Valuation in Tax: Valuation Discounts Every Professional Should Know University of San Diego School of Law Thought Leadership Panel

Transcription

1 11/11/2016 Valuation in Tax: Valuation Discounts Every Professional Should Know University of San Diego School of Law Thought Leadership Panel #AICPAfvs Panelists Leslie H. Finlow, Esq., Senior Technician Reviewer, IRS Office of Chief Counsel John I. Forry, Esq., University of San Diego School of Law Z. Christopher Mercer, FASA, CFA, ABAR, Mercer Capital Lawrence A. Sannicandro, Esq., Agostino & Associates, P.C. American Institute of CPAs #AICPAfvs 60 1

2 11/11/2016 Disclaimer The panelists views expressed in this presentation are their own. They do not necessarily reflect the position of the Internal Revenue Service. Nor should the statements of one presenter be attributed to another. American Institute of CPAs #AICPAfvs Valuation Discounts and the Proposed Regulations Under I.R.C Business and Valuation Perspective American Institute of CPAs #AICPAfvs 60 2

3 11/11/2016 Let s Talk About Fair Market Value American Institute of CPAs #AICPAfvs Both are able and willing to trade Both fully (reasonably) informed Hypothetical willing buyers Engage in a (hypothetical) transaction for the interest for money or money s worth (cash equivalent) Both have financial capacity Neither acting under compulsion On the valuation date Hypothetical willing sellers American Institute of CPAs #AICPAfvs 60 3

4 11/11/2016 Levels of Value American Institute of CPAs #AICPAfvs Minority Interest Discounts Small or Non-Existent American Institute of CPAs #AICPAfvs 60 4

5 11/11/2016 Marketability Discounts Approaches & Methods All known methods fall generally into: Methods under the market approach Methods under the income approach Hypothetical and real buyers and sellers are interested in the expected rates of return on illiquid minority investments Consider the implied expected rate of return based on any marketability discount conclusion American Institute of CPAs #AICPAfvs Approaches & Methods Reviewed BENCHMARK APPROACHES Restricted Stock Studies Pre-IPO Studies Restricted Stock Equivalent Analysis Cost of Flotation Mandlebaum Factors, Judge Laro, 1995 ANALYTICAL APPROACHES Karen Hopper Wruck Hertzel and Smith Bajaj, Denis, Ferris, and Sarin Ashok B. Abbott SECURITY-BASED APPROACHES LEAPS Longstaff Study Chaffe Study Bid-Ask Spread Method OTHER APPROACHES QMDM (Mercer) NICE (Frazier) NERA (Tabak) Partnership Profiles MergerStat American Institute of CPAs #AICPAfvs 60 5

6 11/11/2016 Proposed Changes in Section 2704 Method 1 NAV / Minimum Value Does not represent fair market value Hypothetical willing buyer was not present for the hypothetical negotiations No HWB would pay minimum value for the interest when there is immediate downside risk and lack of control following a put (if the HWB, who is not a family member, gets the put) Many interpret this Method 1 as the goal of the DOT/IRS A number of attorneys have said this is not the right interpretation of the IRS goal based on conversations with IRS personnel However, many make this interpretation, so we show it, even though it ignores Proposed (f) American Institute of CPAs #AICPAfvs 11 Method 2 NAV Less Uncertainties Regarding Liquidation Examine hypothetical family entities holding four distinctly different asset classes Securities only Income producing property (an apartment building) Vacant urban dirt with little immediate potential Rural land with little immediate potential Make simplifying assumptions re basic economics of the partnerships Make simplifying assumptions re the estimated time to liquidate the underlying assets of the partnerships American Institute of CPAs #AICPAfvs

7 11/11/2016 This Levels of Value Chart Will Likely Not Work Under Proposed Changes Controlling Interest Basis Control Premium Minority Interest Discount Marketable Minority Value Marketability Discount Nonmarketable Minority Value American Institute of CPAs #AICPAfvs 13 Levels of Value Under Section 2704? Net Asset Value (Minimum Value) Valuation Adjustment (If warranted by the economics of the investment) Illiquid Minority Value American Institute of CPAs #AICPAfvs

8 11/11/2016 The QMDM is a Shareholder-Level DCF QMDM DCF 1. G v 2. D% 3. G D% Probable Future Economic Benefits 4. Holding Period 5. R HP Discount Rate American Institute of CPAs #AICPAfvs Method 2 NAV Less Uncertainties Regarding Liquidation Hypothetical Buyers Question the Expected Time to Liquidation of Assets All are Hypothetical American Institute of CPAs #AICPAfvs

9 11/11/2016 Proposed Regulations Under I.R.C Restrictions on Liquidation of an Interest American Institute of CPAs #AICPAfvs Regulatory Authority of the Secretary In addition to the general grant under 7805, 2701(e) To clarify the control rules of , with reference to the attribution rules of (a)(3) To apply 2704(a) to the lapse of rights similar to voting and liquidation rights. (cont.) American Institute of CPAs #AICPAfvs 60 9

10 11/11/2016 Regulatory Authority of the Secretary 2704(b)(4) To disregard other restrictions, beyond those imposed, or required to be imposed, by any Federal or State law, in determining the value of any interest in a corporation or partnership transferred to a transferor s family member, if - the restriction has the effect of reducing the value of the transferred interest, but - does not reduce ultimately the value of the interest to the transferee. American Institute of CPAs #AICPAfvs The Result: The Proposed Regulations... Amend to address what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership; Amend to address deathbed transfers that result in the lapse of a liquidation right and clarify the treatment of a transfer that results in the creation of an assignee interest; (cont.) American Institute of CPAs #AICPAfvs 60 10

11 11/11/2016 The Result: The Proposed Regulations... Amend to refine the definition of the term applicable restriction by eliminating the comparison to state law liquidation restrictions; and Add to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not family members. American Institute of CPAs #AICPAfvs Deference to Treasury Regulations Transfer Pricing Regulations as a Comparative Model American Institute of CPAs #AICPAfvs 60 11

12 11/11/2016 Deference to Regulations: Transfer Pricing Regulations as a Comparative Model Levels of Deference Outline pp Transfer Pricing Regulations Brief Explanation Recent Key Decisions Challenging T/P Regulations Xilinx - Bases for Invalidation Altera - Bases for Invalidation - Pending Appeal American Institute of CPAs #AICPAfvs Valuation Discounts in Tax Reporting, Expert Reports, and Tax Litigation Dealing With Unsettled Law American Institute of CPAs #AICPAfvs 60 12

13 11/11/2016 Audit and Litigation Risks Associated With Valuation Discounts Valuation in tax is ubiquitous 340 sections of the Internal Revenue Code require a fair market value determination to properly report and assess tax liability Valuation discounts and premiums routinely at issue Recent staffing initiatives in estate and gift E&G returns more tax dollars per capita than any other subdivision of tax Proposed regulations under 2704 will lead to increased scrutiny Valuation at issue in upwards of 33% of all Tax Court decisions where taxpayer is represented by counsel American Institute of CPAs #AICPAfvs Tax Reporting in Connection With the Proposed Section 2704 Regulations Accuracy-related penalties under 6662(a) Penalty equal to 20% of underpayment Negligence or disregard of rules or regulation Substantial understatements of tax (income, estate, and gift) Substantial valuation misstatements Reasonable cause defense for underpayments under 6664 Issues of first impression: Bunney v. Comm r, 114 T.C. 259 (2000) Understatements of tax reduced under 6662(d)(2)(B) Adequate disclosure and reasonable basis To what extent should attorneys be involved in advising on 2704 issues? Exeleon Corp. v. Comm r, 147 T.C. No. 9 (Sept. 19, 2016) Substantial authority American Institute of CPAs #AICPAfvs 60 13

