, Silber, Willamette, Institutional Investor Study, Gelman, Trout, Moroney, Maher, LiquiStat and
Standard Research Associates)
Black-Scholes Option Pricing Method (Chaffe application)
QMDM (Mercer)
Longstaff
Private Placement Method (Bajaj)
LEAP (Trout/Seaman)
Practical Scoring Method (Curtiss)
Bid-Ask Spread (Chipalkatti)
Time Model (Stockdale)
Finnerty
Meulbroek
Tabak
Mandelbaum (Judge Laro’s ten factor test)
Abrams
Wruck
Hertzel and Smith
MBVG (Abbott)
NICE (Frazier)
Partnership Spectrum
MergerStat

111

the State of Things
Burning Issue No. 1: Discount for Lack of
Marketability
To me, DLOM methods essentially break down into
four categories, which is different from the way
that the DLOM Job Aid categorized them:
• Market Approach methods
• Income Approach methods
• Quantitative methods
• Qualitative methods

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the State of Things
An example:
• I recently received a business appraisal report that computed
DLOM using the following weights:
— Pre-1990 restricted stock studies-30% (when the holding
period was two years)
— Pre-IPO studies-35%
— LEAP-35%
– Then factored through some additional factors
• How could this be justified or explained to the satisfaction of
a court?

113

the State of Things
Another example:
• I recently received a report that computed DLOM using the
following weights:
— Option Methods-50%
— Restricted Stock Studies-35%
— LEAP-15%
• How could this be justified or explained to the satisfaction of
a court?
• Again, it beats me
• No explanation of either why other methods either weren’t
used or used even for a sanity check

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the State of Things
• The IRS recently weighed in on DLOM, making public and
issuing its DLOM Job Aid, in which it critiqued many, but not
all, of the DLOM methods
• The IRS didn’t really prefer a DLOM method, as it pointed out
the strengths and weaknesses of each method that it
reviewed
• The DLOM Job Aid saved quite a bit of venom for one
particular approach, the FMV Opinions Restricted Stock
Study, which I can only explain by saying that they must be
seeing quite a bit of it
• However, I’ve never seen it in use after having read several
hundred business valuation reports

115

the State of Things
Daubert Considerations
• Can so many different DLOM approaches ever give rise to
a truly successful compliance with Daubert and its
progeny for any of these methods? Peer review anyone?
• In light of the disparate positions within the appraisal
community, the answer arguably is “no,” yet a few of
these approaches seemingly have passed muster under
the Daubert test
• Daubert challenges are on the rise too-See the Tax Court
opinion in Boltar v. Comr., which we discussed earlier

116

the State of Things
What’s coming next?
• Examining the entrails of a chicken?
• Seriously, folks, what will the next DLOM approach
be?
• No doubt that it will be published soon
• Where do you find these new DLOM approaches?
Business Valuation Review, a business appraiser
publication, and esoteric finance journals

117

the State of Things
Burning Issue No. 2: DLOM applied to a controlling interest
• Case law clearly has permitted this
• But is this position correct from the standpoint of
valuation theory?
• Appraisers significantly disagree here
• Some business appraisers argue that a controlling owner
has access to all of the cash flows until sale, thereby
negating DLOM
• How large should this discount be relative to DLOM for a
controlling interest-probably small, in my view

118

the State of Things
Burning Issue No. 3: Discount for Built-In Capital Gains
• Disparity between what the Tax Court is doing and
the “bright line” test enunciated by the two courts of
appeals (5th and 11th) that have dealt with thisSupreme Court didn’t take the case in Jelke (11th
Circuit).
• Is the bright line test too good to be true?
• What should the rule be?
• Could the appraisal community agree?
• Doubtful

119

the State of Things
Burning Issue No. 3: Discount for Built-In Capital Gains
• In Jensen Est. v. Comr., the Tax Court allowed 100% of
the discount for imbedded gains that the taxpayer
claimed, but it did not simply take off 100% of the
inherent tax. The court determined that a 17 year
holding period was appropriate. T.C. Memo 2010182.
• I suspect that a holding period analysis will ultimately
prevail-it makes the most sense

120

the State of Things
Burning Issue No. 4: Looking for Private Comps
• Under the market approach, one of the methods involves
finding so-called publicly traded guideline companies
that are comparable to the subject privately held
company
• This method is blessed in Rev. Rul. 59-60 Sec. 4.01(h) and
in Treas. Reg. Sec. 20.2031-2(f)(2) (flush language)
• The problem inherent in any guideline public company
approach is the size and qualitative differences between
those publicly traded companies deemed to be
sufficiently comparable to the subject company
• Could private company transactions be used?

