IRS Hot Button The Lack of Marketability Discount

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1 IRS Hot Button The Lack of Marketability Discount By Gary Ringel, CGREA, Managing Director (480) ~ GaryR@hhcpa.com Definition of Discount for Lack of Marketability ( DLOM ): The discount which exists between the value of an ownership interest or asset that is and is not marketable. Definition of Discount for Lack of Control ( DLOC ): The discount from selling price of an ownership interest or asset that reflects the lack of authority vested in the owner of that equity interest or holding. Nothing in business valuation is more controversial than the DLOM. In fact, an examination of Tax Court cases reveals that business appraisers and the Internal Revenue Service have been disputing the DLOM for over 40 years. Three types of marketability studies are most frequently relied upon by the IRS and business valuators to quantify the lack of marketability or illiquidity associated with ownership interests in a closely-held business. Restricted Stock Studies Restricted stock of a public company is identical to its counterpart that is traded on a major stock exchange, except that restricted stock cannot be openly traded for a period of one year (two years prior to 1990). As a result, the market for restricted stock is limited, resulting in discounted transaction prices. The restricted stock studies attempt to verify the difference in price at which the restricted shares trade versus the price at which the same unrestricted securities trade in the open market as of the same date. Pre-IPO Studies Pre-IPO studies measure marketability by comparing the prices of stock offered in initial public offerings (IPOs) to transactions in the same company s stocks prior to the IPO. Companies that are going public are required to disclose all transactions in their stocks for a period of three years prior to the IPO. Recent criticisms of the IPO Studies (primarily from the IRS) include the argument that the IPO databases only include transactions in private companies that had a successful IPO. This has led to criticism of selection bias because the studies do not include companies that filed for IPOs that were unsuccessful. It is also alleged by some practitioners that IPO prices are inflated by hype, resulting in higher implied discounts.

2 Rate of Return Studies Rate of Return studies quantify the DLOM by comparing buyer s required rates of return when purchasing nonmarketable versus marketable interests or assets. The 2014 Rate of Return Study published by Partnership Profiles, Inc. asserts One of the primary issues an investor considers when making an investment is the expected rate of return. As the risk of an investment increases, an investor requires a higher rate of return. Alternatively, the amount an investor is willing to pay for an investment is dependent on the rate of return the investment will yield. This is most clearly illustrated in the bond market where the value of a bond is inversely related to market interest rates. As interest rates increase, the amount an investor is willing to pay for a fixed rate bond decreases in order to increase the effective yield on the bond to a level commensurate with market rates. As an example, if a bond has a stated coupon rate of 5% and the market rate of interest increases to 7%, an investor would pay less for that bond in order to increase the effective yield of the bond to the prevailing market rate. Quantification of Marketability Discount Utilizing the Partnership Profiles, Inc. Rate of Return Study We place the most emphasis on Partnership Profiles, Inc. s Rate of Return Study while determining the discount for lack of marketability when valuing fractional interests in enterprises such as limited partnership and limited liability companies that own marketable securities and/or real property. These types of entities are frequently referred to as holding companies rather than going concerns. In other words, they are not operating businesses. For purposes of illustration, let s assume that Henry & Horne, LLP has been retained to estimate the market value of a 20% noncontrolling, nonmarketable limited partnership interest ( LP Interest ) in a family limited partnership ( FLP ) that only owns a retail shopping center. The market value of the center is $10 million. Consequently, the controlling, marketable value of the 20% LP Interest is $2 million. Next, we apply a 15% discount for lack of control to the subject 20% LP Interest based on lack of control studies. 1 Consequently, the noncontrolling, marketable value of the subject LP interest is $1.7 million. We then develop a set of assumptions based on management s representations and our own independent analysis in order to ascertain the specific risk-return attributes associated with the 20% minority interest. The presumptions include, but are not limited, to the following factors: 1. The estimated remaining term of the FLP prior to its dissolution ( holding period ). 2. The projected annual appreciation of the shopping center during the holding period based on historical data. 1 Discount for lack of control studies will not be examined in this article.

3 3. The projected annual income derived from the shopping center during the holding period based on historical data. 4. The possible reallocation of the FLP s asset portfolio during the holding period. 5. The projected annual appreciation of the reallocated portfolio, based on historical data, subsequent to the estimated date on which the assets are reinvested. 6. The projected annual income of the reallocated portfolio. 7. Anticipated annual distributions issued to all partners during the holding period. 8. Whether or not the FLP will incur debt during the holding period and the resulting capital structure of the partnership. 9. A reasonable rate of return expected by hypothetical buyer of LP interest during the holding period, based on historical data, subsequent to the estimated date on which the assets are reinvested. Then we populate a model that considers the aforementioned suppositions; the 15% DLOC applied to the subject LP Interest; and empirical information that documents anticipated returns on investments for transactions in the secondary market. These trades are comprised of noncontrolling, nonmarketable limited partnership interests in publicly registered limited partnerships that own real estate. Below is a chart that summarizes median estimated annual returns reflected by the sales prices for publicly held limited partnership interests in the secondary market over the past 20 years. Median Estimated Annual Returns Overall No-to-Low Mod to High Non- Study Debt Debt Distributing distributing % 18.7 % 23.5 % 19.0 % 23.5 % % 18.1 % 24.7 % 18.7 % 25.7 % % 18.9 % 26.0 % 19.5 % 26.3 % % 17.5 % 21.8 % 18.3 % 21.7 %

4 % 18.0 % 21.1 % 19.0 % 22.5 % % 17.0 % 24.7 % 18.7 % 22.6 % % 19.5 % 23.6 % 20.7 % 17.1 % % 20.7 % 24.3 % 21.6 % 18.2 % % 18.1 % 20.7 % 18.9 % 15.2 % % 16.8 % 18.3 % 17.3 % 15.3 % % 15.9 % 26.3 % 17.1 % 14.7 % % 16.4 % 24.5 % 16.7 % 23.6 % % 15.2 % 24.5 % 15.9 % 24.7 % % 15.2 % 24.5 % 14.7 % 22.6 % % 13.1 % 20.6 % 15.2 % 20.6 % % 17.3 % 21.0 % 20.1 % 14.8 % % 14.1 % 26.3 % 17.9 % 21.7 % % 17.1 % 25.4 % 19.4 % 24.1 % % 16.4 % 29.3 % 19.0 % 25.8 % % 14.7 % 23.3 % 17.6 % 25.8 % Med 18.9 % 16.9 % 23.6 % 18.3 % 21.3 % It is no surprise that investors demand a higher rate of return when acquiring a noncontrolling, nonmarketable limited partnership interest in a publicly registered limited partnership that is highly leveraged and not issuing distributions to its partners.

5 Summary In this instance, the blended DLOC and DLOM applied to the subject 20% LP interest will indicate an opinion of value that would likely provide a hypothetical buyer with a return on investment somewhere between 15% and 20% based on facts and circumstances. Gary Ringel, CGREA, is the Managing Director of Henry & Horne, LLP s Business Valuation & Litigation Support Services and Managing Director of the Real Estate Appraisal & Consulting Group. He has prepared more than 3,000 business valuations and real estate appraisals for attorneys, accountants, trust officers, financial planners, real estate developers, and lending institutions. He can be reached at (480) or GaryR@hhcpa.com. Tempe Scottsdale Casa Grande 2055 E. Warner Road 7098 E. Cochise 1115 E. Cottonwood Suite 101 Suite 100 Suite 100 Tempe, AZ Scottsdale, AZ Casa Grande, AZ (480) (480) (520) w w w. h e n r y a n d h o r n e. c o m