14 11/11/2016 Expert Reports & Tax Litigation Concerning the Proposed Section 2704 Regulations Expert s role in tax litigation Expert reports in Tax Court In writing, exchanged 30 days before trial Self-contained, and must include (among other items): Complete statement of all opinions and the reasons for them The facts or data considered Regulations under 2704 will require changes to expert reports Daubert: Complying with USPAP jurisdictional exception rule Disclose law on both sides and evaluate Explain the right answer from a valuation perspective Leave the lawyering to the lawyers and the valuing to the valuators American Institute of CPAs #AICPAfvs Expert Reports & Tax Litigation Concerning the Proposed Section 2704 Regulations Family-owned businesses Income approach more important than ever Two-track valuation approach Evaluate cash flows with the 2704 restrictions Evaluate cash flows without the 2704 restrictions Reconciliation important Consider changes in the law on the opinion of value. Think of: Built-in capital gains tax discount Tax-affecting S corporations Nonfamily business Outdated studies for DLOM and DLOC need to be revisited (again, and again, and again) American Institute of CPAs #AICPAfvs 60 14

15 11/11/2016 Questions? Leslie H. Finlow, Esq., IRS Office of Chief Counsel (202) John I. Forry, Esq., University of San Diego School of Law (619) , Z. Christopher Mercer, FASA, CFA, ABAR, Mercer Capital (901) , Lawrence A. Sannicandro, Esq., Agostino & Associates, P.C. (201) , x. 128; American Institute of CPAs #AICPAfvs Thank You Copyright 2013 American Institute of CPAs. All rights reserved

16 Valuation in Tax: Valuation Discounts Every Professional Should Know Presented at the AICPA s Forensic & Valuation Services Conference Gaylord Opryland Hotel, Nashville, TN Monday, November 7, 2016 Panelists: Leslie H. Finlow, Esq., Senior Technician Reviewer, IRS Office of Chief Counsel John I. Forry, Esq., University of San Diego School of Law Z. Christopher Mercer, FASA, CFA, ABAR, Mercer Capital Lawrence A. Sannicandro, Esq., Agostino & Associates, P.C. 1 Table of Contents I. Introduction II. III. Overview of Valuation A. Valuation a Frequently Litigated Issue 1. Between 20% and 33% of Tax Court Cases Concern Valuation 2. Valuation Discounts Frequently Litigated B. Valuation Distilled 1. Overview 2. Core Valuation Concepts 3. Step 1: Entity Valuation 4. Step 2: Apply Appropriate Discounts and Premiums Owner-Level Discounts A. Discount for Lack of Marketability 1. Overview 2. Factors That Affect Marketability 3. Quantifying the DLOM 4. Issues to Be Aware of With Respect to the DLOM 5. Cases Applying DLOM B. Blockage & Market Absorption Discounts 1. Overview 2. Factors That Affect Blockage Discount 3. Quantifying the Blockage Discount 4. Issues to Be Aware of With Respect to Blockage Discount 5. Cases Applying Blockage Discount C. Lack of Control Discount 1. Overview 2. Factors That Affect Lack of Control Discount 3. Quantifying the Lack of Control Discount 4. Issues to Be Aware of With Respect to Lack of Control Discount 5. Cases Applying Lack of Control Discount 1 This Outline was prepared by Lawrence A. Sannicandro, Esq. The views expressed herein are his own, and do not necessarily reflect the views of the Internal Revenue Service or any of the other panelists

17 D. Lack of Voting Rights Discount E. Control Premium 1. Overview 2. Factors Affecting Control Premium 3. Quantifying the Control Premium 4. Issues to be Aware of With Respect to Control Premium 5. Cases Applying Control Premium IV. Entity-Level Discounts A. Key Person Discount 1. Overview 2. Factors That Affect the Key Person Discount 3. Quantifying the Key Person Discount 4. Issues to Be Aware of With Respect to the Key Person Discount 5. Cases Applying Key Person Discount B. Discount for Contingent Liabilities 1. Overview 2. Factors That Affect the Discount Contingent Liabilities 3. Quantifying the Discount for Contingent Liabilities 4. Issues to Be Aware of With Respect to the Discount for Contingent Liabilities 5. Cases Applying Discount for Contingent Liabilities C. Portfolio Discount 1. Overview 2. Factors That Affect the Portfolio Discount 3. Quantifying the Portfolio Discount 4. Issues to Be Aware of With Respect to the Portfolio Discount 5. Cases Applying Portfolio Discount D. Discount for Built-In Capital Gains Tax 1. Overview 2. Factors That Affect the Discount for Built-In Capital Gains 3. Quantifying the Discount for Built-In Capital Gains 4. Issues to Be Aware of With Respect to the Discount for Built-In Capital Gains 5. Cases Applying Discount for Built-In Capital Gains Tax E. Valuation of S Corporations 1. Overview 2. Tax-Affecting 3. Tax Court s Criticisms of Tax-Affecting 4. Evolution of Valuators Views 5. The Risk Concerning Tax-Affecting 6. What Should Practitioners Do? V. Property-Type Discounts A. Fractional Interest Discounts 1. Overview

18 2. Factors That Affect the Fractional Interest Discount 3. Quantifying the Fractional Interest Discount 4. Partition Analysis 5. Issues to Be Aware of With Respect to the Fractional Interest Discount 6. Cases Applying Fractional Interest Discount VI. Multiple Discounts A. Overview B. Do Not Improperly Layer Discounts 1. Step 1: Determine the Discounts and Premiums That Apply 2. Step 2: Apply Entity-Level Discounts Before Owner-Level Discounts 3. Step 3: Do Not Aggregate Discounts 4. Example C. Multi-Tiered Entities 1. The IRS s View 2. The Tax Court s View VII. Recently Proposed Regulations Under I.R.C. ' 2704 A. The Enactment of I.R.C. ' Background 2. Key Rules of I.R.C. ' The Statute 4. Regulatory Authority B. Proposed Regulations Under I.R.C. ' Issuance of Proposed Regulations 2. Reasons for Enacting Proposed Regulations 3. Underlying Principles of the Proposed Regulations 4. Summary of Key Rules 5. Detailed Explanation of Operative Provisions 6. Effective Date, Comments, and Hearing C. Takeaways From and Challenges to the I.R.C. ' 2704 Regulations 1. In General 2. Proposed, Not Final Regulations 3. Deference to Regulations Under Mayo 4. Effect on Estate Planning VIII. Audits of Valuation Discounts, ADR Alternatives, and Litigation A. Overview 1. Audits of Valuation Discounts Emphasized 2. Routine Questions in the Context of Audits of Closely Held Businesses B. Sample IDR Requests 1. DLOM 2. Lack of Control Discount C. The 30-Day Letter and Administrative ADR 1. In General 2. Fast Track Settlement

19 3. Fast Track Mediation 4. Post-Appeals Mediation 5. Arbitration IX. Litigating Valuation Discounts A. Overview of a Valuation Trial 1. A Valuation Trial is About Proving Value 2. Typically Involves Mixed Questions of Law and Fact 3. The Trier of Fact May Need Help to Understand the Evidence 4. The Role of the Court, the Expert, and the Attorney B. Selecting an Expert 1. Overview 2. Using the Same Appraiser Who Prepared the Appraisal to Support the Tax Reporting Position 3. Area of Expertise 4. Factors to Consider in Selection C. Procuring the Expert Witness Report 1. Protecting Privilege D. Attorney Involvement From Report Preparation to Litigation 1. Overview 2. Fact-Gathering 3. The Report Preparation Process 4. The Report Review Process 5. Sanctions for Improper Attorney Assistance E. Using the Appraiser to Negotiate With Tax Authorities F. Available Forums 1. Choice of Forums 2. The Role of the Doctrine of Variance in Refund Actions G. Discovery of the Opposing Party s Expert Witness Material 1. Overview of Discovery 2. Expert Reports Prepared in Advance of Trial v. Reports Prepared to Support a Tax Reporting Position 3. Limitations on Discovery 4. Discovery of Material Through I.R.C. ' 7517, I.R.C. ' 7602, and FOIA 5. Discovery of Material Through Court-Sanctioned Discovery H. Qualifying the Expert, Satisfying Daubert, and Daubert Challenges 1. In General 2. Qualifying Your Expert 3. Daubert Challenges I. Timing, Procedure for Receiving, and Submission of Expert Reports 1. In General 2. Tax Court 3. District Courts 4. Court of Claims J. Preparing Rebuttal Reports in Advance of Trial 1. In General