121

the State of Things
Burning Issue No. 4: Looking for Private Comps
• Databases of private company transactions are being aggressively
marketed-for example, BIZCOMPS®, DONEDEALS®, IBA Market
Database and Pratt’s Stats®
• There is scant tax case law, which makes me nervous due to a lack
of public track record

• There are significant criticisms in the appraisal literature of each of
the private databases
• There is something attractively appealing to using private company
data, but the lack of guidance and the criticisms give me heartburn

• Even though some business appraisers will disagree with me, I don’t
think that these databases are ready for primetime

122

the State of Things
Burning Issue No. 5: What is the “Small Firm Effect,” if
any?
• The small firm effect provides that smaller cap firms out
perform larger cap firms, but at greater risk
• There are two schools of thought-no small firm element
of additional risk or a small firm element of additional
risk (which reduces value)
• This added increment of risk usually is added without any
discussion in the appraisal report, which I like to see
• Klauss v. Comr. held in favor of the small firm effect

123

the State of Things
Burning Issue No. 6: Are Synergistic Buyers Properly
Included Within the Definition of “Hypothetical Buyer?”
• Judge Laro says yes. Is he correct?
• I think not, but who in the Sam Hill am I?
• If synergistic buyers were included within the
hypothetical willing buyer, then lots of potential willing
buyers would be excluded because they wouldn’t pay
what a synergistic buyer would pay, which would in my
opinion violate the “hypothetical” nature of the “willing
buyer”

124

the State of Things
Burning Issue No. 7: The Levels of Value
• Appraisers disagree over the levels of value charts
that end up in appraisal reports, although there are
majority and minority schools of thought
• Where your appraiser stands on this issue could
mean a huge difference in a conclusion of value
• This is rarely, if ever, discussed in appraisal reports
• It impacts the discount for lack of control (DLOC)
• An example will illustrate how the levels of value
work

125

the State of Things
• Suppose that there is a closely-held operating
company that is reflecting net income of $250,000
• However, on closer examination, the controlling
shareholder is taking out $500,000 per year more in
salary than that would be paid to a third party
manager
• Moreover, there is a lease to the company by the
controlling shareholder that calls for rent that
exceeds fair market value by approximately $100,000
per year
126

the State of Things
• Additionally, the controlling shareholder’s spouse is on
the payroll to the tune of $60,000 per year, and all
indications are that the spouse is not even reporting for
work
• A potential control buyer could save $50,000 per year by
decreasing inventory turns and by providing additional
operating capital
• A synergistic/strategic buyer of the company could
eliminate the accounts payable and accounts receivable
departments of the subject company, together with
certain executive positions, for a total proposed savings
of $300,000 per year

127

the State of Things
• Assume a price-to-earnings multiple of 5.
• From the standpoint of the levels of value:
• The unadjusted value of the company is $250,000 x
5=$1,250,000
• Normalizing adjustments could be made to the marketable
minority level as follows: $250,000 (net income as reported) +
$500,000 (excess compensation) + $60,000 (spouse
compensation) + $100,000 (excess lease payments) =
$910,000 x 5=$4,550,000
• Additional adjustments could be made at the control level of
$50,000, bringing the value of the company to $4,800,000
(4,550,000 + 250,000)

128

the State of Things
• At the strategic level of value, an additional adjustment of $300,000
per year for reduction of expenses of another owned entity due to
duplication that could bring the value of the company to $6,300,000
($4,800,000 + $1,500,000).
• Summary of valuation indications:
• As reported:
$1,250,000
• Marketable minority level of value: $4,550,000
• Control Level of Value:
$4,800,000
• Strategic Level of Value:
$6,300,000.
• As you should be able to readily see, the values go up with each
increasing level of value
• There actually might be a higher level of value-the price that an
irrational buyer might pay-think about that-dot coms, anyone?

