Understanding Valuation Discounts

Transcription

1 Understanding Valuation Discounts Presented to CPA Academy Lawrence A. Sannicandro, Esq. Agostino & Associates, P.C.

2 Overview Valuation at issue in upwards of 33% of taxpayer-represented Tax Court decisions Discounts and premiums routinely at issue Property-Type Discounts Fractional interest discount Owner-Level Discounts Discount for lack of marketability Blockage & market absorption discounts Lack of control discount Lack of voting rights discount Control premium Entity-Level Discounts Key person discount Discount for contingent liabilities Portfolio discount Discount for built-in capital gains tax Valuation of S corporations 2

3 Polling Question 1 How Frequently Do You Deal With Valuation How often do you deal with valuation issues in your practice? Frequently Sometimes Rarely Never 3

4 Fair market value Market value Fair value Quick sale value Salvage value Liquidation value Investment value Intrinsic value Measures of Value 4

5 Fair Market Value Defined the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973) Rev. Rul , C.B. 237 Treas. Reg A-1(c)(2) 5

6 Fair Market Value Implied Assumptions (1) Fair market value assumes that the property to be valued must be valued at its highest and best use, which means the property will be used in such a way so as to ensure that a putative hypothetical buyer will use the property in such a way so as to maximize his or her value therefrom (2) The property to be valued is generally valued without regard to events occurring subsequent to the valuation date unless such an event was reasonably foreseeable as of the valuation date or relevant to the valuation (3) Third, fair market value assumes that the transaction between the buyer and the seller will be for cash, and that it will be consummated within a commercially reasonable time. 6

7 The Valuation Equation Fair market value is generally calculated as follows: Net asset value (or undiscounted fair market value); +/- appropriate entity level discounts or premiums; +/- appropriate owner level discounts or premiums; = fair market value. 7

8 Step 1: Getting to Net Asset Value: Three approaches Approach 1: market approach (a/k/a comparable sales method) The market approach values the subject property by taking into account the sale prices of the comparable property and the differences between the comparable property and the subject property. Arm s-length transactions Similar timeframe...the market approach measures value properly only when the comparable property has qualities substantially similar to those of the subject property... 8

9 Step 1: Getting to Net Asset Value: Approach 2: income capitalization method The income approach relates to capitalization of income and discounted cashflow. This approach values property by computing the present value of the estimated future cashflow as to that property. The estimated cashflow is ascertained by taking the sum of the present value of the available cashflow and the present value of the residual value. 9

10 Step 1: Getting to Net Asset Value: Approach 3: cost approach The cost approach generally values property by determining the cost to reproduce or replace it less any applicable depreciation. In business valuation, the cost approach generally values a business by determining the cost to reproduce it and focuses on a company s net asset value (i.e., the fair market value of its total assets minus its total liabilities). In practice, the fair market value of assets (e.g., marketable securities or real estate valuation) is substituted for the respective book values on the balance sheet of the company to be valued. 10

11 Step 2: Property-Type Discounts Fractional Interest Discount Fractional Interests Defined: Percentage deducted from undiscounted fair market value to reflect the lack of control associated with joint tenancies. Quantifying the Fractional Interest Discount: of factors below in light of existing case law. Factors That Affect Fractional Interest Discount: Liability for actions of their co-owners; Requirement of unanimous consent of all co-owners; Impairment of ability to use property as collateral; Lost rights to use the property; and The right of the co-owners to bring a partition suit. Make a qualitative analysis 11

12 Step 2: Owner-Level Discounts - DLOM Discount for Lack of Marketability Defined: Percentage deducted from net asset value to reflect the relative absence of marketability (i.e., salability). Quantifying the DLOM: Benchmark study approaches (restricted stock & pre-ipo studies); Security-based approaches; Analytical approaches; and Other approaches, including Mandelbaum. Issues to Be Aware Of: Do not ignore the hypothetical seller; Understand the value being discounted; Qualitative analysis important (in light of Mandelbaum factors); and Ensure reasonableness. 12

13 Step 2: Owner-Level Discounts - DLOM Discount for Lack of Marketability (continued) Mandelbaum Factors: The value of the subject corporation s privately traded securities vis-à-vis its publicly traded securities; An analysis of the subject corporation s financial statements; The corporation s dividend-paying capacity (ability, history, and amount); The nature of the corporation, its history, its position in the market, and its economic outlook; The corporation s management The degree of control transferred with the block of stock to be valued; Any restriction on the transferability of the corporation; The period of time an investor must hold the stock to realize a profit; The corporation s redemption policy; The cost of effectuating a public offering of the stock to be valued. 13

14 Step 2: Owner-Level Discounts - Blockage Discounts for Blockage & Market Absorption Defined: Percentage deducted from net asset value to reflect the depressing effect of placing a large block of property on the open market at the same time. Closely related to DLOM Quantifying the Blockage Discount: Step 1: Make an assumption of how shares or property will be disposed (e.g., private placement, dribbled sales, or redemption). Step 2: Assuming property will be dribbled into market over an extended period of time, analyze the historical trading volume and price volatility to determine (1) the number of units that can be added to normal trading volume, and (2) the time over which the units can be sold into the market without having an adverse affect on the market property. Step 3: Use DCF method or a restricted stock study to quantify the blockage discount. Step 4: Reflect the blockage discount as a percentage and apply it to the property being valued. Issues to Be Aware Of: Blockage discount v. expenses to sell the stock; Reasonableness of period of time; 14