20 2. Tax Court 3. District Courts 4. The Attorney s Role With Respect to Rebuttal Reports Moving and Submitting a Rebuttal Report K. Burden of Proof Allocation of the Burdens of Production and Persuasion 1. General Allocation of the Burden of Proof 2. I.R.C. ' 7491 Allows Burden of Proof to Shift 3. The Anomalous Result of I.R.C. ' 7491 L. Concurrent Evidence, Concurrent Testimony, and Hot-Tubbing 1. Court s Distrust Towards Partisan Experts 2. Shortcomings of the Traditional Adversarial Process 3. Concurrent Witness Testimony as a Welcome Alternative M. Court-Appointed Experts 1. Overview 2. The Evidentiary Basis for Court-Appointed Experts 3. Having Court-Appointed Experts Appointed X. Conclusion

21 Outline I. Introduction Valuation permeates almost every aspect of federal tax. Still, many practitioners struggle to understand core valuation concepts that affect estate tax, gift tax, income tax, and collection cases. This Outline seeks to eliminate that confusion. It begins with the general premise that the fair market value of an interest in an entity or property can be figured by determining the net asset value of an entity or the undiscounted fair market value of property and applying appropriate discounts and premiums to arrive at the fair market value of the interest. This Outline focuses on the second part of that equation: the discounts and premiums that apply to determine the value of the interest in the property. As recent litigation confirms, valuation discounts and premiums are big-dollar, high-stakes issues that the Internal Revenue Service ( Service ) examines regularly and with great skepticism. This Outline introduces readers to the valuation techniques and tax concepts practitioners are most likely to encounter in owner-level securities valuations, entity-level valuations, and real property valuations. With respect to owner-level valuations, this Outline examines the following discounts and premiums: discount for lack of marketability; blockage and market absorption discounts; lack of control (or minority interest) discount; and control premium. With respect to entity-level valuations, this Outline discusses the following discounts: key person discount; discount for contingent liabilities; portfolio discount; and S corporation premiums. Finally, with respect to real property valuations, this Outline details fractional interest discounts for tenancyin-common interests. Then, this Outline explores recently proposed regulations under I.R.C. ' The effect of these regulations, if finalized, will be to significantly reduce taxpayers ability to claim valuation discounts, and especially the lack of control discount, when valuing family-owned entities and businesses. This Outline also discusses the extent to which the courts, the Service, and taxpayers must follow these regulations in their proposed form. In the light of the well-documented potential for abuse with valuation discounts, as well as the expectation that the Service will audit such issues with increased frequency under the new I.R.C. ' 2704 proposed regulations, this Outline then discusses controversy-related aspects of valuation discounts with which every practitioner should be familiar. In this regard, this Outline summarizes typical information requests all practitioners can expect to receive from the Service in connection with audits of valuation discounts. Then, because courts have instructed that valuation cases should settle, this Outline discusses available alternative dispute resolution programs the Service offers. Finally, for valuation cases where trial is necessary, this Outline discusses litigation aspects of valuation trials before the United States Tax Court ( Tax Court ), the United States District Courts, and the United States Court of Federal Claims ( Court of Claims ). This discussion of litigation is geared towards the non-attorney practitioner

22 II. Overview of Valuation A. Valuation a Frequently Litigated Issue 1. Between 20% and 33% of Tax Court Cases Concern Valuation: a. Statistics for 2014: The Tax Court published 422 opinions in Of these 422 opinions, 148 involved taxpayers represented by counsel and 274 involved taxpayers appearing pro se. Questions of valuation were resolved, in one form or another, in roughly 52 of the 148 cases involving taxpayers represented by counsel, which means that valuation was at issue in approximately 35.1% of cases in represented taxpayer cases in b. Statistics for 2013: The Tax Court published 443 opinions in Of these 443 total opinions, 98 involved taxpayers represented by counsel and 345 involved taxpayers proceeding pro se. Valuation issues were resolved in one form or another in 20 of the 98 cases involving taxpayers represented by counsel, which means that valuation was at issue in approximately 20.4% of cases in which practitioners had entered an appearance for taxpayers. c. Percentage Likely Higher: The foregoing statistics are staggering when viewed in the light of the fact that valuation cases are more likely to settle than non-valuation cases Valuation Discounts Frequently Litigated: Not surprisingly, valuation issues were often presented in connection with estate tax or gift tax deficiency cases. a. Highly Visible and Often Litigated: The valuation of closely held companies, and related valuation discounts, have been areas that the Service continues to focus on. B. Valuation Distilled: 1. Overview: A complete discussion of valuation is outside the scope of this Outline, but it is appropriate to first discuss some basic valuation concepts before an in-depth examination of valuation discounts and premiums. a. The Valuation Equation: For federal tax purposes, the value of any property (real, tangible, intangible, and personal) can be calculated by figuring the undiscounted fair market value of the property to be valued and then applying appropriate valuation discounts and 2 In Estate of Aucker v. Commissioner, T.C. Memo , the Tax Court explained the reason so many cases filled its docket as of 1998 as follows: Disputes over valuation fill our dockets, and for good reason. We approximate that 243 sections of the Code require fair market value estimates in order to assess tax liability, and that 15 million tax returns are filed each year on which taxpayers report an event involving a valuation-related issue. It is no mystery, therefore, why valuation cases are ubiquitous. Today, valuation is a highly sophisticated process. We cannot realistically expect that litigants will, will be able to, or will want to, settle, rather than litigate, their valuation controversies if the law relating to valuation is vague or unclear. We must provide guidance on the manner in which we resolve valuation issues so as to provide a roadmap by which the Commissioner, taxpayers, and valuation practitioners can comprehend the rules applicable thereto and use these rules to resolve their differences. Clearly articulated rules will also assist appellate courts in their review of our decisions in the event of an appeal

23 premiums. b. Focus of Outline: This Outline focuses on the second part of the equation: valuation discounts and premiums. However, before discussing valuation discounts and premiums in detail, an introduction to the concept of fair market value is appropriate. 2. Core Valuation Concepts: Practitioners should be well-versed in (1) the three most common approaches to determine the fair market value of property in tax cases, and (2) the principles of Revenue Ruling when valuing a business. a. Core Approaches to Valuation: The core approaches to valuation are (1) the market approach (also known as the comparable sales approach), (2) the income approach, and (3) the asset-based approach (also known as the cost approach). i. Different Values Indicated By Each Approach: Generally, each valuation approach may (and often does) result in different values. ii. Reconciliation Recommended: An appraisal report should reconcile different conclusions of value derived using the various approaches. Reconciliation allows the appraiser to evaluate alternate conclusions of value and select a final opinion of value from among two or more indicated values. Reconciliation also provides the appraiser with an opportunity to address shortcomings in his or her report, to determine which indication of value is most reliable, and to resolve any differences between the values indicated by his or her various approaches. iii. The Appraiser Must Understand the Level of Value Represented by Each Approach: As discussed below, the American Society of Business Valuation Standards VII notes that discounts and premiums have no meaning until the conceptual basis underlying the base value to which it is applied is defined. Different discounts and premiums may be applicable depending on which approach is applied. For example, when valuing a minority interest in an S corporation under the Guideline Public Companies Method (a subset of the Market Approach), consideration should be given to the fact that (a) the comparable companies may be C corporations, and thus an additional adjustment may be warranted for the S corporation nature of the company and (b) the trading prices of the public companies represent the price paid for fully marketable investments, and thus a marketability discount would likely be applicable. Valuations prepared under other approaches (such as the Cost Approach) may result in a base value with a different conceptual meaning, and thus require different discounts and/or premiums