129

the State of Things


130

the State of Things
Burning Issue No. 8: To Tax-Effect or Not S Corporations
• Disparity between what most appraisers seem to be doing and
what the Tax Court is doing! The appraisers are right, and the Tax
Court is acting like a flat earth society, although there is a minority
school of appraisers who agree with the Tax Court
• Again, too much “my model is better and your method ain’t worth a
damn”-several models
• There seems to be no way to reconcile the differences of opinion
here per Shannon Pratt
• Very little discussion of competing approaches in appraisal reports
• Demand this discussion be included in the appraisal report
• It may make more sense for a business appraiser to address this
issue indirectly through adjustments to multiples or in some other
way

131

the State of Things
Burning Issue No. 8: To Tax-Effect or Not S Corporations
• There are five main recognized approaches in the taxaffecting of S corporations: Grabowski, Fannon, Van
Vleet’s SEAM, Mercer and Treharne
• I prefer to see all of the five methods illustrated in the
appraisal report so that I can see the differences, even if
the business appraiser ultimately relies only on one
approach
• There will be differences depending upon a number of
factors, including the size of the subject interest (control
versus minority), the cash flows to shares presently being
paid out or projected to be paid out in the future and the
universe of potential buyers of the subject interest

132

the State of Things
Burning Issue No. 9: Financial Statement Adjustments to
Be Made When Valuing a Non-Controlling Interest
• These adjustments usually are material
• There are two schools of thought on this issue
– One school says always make the adjustments
because one should assume a well-run company
– The other school says that if the minority shareholder
can’t force the adjustment, then don’t make it
• This is rarely discussed in appraisal reports, but should
be-demand to see it discussed

133

the State of Things
Burning Issue No. 9: Financial Statement Adjustments to Be
Made When Valuing a Non-Controlling Interest
An example:
• Suppose the controlling shareholder overpays himself by
$100,000 annually, and takes out other perks worth $250,000
• One school would say to adjust out the excesses even when
valuing a noncontrolling interest because of fiduciary duty and
that these shareholders have the right to expect a well run
company
• The other school says no because the minority shareholder is
powerless to stop the majority shareholder, but is this true?
• I agree with the first school-make the adjustments

134

the State of Things
Burning Issue No. 10: Validity of CAPM in Valuing
Closely Held Companies
• The Capital Asset Pricing Model (CAPM) method forms the basis for a lot
of appraisers’ estimation of the proper risk level
• It apparently is difficult to explain to courts, or courts have just been
resistant to it
• In Gallagher v. Comr., T.C. Memo 2011-148, Judge Halpern expressed a
favoring of a build-up method over the CAPM
• The problem is that the build-up method is a variant of CAPM
• CAPM also has some doctrinal difficulty in its application to closely held
businesses
• I’ve never seen the caveats associated with this method discussed in an
appraisal report-but they should be


135

the State of Things
Bonus Burning Issue: Company Specific Risk Premium and
Total Beta
• There is an emerging movement in business valuation that attempts
to quantify a company specific risk premium utilizing a concept
called “total beta”
• Currently, there are two basic ways that business appraisers
develop a discount-CAPM, which uses beta) and a build-up method,
which computes a discount rate by adding up the following
elements: (1) a risk-free rate (usually the U.S. 20 year treasury bond
rate), (2) an equity risk premium (for the extra risk of holding an
equity security, as opposed to a bond), (3) small size risk premium
and (4) a company-specific risk premium (which represents
unsystematic risk)
• With respect to the last item, unsystematic risk, a new concept,
called “total beta,” has come out

136

the State of Things
Bonus Burning Issue: Company Specific Risk Premium and Total Beta
• Total Beta of a particular publicly traded stock is the product of the
standard deviation of the returns of that particular stock divided by the
standard deviation of the returns of the market (often represented by the
S&P 500)
• Total Cost of Equity, the historically accepted view, is comprised of the sum
of the risk-free rate plus total beta times the excess return premium
• There is something new called the Butler-Pinkerton Calculator
(“BPC”), which attempts to extend the total beta concept to privately-held
companies through the use of Total Beta for comparable (or guideline)
public companies
• The BPC has passed a Daubert challenge, but it is still very controversial
among business appraisers
• The jury is still out for me on the BPC, but I think that they may be on to
something


137

the State of Things
• I appreciate your attention today! Thank you!
• If you have any comments or questions, I’d
love to take them, either now or later
• You can e-mail or call me:
– 504.452.7574
– paul@paulhoodservices.com
– paulhood@acadiacom.net


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Business valuation 2012 the state of things presentation

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