15 Step 2: Owner-Level Discounts - Blockage Discounts for Blockage & Market Absorption (continued) Issues to Be Aware Of (continued): Isolate blockage & market absorption discounts from other discounts; Failure to take into account dividends; and Control prerogatives of a block of stock. Factors Affecting Blockage Discount: Mean market quotation for the property on the valuation date; Size of the block in relation to the total outstanding stock); Trading activity in the stock on or near the valuation date; Depth and trend of the market for the security; Market depth and trend as a whole (measured at and after the valuation date); Opportunity cost of holding the property as inventory; Carrying cost of holding the property as inventory; Ability of the property owner to control the market in terms of how many pieces of property would be available for sale at any one time; and Length of time necessary to liquidate (i.e., dispose of) the property. 15

16 Step 2: Owner-Level Discounts Lack of Control Discount for Lack of Control Defined: Percentage deducted from net asset value to reflect that an owner of shares cannot unilaterally direct various corporate actions. Quantifying Lack of Control Discount: Method: Top-down method; Horizontal method; and Bottom-up method. Studies: Mergerstat Review Study; Closed-End Fund Studies; and Partnership Profiles. 16

17 Step 2: Owner-Level Discounts Discount for Lack of Control (continued) Issues to Be Aware Of: Lack of Control Isolate blockage & market absorption discounts from other discounts; Evaluate whether a non-controlling interest has veto rights; and Analyze the full spectrum of control. Factors Affecting Lack of Control Discount: Whether the interest will deliver operational control of the underlying entity or business; Whether the interest would deliver the ability to control allocation of assets and available resources; Whether the interest would deliver control of the board of directors or management of the underlying entity or business; Whether the interest would deliver control to optimize or modify capital structure; Whether the interest would deliver control to declare that dividends be paid or withheld; Whether the interest would deliver control to liquidate, merge, or consolidate the company; and The purchaser s desire or need to acquire the company to complement a present operation. 17

18 Step 2: Owner-Level Discounts Misc. Lack of Voting Rights Discount Additional discounts may be appropriate where a noncontrolling interest altogether lacks voting rights. Control Premium The ability of a purchaser to control varying aspects of a company may command a premium. 18

19 Step 2: Entity-Level Discounts Misc. Key Person Discount Where a business depends upon the services of one person, and where the person is no longer able to perform those services, a key person discount is appropriate. Discount for Contingent Liabilities Where a business has potential liabilities (e.g., environmental, product warrant, or pending litigation), a discount for the liability is appropriate. Portfolio Discount Where a company holds nondiversified assets that would not be attractive to a potential buyer, a portfolio discount is appropriate. Discount for Built-In Capital Gains Tax Where a corporation has built-in gains tax on appreciated nonoperating assets, a discount for the resulting built-in capital gains tax is appropriate. Valuation of S Corporations To tax-affect or not to tax-affect? 19

20 Step 2: Multiple Discounts Methodology How to Apply Multiple Discounts Step 1: Determine the discounts and premiums that apply. Step 2: Apply entity-level discounts before ownerlevel discounts. Step 3: Do not aggregate discounts. 20

21 Example Step 2: Multiple Discounts Putting It All Together Net asset value $ 100,000,000 Less 5% key person discount (5,000,000) Controlling, marketable net asset value 95,000,000 10% pro rata share of controlling, marketable interest 9,500,000 Less 12% DLOC (1,140,000) Marketable, non-controlling interest 8,360,000 Less 22% DLOM (1,839,200) Nonmarketable, non-controlling interest $ 6,520,800 21

22 Polling Question 2 Involving the Controversy Attorney If your client is under audit by the IRS, when would you refer your client to a tax controversy attorney? At the first sign of an audit Before the 30-day letter After the 30-day letter Never 22

23 Audits & Alternative Dispute Resolution Audit and assessment process generally Audits of valuation discounts emphasized Estate and gift tax auditors return more dollars per capita than any other subdivision of tax. Routinely at issue in FLPs and valuations of closely-held companies Tips for defending an audit Engineering Program Concluding the Audit 30-day letter and opportunities to resolve valuation issues with Appeals Fast Track Settlement Broad applicability Fast Track Mediation Limited applicability Post-Appeals Mediation Notice of deficiency (i.e., the 90-day letter) 23

24 Role of the Players in a Valuation Case Value is a question of fact Often involves legal conclusions about rights in property relative to value Role of the Court Examine the evidence, including expert testimony, to find facts and apply law to facts. Are judges trending towards piecemeal valuation in a Solomon-like approach? Role of the expert Duty to assist the Court to understand the evidence or decide a fact in issue. Role of the attorney Ensure procedural and technical requirements are met to have expert s testimony admitted, ensure facts in evidence to argue value on brief, and make appropriate motions to secure advantages for the client with respect to value. No ghost-writing reports. 24

25 Discovery of Expert Material Court-sanctioned and extrajudicial discovery Service s summons authority under I.R.C Ability to reach appraisals to support tax reporting position Limitations Attorney-client privilege; Work product doctrine; Unfairness doctrine; and Draft appraisal reports and communications in connection with litigation; provided that they are between the attorney and the expert. Taxpayers rights under I.R.C. 7517, 7602, and FOIA I.R.C Requests in Estate and Gift Cases I.R.C. 7602(c) Third Party Contacts Freedom of Information Act (FOIA), 5 U.S.C. 552, et seq. Requests, Responses, and Administrative and Judicial Review 25

26 Polling Question 3 What Do You Want to Hear More About What was the most valuable part of today s webinar? Standards of value Getting to net asset value Valuation discounts Audits of valuation issues and administrative rights 26

27 Polling Question 4 Would You Like Tax Controversy News? Agostino & Associates, PC publishes a monthly journal which discusses tax, audit, and valuation issues. Would you like to be added to our mailing list? Yes No 27

28 Questions Lawrence A. Sannicandro, Esq. Agostino & Associates, P.C. (201) , x