24 b. The Market Approach (a/k/a the Comparable Sales Method): The market approach requires a comparison of the subject property with similar property sold in an arm s-length transaction in the same timeframe. 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....the market approach measures value properly only when the comparable property has qualities substantially similar to those of the subject property... Bank One Corp. v. Commissioner, 120 T.C. 174 (2003), aff d in part, vacated in part, and remanded sub nom. J.P. Morgan Case & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006) (internal quotations and citations omitted). c. The Income Approach: 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. Id. i. Methods Used Under the Income Approach: Within the income approach, there are two generally accepted valuation methods: 1. The discounted cash flow method, which typically uses a static growth rate assumption; and 2. The income capitalization method, which typically uses a variable growth rate assumption. d. The Cost Approach: The cost approach generally values property by determining the cost to reproduce or replace it less any applicable depreciation. Id. In business valuation, however, the definition is slightly more nuanced. There, 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. e. Other Approaches: The three main approaches to valuation can be further subdivided into several other valuation methods. Some of the approaches considered in recent tax cases include, but are not limited to, the subdivision development approach used in Crimi v. Commissioner, T.C. Memo For any specialized valuation case, the attorney should become familiar with the proper method to be used under those facts and then ensure that his expert s report comports with those standards. f. Rev. Rul : Rev. Rul , C.B. 237 generally Outlines and reviews the approach, methods, and criteria to be used in valuing property, with an emphasis on valuing a closely held business. The factors that the revenue ruling draws special

25 attention to are as follows: i. The nature of the business and the history of the enterprise from inception; ii. The economic outlook in general and the condition and outlook of the specific industry in particular; iii. The book value of the stock and the financial condition of the business; iv. The earning capacity of the company; v. The dividend-paying capacity of the company; vi. Whether or not the enterprise has goodwill or other intangible value; vii. Sales of the stock and the size of the block of stock to be viii. valued; and The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. 3. Step 1: Entity Valuation: To value a fractional interest in an entity or a property, it is common practice to first determine the value of the entity / property as a whole, before making any adjustment to account for the fractional interest nature of the interest in the entity / property being valued. a. Fair Market Value Defined: The fair market value of property is 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); see also Rev. Rul , C.B. 237; Treas. Reg A-1(c)(2). b. Implicit Assumptions: Implicit in the term fair market value are the following three base assumptions: i. Highest and Best Use: Fair market value assumes that the property to be valued must be valued at its highest and best use, which means that 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. In other words, the hypothetical willing buyer and willing seller will seek to maximize their economic advantage. 3 ii. Determined Without Regards to Subsequent Events: Fair market value requires that the value of the property is generally determined without regard to events occurring subsequent to the valuation date unless such an event was reasonably foreseeable as of the valuation date or relevant 3 See the discussion in Hall, Lance S., What You Don t Know About Fair Market Value Will Hurt You! (Part 5) Valuation Strategies: May/June

26 to the valuation. While simple on its face, in practice this concept can be ambiguous to apply. In Gallagher v. Commissioner, T.C. Memo , the Tax Court found that financial statements reflecting a period that had already occurred as of the valuation date, but had not yet been completed and closed by the company s internal accountants, would have been reasonably knowable by a hypothetical willing buyer of an interest in the subject company. In addition, sales and other market activity that provide evidence of market conditions affecting an asset to be valued (and would be considered by a hypothetical willing buyer of the interest) can generally be considered. 4 iii. Transaction for Cash and on Commercially Reasonable Terms: 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. See David Laro & Shannon P. Pratt, Business Valuation and Taxes: Procedure, Law, and Perspective, p. 9 (2d ed. John Wiley & Sons 2011). c. Fair Market Value as the Appropriate Measure of Value for Federal Tax Purposes: There are many different measures of value, some of which are appropriate for federal tax purposes, and some which are not. The appropriate measure of value for federal tax purposes, and the one that Treasury Regulations requires appraisers to use, is fair market value. See Treas. Reg A-13(c)(3)(ii) (for charitable contribution deductions), (b) (for estate tax purposes), (for gift tax purposes). i. Measures of Value: Different measures of value include, but are not limited to, market value, fair market value, fair value, appraised value, replacement value, orderly liquidation value, forced liquidation value, quick sale value, investment value, and intrinsic value. ii. Market Value Inappropriate: Appraisers, who generally speak in terms of the Uniform Standards of Professional Appraisal Practice ( USPAP ), often use market value as the appropriate measure of value. 5 The Tax Court has 4 See the discussion in Hall, Lance S., What You Don t Know About Fair Market Value Will Hurt You! (Part 2) Valuation Strategies: January/February USPAP Advisory Opinion 22 defines market value as the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition are the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

27 rejected appraiser s reliance of market value as the appropriate measure of value in federal tax cases. 1. Fair Market Value and Market Value Are Not Necessarily Synonymous: In Crimi v. Commissioner, T.C. Memo , 105 T.C.M. (CCH) 1330 (2013), the Tax Court observed that market value is an approximate value for fair market value and the two terms are not necessarily synonymous depending on how they are defined. See also Alli v. Commissioner, T.C. Memo n.17, 107 T.C.M. (CCH) 1082 (2014); Rothman v. Commissioner, T.C. Memo , 103 T.C.M. (CCH) 1864 (2012) (comparing Treas. Reg A-1(c)(c) (defining fair market value) with USPAP, Advisory Opinion 22 (2008) (defining market value)), vacated in part on reconsideration, T.C. Memo , 104 T.C.M. (CCH) 126 (2012); DiDonato v. Commissioner, T.C. Memo n.8, 101 T.C.M. (CCH) 1739 (2011). 2. Differences Between Fair Market Value and Market Value: The Tax Court s statement was not a mere exercise in semantics. A complete discussion of the ways in which market value and fair market value differ is outside the scope of this Outline, but the following points help to explain the key differences between the terms: a. Fair market value contemplates a transaction between a hypothetical willing buyer and a hypothetical willing seller; market value contemplates a transaction between an actual buyer and an actual seller; b. Fair market value assumes a hypothetical transfer of title; market value assumes an actual transfer of title; c. Fair market value requires the buyer and the seller to have reasonable knowledge of relevant facts ; market value requires only that the buyer and seller are well-informed 1. Buyer and seller are typically motivated; 2. Both parties are well informed or well advised and acting in what they consider their best interests; 3. A reasonable time is allowed for exposure in the open market; 4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and 5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale

28 and well-advised; and d. Fair market value does not require an actual date on which the title changes hands; market value requires an actual transfer of title on a date certain. Note: For a full discussion of the differences between market value and fair market value, see Alli v. Commissioner, T.C. Memo n.17, 107 T.C.M. (CCH) 1082 (2014); David Maloney, Market Value vs. Fair Market Value: What s the Difference?, available at 012/10/01/1265/ (as excerpted from David J. Maloney, Appraising Personal Property: Principles & Methodology (5th ed. 2012)). 3. Issues With Using the Wrong Measure of Value: Market value is an approximate measure for fair market value, but the two are not necessarily the same depending upon how the terms are defined and used. An appraiser s insistence to use market value could mean the appraisal is not reliable (i.e., it is not admissible because it fails Daubert). 4. Step 2: Apply Appropriate Discounts and Premiums: The second step in determining fair market value of a fractional interest in an entity or property is to apply appropriate discounts and premiums to the fair market value of the entity or property as a whole. This Outline focuses on this second step. a. Types of Valuation Discounts and Premiums: There are numerous types of valuation discounts and premiums, some of which are appropriate at the owner level, some of which are appropriate at the entity level, and some of which apply principally to real property. Among the types of valuation discounts and premiums discussed below are: i. Discount for lack of marketability; ii. Blockage or market absorption discounts; iii. Lack of control discount; iv. Lack of voting rights discount; v. Control premium / Minority interest discount; vi. Discount for built-in capital gain; vii. Key person discount; viii. Discount for contingent liabilities; ix. Portfolio discount; x. S corporation premiums; and ii. Fractional interest (i.e., partition) discounts. b. Appraiser s Standards for Valuation Discounts and Premiums: The

29 balance of this Outline focuses on legal and tax principles applicable to valuation discounts and premiums. However, it is also important to understand appraisers approaches to those items. The American Society of Appraisers Business Valuation Standards VII summarizes as follows how valuation discounts and premiums apply to business valuations: I. Preamble A. This Standard must be followed in all valuations of businesses, business ownership interests, securities and intangible assets developed by all members of the American Society of Appraisers, be they Candidates, Accredited Members (AM), Accredited Senior Appraisers (ASA), or Fellows (FASA). B. The purpose of this Standard is to define and describe the requirements for the use of discounts and premiums whenever they are applied in the valuation of businesses, business ownership interests, securities and intangible assets. C. This Standard applies to appraisals and may not necessarily apply to limited appraisals and calculations as defined in BVS-I General Requirements for Developing a Business Valuation, Section II.C. D. This Standard incorporates the General Preamble to the ASA Business Valuation Standards. E. This Standard applies at any time in the valuation process, whether within a method, to the value indicated by a valuation method, or to the result of weighting or correlating methods. II. The concepts of discounts and premiums A. A discount has no meaning until the conceptual basis underlying the base value to which it is applied is defined. B. A premium has no meaning until the conceptual basis underlying the base value to which it is applied is defined. C. A discount or premium is warranted when characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied. D. A discount or premium quantifies an adjustment to account for differences in characteristics affecting the value of the subject interest relative to the base value to which it is compared

30 III. The application of discounts and premiums A. The purpose, applicable standard of value, or other circumstances of an appraisal may indicate the need to account for differences between the base value and the value of the subject interest. If so, appropriate discounts or premiums should be applied. B. The base value to which the discount or premium is applied must be specified and defined. C. Each discount or premium to be applied to the base value must be defined. D. The primary reasons why each selected discount or premium applies to the appraised interest must be stated. E. The evidence considered in deriving the discount or premium must be specified. F. The appraiser s reasoning in arriving at a conclusion regarding the size of any discount or premium applied must be explained

31 III. Owner-Level Discounts A. Discount for Lack of Marketability 1. Overview: a. Marketability Defined: Marketability is the ability to quickly convert property to cash at a minimal cost. International Glossary of Business Valuation Terms, as adopted in 2001 by the American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Businesses Valuators, National Association of Certified Valuation Analysis, and the Institute of Business Appraisers. b. Discount for Lack of Marketability Defined: A discount for lack of marketability (sometimes, DLOM ) is an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Shannon P. Pratt & Alina V. Niculita, Valuing a Business, The Analysis and Appraisal of Closely Held Companies, p. 39 (5th ed. New York, McGraw Hill, 2008). It is designed to reflect that there is no ready market for shares in a closely held corporation. Estate of Andrews v. Commissioner, 79 T.C. 938, 953 (1982). i. Liquidity Compared to Marketability: While some appraisers see liquidity and marketability as largely overlapping, others identify a difference between liquidity and marketability that is fine yet distinct. 1. Marketability: The term marketability refers to the salability of property (i.e., whether the property can be sold). 2. Liquidity: The term liquidity refers to whether the property can be readily converted into cash without a significant loss of principal (i.e., how long it will take for the property to be sold). 3. Applicability of Discounts: While generally discounts are warranted for non-marketable investments, whether a discount would be applicable to an illiquid investment depends on the facts and circumstances of the valuation. For example, if a real property investment (which is less liquid than publicly traded stock) would require a six-month marketing period to sell, but is valued by reference to sales of similar properties which would also require six months to sell, then the illiquidity of the property is already reflected in the selling prices of the comparable properties and thus no discount is applicable. In contrast, if a large block of publicly traded stock would require six months to sell in full, but is valued by reference to the public trading price, then an illiquidity discount should be applied 60-31

32 from the public trading price. c. Theory Behind DLOM: The theory behind the DLOM is that a hypothetical willing buyer, given two otherwise identical business interests, will generally pay a premium for a business interest that can be readily converted into cash without risk of loss in value. The corollary, of course, is that a hypothetical willing buyer will generally want a discount for acquiring a business interest that cannot be quickly sold and converted into cash. (See also Revenue Ruling , which identifies the factors causing the marketability discount as the risk that underlying value of the stock will change in a way that, absent the restrictive provisions, would have prompted a decision to sell and the risk that the contemplated means of legally disposing of the stock may not materialize. Because there is a greater level of market demand for assets that will allow investors to exit their investment at the time of their choosing (which is more valuable in the context of greater volatility in the returns of the investment) as well as allow investors to rebalance their portfolios on a more regular basis and thus more optimally achieve portfolio diversification, the aggregate market demand for marketable assets will generally result in their price being bid up to a level greater than that of non-marketable investments. In other words, while there exist investors who do not require marketability to the same extent as others, those long-term investors will not overpay for non-marketable assets but rather seek to capture a liquidity premium (through a lower price paid) associated with their non-marketable assets. 2. Factors That Affect Marketability: a. Fact-Sensitive Inquiry: There are many factors that can affect the marketability of property, but ascertaining the appropriate DLOM is always a factual determination. b. The Mandelbaum Factors: The factors were summarized by the Tax Court in Mandelbaum v. Commissioner, T.C. Memo , aff d without published opinion, 91 F.3d 124 (3d Cir. 1996). The factors set forth in Mandelbaum are as follows: i. The value of the subject corporation s privately traded securities vis-à-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation s public and private stock); ii. An analysis of the subject corporation s financial statements; iii. The corporation s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends; iv. The nature of the corporation, its history, its position in the industry, and its economic outlook; v. The corporation s management;

33 vi. The degree of control transferred with the block of stock to be valued; vii. Any restriction on the transferability of the corporation s stock; viii. The period of time for which an investor must hold the subject stock to realize a sufficient profit; ix. The corporation s redemption policy; and x. The cost of effectuating a public offering of the stock to be valued (e.g., legal, accounting, and underwriting fees). Approved by the Eleventh Circuit: The Mandelbaum factors and opinion s reasoning was cited approvingly by the U.S. Court of Appeals for the Eleventh Circuit in Estate of Jelke v. Commissioner, 507 F.3d 1317 (11th Cir. 2007), cert. den. 129 S. Ct. 168 (2008). 3. Quantifying the DLOM: Overview: There are various approaches valuators use to quantify the appropriate discount for lack of marketability when valuing a business interest. For convenience, and given that many appraisers can categorize these approaches in different ways, we have categorized the approaches following the Job Aid for IRS Valuation Professionals entitled Discount for Lack of Marketability and dated September 25, These approaches include: i. Benchmark study approaches, including restricted stock studies and pre-initial public offering ( IPO ) studies; ii. Security-based approaches; iii. iv. Analytical approaches; and Other approaches, including an analysis using the factors in Mandelbaum v. Commissioner, T.C. Memo b. Benchmark Study Approaches: i. Overview: The so-called benchmark studies come in two forms: restricted stock studies; and pre-ipo studies. We discuss each in turn. ii. Restricted Stock Studies: 1. How Restricted Stock Studies Determine DLOM: Restricted stock studies estimate the DLOM on the basis of restricted stock. These studies are premised on the theory that the effect of lack of marketability can be quantified by comparing the sales price of publicly traded shares of stock to the sale price of restricted shares of stock of the same company that are identical in all rights and powers other than the ability to be freely transfer the shares. Valuators 6 This is a key document and it explains the ways in which to calculate the DLOM. It is an excellent resource for anyone reviewing an appraisal report or preparing for a case in which DLOM is at issue

34 often use the Mandelbaum factors to refine or adjust their determination of DLOM, and others treat Mandelbaum as a standalone approach for calculating DLOM. a. Restricted Stock Defined: Restricted stock is unregistered common stock of a corporation that is identical in every respect to its publicly traded shares, except that the restricted stock has not been registered and may not be freely sold through public transactions due to securities laws and regulations. Restricted stock is often used synonymously with unregistered stock or letter stock, and refers to (1) unregistered shares issued by public companies in private placement transactions, and (2) registered and unregistered securities held by affiliates of issuers. 7 b. Restricted Stock Studies: Restricted stock studies are published, empirical studies. The most common restricted stock studies (and the indicated DLOMs are summarized in the following chart: Restricted Stock Studies Attempting to Measure the DLOM for Private Firms 8 Empirical Study Period Covered Average Discount SEC overall average (a) 1/66 6/ SEC nonreporting OTC companies (a) 1/66 6/ Gelman (b) 1/68 12/ Trout (c) 1/68 12/ Moroney (d) 1/69 12/ Maher (e) 1/69 12/ Standard Research Consultants (f) 10/78 6/ (median) Willamette Management Associates (g) (median) Silber (h) 1/81 12/ FMV Opinions, Inc. (i) 7/80 9/ Management Planning, Inc. (j) 1/80 12/ Bruce Johnson Study (k) 1/91 12/ Columbia Financial Advisors (l) 1/96 4/ Columbia Financial Advisors (l) 5/97 12/ See Determining Discounts for Lack of Marketability: A Companion Guide to the FMV Restricted Stock Study. FMV Opinions, Inc. and Business Valuation Resources, 2015 Edition. 8 Source: Stockdale Sr., John J. Discounts for Lack of Marketability Theory, Evidence and Technique. Business Valuation Resources, LLC: 2011; Pratt and Niculita, ibid; and FMV Opinions, ibid

35 Bajaj, Denis, Ferris, Sarin 2001 (m) Finnerty (n) Wu (o) Barclay / Holderness / Sheehan (p) Harris Trugman Valuation Associates (q) (a) Discounts Involved in Purchases of Common Stock ( ), Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Do. No , Part 5, 92nd Congress, 1st Session, 1971, (b) Milton Gelman, An Economist Financial Analyst s Approach to Valuing Stock of a Closely Held Company, J. TAX N, (June 1972). (c) Robert R. Trout, Estimation of the Discount Associated with the Transfer of Restricted Securities, TAXES, (June 1997). (d) Robert E. Moroney, Most Courts Overvalue Closely Held Stocks, TAXES, (Mar. 1993). (e) Michael J. Maher, Discounts for Lack-of-marketability for Closely Held Business Interests, TAXES, (Sept. 1976). (f) William F. Pittock, and Charles H. Stryker, Revenue Ruling Revisited, SRC Quarterly Reports (Spring 1983). (g) Willamette Management Associates study (unpublished) (h) William L. Silber, Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal, (July-August 1991). (i) Determining Discounts for Lack of Marketability: A Companion Guide to the FMV Restricted Stock Study. FMV Opinions, Inc. and Business Valuation Resources, 2015 Edition. (j) Robert P. Oliver & Roy H. Meyers, Discounts Seen in Private Placements of Restricted Stock: The Management Planning, Inc., Long-Term Study ( ) (Chapter 5) in Robert F, Reilly and Robert P. Schweihs, eds, The Handbook of Advanced Business Valuations (New York: McGraw-Hill, 2000). (k) Bruce Johnson, Restricted Stock Discounts, , Shannon Pratt s Business Valuation Update, Vol. 5, No. 3, March 1999, pp Quantitative Support for Discounts for Lack of Marketability. Business Valuation Review, December, 1999, pp (l) Kathryn F. Aschwald, CFAI Study, Restricted Stock Discounts Decline as Result of 1-Year Holding Period Studies After 1990 No Longer Relevant for Lack of Marketability Discounts, SHANNON PRATT'S BUSINESS VALUATION UPDATE, Vol. 6, No. 5, May 2000, pp (m) Mukesh Bajaj, David J. Denis, Stephen P. Ferris & Atulya Sarin, Firm Value and

36 Marketability Discounts. Journal of Corporation Law, Vol. 27 (Fall 2001), (n) John D. Finnerty, The Impact of Transfer Restrictions on Stock Prices, Presented at Various Conferences. (o) YiLun Wu, The Choice of Equity Selling Mechanisms, Journal of Financial Economics 74 (2004) (p) Michael J. Barclay, Clifford G. Holderness & Dennis P. Sheehan, Private Placements and Managerial Entrenchment, The Journal of Corporate Finance 2007 Vol. 13 Issue (q) Harris William, Trugman Valuation Associates, Inc. (TVA) Restricted Stock Study, Business Valuation Review, Vol. 28 No. 3 (Fall 2009), c. More Recent Restricted Stock Studies Generally Support a Lower DLOM Than Older Restricted Stock Studies: Generally, the DLOM indicated by older restricted stock studies is greater than that indicated by more recent restricted stock studies. This phenomenon can be explained by (1) the increase in volume of private placed stock under Rule 144 than in earlier years, and (2) changes in the minimum investment holding period required under Rule 144 from two years to one year and then from one year to six months. d. How to Apply: In the past, many appraisers would rely on averages from one or more restricted stock studies, and by judgment alone would adjust the discount upward or downward based on a qualitative analysis. Increasingly, however, appraisers are performing a detailed comparison between the subject entity and the transactions in the restricted stock studies. A detailed comparison analysis is generally preferred by the Courts; for example, in Temple v. U.S. (No 903-CV-165 March 10, 2006), Judge Heartfield writes that rather than picking a discount based on average discount indications from restricted stock studies, the better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner. Similarly, in Peracchio v

37 Commissioner, T.C. Memo ,, Judge Halpern also criticized an approach relying on average discount indications rather than a comparative analysis. 9 For certain studies, there is enough detailed information about the publicly-traded companies issuing restricted stock to allow for a robust comparative analysis. Generally, comparative analyses of the restricted stock studies suggest that discounts are higher for companies that (a) are smaller in size; (b) have a high market-to-book ratio (in other words, a lower percentage of the market capitalization is comprised of tangible assets); (c) are less profitable; and (d) are more volatile in terms of historical pricing. In addition, while restricted stock studies generally include few companies that pay dividends (thus making a thorough comparative analysis on this issue less feasible), appraisers generally agree (consistent with the Mandelbaum factors) that companies which pay dividends warrant lower marketability discounts, all else being equal. 2. Strengths and Weaknesses of Restricted Stock Studies as Compared to Pre-IPO Studies: a. Strengths: i. The stock is generally identical to its freely traded counterpart, except for the duration of the resale restriction; ii. Restricted stock studies tend to be reliable because valuators performed concentrated research and actual iii. numerical values were produced; and Historically, the Tax Court has accepted these types of studies. b. Weaknesses: i. Restricted stock studies rely heavily on historical data and may not be indicative of then-current fair market value; 9 Specifically, Judge Halpern states that the appraiser makes no attempt whatsoever to analyze the data from those studies as they relate to the transferred interests. Rather, he simply lists the average discounts observed in several such studies, effectively asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests

38 ii. iii. Restricted stock studies may include restricted stock with a longer holding period than is currently allowed. In this regard, pre-1997 restricted stock studies rely on a two-year holding period to reflect then-current law. However, in April 1997 the holding period for restricted stock was reduced from two years to one year. Then, effective in 2008 the holding period was further reduced from one year to six months. The appraiser will need to understand how the different initial holding periods will affect the magnitude of the discount for a given transaction. Furthermore, the initial holding period of between six months and two years (after which the restricted shares can be freely traded subject to Rule 144 volume limitations) means that in many cases restricted shares are more liquid than interests in closelyheld businesses which cannot be freely sold for an indefinite period of time. The appraiser will need to evaluate whether an adjustment must be made to the discount indicated by the restricted stock studies to account for what in many cases will be a materially lower level of marketability for the private entity. Restricted stock studies, because some provide such a broad range, create the opportunity for abuse. For this reason, and consistent with the approaches taken by the Courts, it is advisable for appraisers to perform a detailed comparative analysis to isolate the factors which would result in relatively higher or lower discounts within a particular range. 3. Questions to Ask When Reviewing Restricted Stock Studies: A number of errors regularly arise with respect to restricted stock studies. These errors can be minimized by asking the following questions:

39 iii. a. Is the appraiser using the most currently available restricted stock studies? b. If the appraiser is using a combination of old and new restricted stock studies, how is he or she weighting the new restricted stock studies more relative to the old restricted stock studies? c. Has the appraiser taken into account the difference in holding period under existing restricted stock studies (e.g., one or two years) and for current restricted stock (e.g., six months). d. Has the appraiser considered the extent to which the marketability discounts for certain transactions in the restricted stock studies may be affected by blockage and/or Rule 144 volume limitations (in other words, resulting in a longer effective holding period than the initial holding period required under Rule 144)? e. Has the appraiser addressed (and reconciled) variances and ranges of discounts indicated by the restricted stock studies? f. Has the appraiser explained the basis for relying on a median or mean indicated by the restricted stock studies? g. Has the appraiser explained similarities and differences between the subject company and the companies identified in the restricted stock studies? h. **Has the appraiser analyzed the Mandelbaum factors to determine how (if at all) the DLOM indicated by the restricted stock studies should be adjusted? Pre-IPO Studies: 1. How Pre-IPO Studies Determine DLOM: Pre-IPO studies estimate the DLOM on the basis of restricted stock Pre-IPO studies are premised on the theory that the effect of lack of marketability can be quantified by analyzing identical stock of the same company and comparing price points before the stock is publicly traded and at the point that a liquidity event, such as an IPO, occurs It is important to note that many IPO companies enter into agreements with the investment bank(s) underwriting their IPO which restricts holders of pre-ipo stock from selling the stock in the public market for a period of time after the IPO (often approximately six months)

40 a. Less Prevalent Than They Once Were: Pre- IPO studies are less prevalent than they used to be because the Tax Court rejected pre- IPO studies in McCord v. Commissioner, 120 T.C. 358 (2003), rev d, 461 F.3d 614 (5th Cir. 2006). 2. How it Works: Pre-IPO studies examines arm slength sale transactions in the stock of a closely held company that has subsequently achieved a successful IPO of its stock. In a pre-ipo study, the DLOM is quantified by analyzing (with various adjustments) the difference between the public market price at which a stock was issued at the time of the IPO and the private market price at which a stock was sold prior to the IPO. The amount of the indicated DLOM should then be adjusted using the Mandelbaum factors. 3. Sets of Studies: Pre-IPO studies are also published, empirical studies. The most common pre-ipo studies (and the indicated DLOMs) are: a. WMA Study: Willamette Management Associates ( WMA ) performed a series of studies on the prices of private stock transactions relative to those of public offerings of stock of the same companies. The studies covered the years 1975 through The median discounts ranged from 31.8% to 73.1%. b. Emory Study: John D. Emory of Robert W. Baird & Company conducted another series of pre-ipo studies. The studies covered various time periods from 1981 through 2000, and each employed the same methodology. The population of companies in each study consisted of IPOs during the respective time period in which Baird & Company participated in or for which prospectuses were received. The prospectuses of over 4,000 offerings were analyzed to determine the relationship between (1) the price at which the stock was initially offered to the public, and (2) the price at which the latest private transaction occurred up to five months prior to the IPO. The mean discount for all nine studies is 46%

41 c. Pearson Study: Brian Pearson of Valuation Advisors, LLC (VAL) developed Valuation Advisors' Lack of Marketability Discount Study. This study, which currently includes 12,078 pre-ipo transactions from 1985 to the present, compares the IPO stock price to pre-ipo common stock, common stock option and convertible preferred stock prices. These market-based transactions demonstrate the lack of marketability discount afforded by the pre-ipo securities as a result of their illiquidity when issued by a privately held company. 4. Strengths and Weaknesses of Pre-IPO Studies: a. Strengths: i. Pre-IPO studies rely upon market and empirical data to derive the DLOM; and ii. Pre-IPO studies include a substantial number of transactions, which allows for a robust comparative analysis by the appraiser. b. Weaknesses: i. Pre-IPO studies are rarely (if ever) contemporaneous. Thus, it is often the case that too much time exists between the pre-ipo transaction and the public offering. As a result, part of the discount might reflect an increase in the value of the business between the date of the private transaction and the IPO. ii. iii. iv. Pre-IPO companies rapidly evolve and the indicated DLOM may be attributable to a change in value of the company over that time frame. The data in the pre-ipo studies includes only firms with successfully completed IPO s. The studies do not account for candidate companies where the IPO eventually does not occur. However, the price at which the pre-ipo stock is acquired would reflect some probability of the IPO not proceeding. Pre-IPO transactions tend to be

42 iv. under-priced because (1) most IPOs involve high growth companies, and (2) underwriters usually strive for a full subscription. 5. Pre-IPO Studies Compared to Restricted Stock Studies: Pre-IPO studies tend to indicate a DLOM that is higher than that provided by restricted stock studies. 6. Questions to Ask When Reviewing Pre-IPO Studies: A number of errors arise regularly arise with respect to pre-ipo studies. These errors can be minimized by asking the following questions: a. Has the appraiser considered separation of lack of marketability from other effects (e.g. management compensation, risk of the IPO failing, and appreciation between the date of the pre-ipo transaction and the IPO) that might be contributing to discounts observed in the Pre-IPO studies? b. Has the appraiser addressed variance and/or range of discounts observed in the Pre-IPO studies? c. On what basis did the appraiser determine that a particular mean or median discount from the Pre-IPO studies applies? d. On what basis did the appraiser adjust the mean or median discount data to value the subject interest? e. If the appraiser is using specific pre-ipo transactions from a database, on what basis did the appraiser isolate those particular pre- IPO transactions to compare to the subject interest? f. **Has the appraiser analyzed the Mandelbaum factors to determine how (if at all) the DLOM indicated by the pre-ipo studies should be adjusted? Analyzing Restricted Stock Studies and Pre-IPO Studies Common: Many valuators consider the results indicated by the restricted stock studies and the pre-ipo studies and reconcile the two (to the extent inconsistent). c. Security-Based Approach: i. In General: The security-based approaches to estimate he DLOM are based upon theoretical option pricing models and the illiquidity demonstrated by traded stock prices and option prices

43 ii. Calculating the DLOM Using the LEAPS Study: The LEAPS study was originally published in 2003 and updated in 2005, 2007, and A LEAP is a long-term put option with a term of approximately 1.5 to 2.0 years. Thus, an investor can buy protection against stock price declines by purchasing a LEAP option. The LEAP studies examined the cost of purchasing the LEAP option. The DLOM is then calculated as the cost of the put option divided by the stock price. 1. One-Year LEAPS: One-year median discounts indicated under the LEAPS approach range from 8.3% for the safest company and 17% for the riskiest company. 2. Two-Year LEAPS: Two-year median discounts indicated under the LEAPS approach range from 9.3% for the safest company and 31% for the riskiest company. 3. Which LEAP to Use? Which LEAP option to use would depend upon the length of time it would take to market and sell the subject interest. iii. Calculating the DLOM Using Black Scholes Option Pricing: 1. In General: In 1993 David Chaffee III published an article on his theory that the Black Scholes Option Pricing Model could be used to determine the DLOM. He found that a European Option, which can be exercised only at maturity, was an appropriate model for Rule 144 Holding Period of restricted shares. 2. Method of Calculating DLOM: The Chaffee article relied upon the Black Scholes Option Pricing Model for a put option to determine the cost or price of the put option. The cost of the put option divided by the market price equals the DLOM. a. Two-Year Options: The indicated DLOM for a stock with a two-year holding period was between 28% and 41%, which Chaffee cites as similar to restricted stock studies. b. Four-Year Options: The indicated DLOM for a stock with a four-year holding period was between 32% and 49%. c. Greater-Than Four Years: The indicated DLOM for a stock with a holding period greater than four years was comparable to those indicated for four-year options. iv. Calculating the DLOM Using the Longstaff Study: The

44 Longstaff study is based on the price of a look back option, which is an option that settles based upon the maximum or minimum underlier value achieved during the life of the option. Using option-pricing theory, the model relies on the restriction period and the volatility or standard deviation of a security s return. The Longstaff study assumes that an investor with perfect timing ability could identify a point in time in which the security price reaches its maximum value. If an investor is locked up for a certain period of time the investor gives up the opportunity to sell the security at its maximum price. The DLOM in the Longstaff study is the present value difference between what the investor could sell the security for after the marketability restrictions have lapsed and the maximum price the security could have sold for during the restriction period. 1. Generally Not Favored: Because the Longstaff study assumes perfect timing, the indicated DLOM is generally higher than under other approaches. It also produces results which may not be realistic depending upon the facts and circumstances of the case. Thus, Longstaff option pricing should be viewed skeptically. v. Strengths and Weaknesses of Securities-Based Approaches: 1. Strengths: a. Magnitude of the discount is affected by factors such as holding period, dividends, and volatility which most appraisers agree are key factors when determining the marketability discount. b. Data that is valuation date-specific can be utilized (for example, pricing as of a given valuation date would be available for many LEAPS). 2. Weaknesses: a. Many of the securities-based approaches effectively calculate the cost of a put option such that an investor s return will be locked in, thus removing some of the negative impact to lack of marketability (namely the risk of experiencing a decline in price and being unable to sell the security in the public market). However, while a put option provides downside protection, the investor can still benefit from appreciation. Thus, the price of a put option to a large extent reflects

45 the benefit to the purchaser of generating asymmetric returns. Some appraisers have suggested an analytical approach that offsetts the cost of a put with the potential income that can be generated by selling call options (and thus creating a collar). 11 b. With the exception of LEAPs, the securitiesbased approaches are not based on actual transactions between buyers and sellers. Thus, the appraiser must carefully address whether the discount calculated from a securities-based approach would be acceptable to the hypothetical willing seller of the interest. d. Analytical Approach: i. Karen Hopper Wruck Study 12 : 1. Summary: Karen Wruck studied 128 private sales of equity between July 1979 and December She studied the difference in reported discounts between placement of registered shares and unregistered shares and found an average difference in discounts of 17.6% and a median difference in discounts of 10.4%. The difference in discounts was largely attributed to different levels of marketability between the registered and unregistered shares. 2. View of Appraisers: The Wruck Study is often used as background material by appraisers in determining the theory behind the discount for lack of marketability and is usually not presented as actual evidence. ii. Hertzel & Smith Study: 1. The Theory: The Hertzel & Smith study examined market discounts and shareholder gains involved in the private placement of equity. The authors hypothesized that private equity placements are often undertaken by firms with limited tangible assets, by firms engaged in the speculative development of new products and by firms in financial distress. Due to the higher risk inherent in these types of firms, they tend to offer private 11 For example, David M. Eckstein writes that the Black-Scholes Option Pricing Model is inappropriate for determining marketability discounts because it measures the value of a derivative security with an asymmetrical payoff, not the value of liquidity it allows (in greatly simplified terms) the holder of an asset to continue to benefit from an increase in the value of the asset while not being hurt by a decrease in the value of the asset. See David M. Eckstein, Black-Scholes and Marketability: Another View. Valuation Strategies: September/October Wruck, Karen Hopper, Equity Ownership Concentration and Firm Value, Journal of Financial Economics 23 (1989)

46 iii. placements priced at higher than normal discounts. These higher than normal discounts compensate investors for the higher information costs incurred and the higher monitoring costs required to keep suitably informed of investment status. Based upon these premises, the authors believed that the discounts required to sell equity privately existed for a number of reasons beyond the potential lack of marketability of the purchased shares or the expectation that the buyers would provide services as well as investment capital. 2. How Hertzel & Smith Tracks the DLOM: The authors analyzed 106 private equity placements with about 75% of those being firms traded overthe-counter (i.e., in secondary markets). The time period of the study was January 1, 1980, through May 31, The measurement date used was 10 days after the announcement of the placement was made. 3. Regression Analysis Used to Determine DLOM: The authors performed a regression analysis using seven independent variables with the registered versus unregistered variable used to estimate DLOM. The average private placement discount (i.e., the indicated DLOM) equaled 20.14%. 4. View of Appraisers: Similar to the Wruck Study, often used as background material but not presented as actual evidence. Bajaj, et al: 1. Similarity to Hertzel & Smith: Mukesh Bajaj, et. al analyzed private equity placements from January 1, 1990, through December 31, 1995, involving 88 transactions. The measurement date used was 10 trading days after the announcement date. Accounting data was drawn from Compustat and a cross-sectional analysis of discounts was made using regression techniques. 2. Indicated DLOM: Bajaj found that, on average, all private placements are made at discounts whether the block placed consists of registered shares or non-registered shares. For registered shares, the average discount was 14.04% and for unregistered shares the average discount was 28.13%. The respective median discounts were 9.85% and 26.47%. Combining unregistered and registered share transactions gave an overall average discount

47 of 22.21% and a median discount of 20.67%. Dr. Bajaj and his co-authors noted that the percentage difference between registered and unregistered shares was 14.09%and after preparing a regression analysis, suggested that registered shares (holding all other factors constant) would warrant a discount 7.23 percentage points less than unregistered shares. Dr. Bajaj and his co-authors postulated that because registered shares were believed to be readily marketable, then the difference in discounts between registered and unregistered shares represented the appropriate marketability discount. 3. Criticisms and Support: Dr. Bajaj has argued that discounts for lack of marketability may be overstated in many cases because the discount for restricted stock may reflect elements of compensation. See Mukesh Bajaj et al., Firm Value and Marketability Discounts, J. Corp. L. (Oct. 2001). Many in the valuation community have criticized Dr. Bajaj s interpretations of his results. For example, the registered private placements which Dr. Bajaj assumed to be liquid were indeed illiquid under Rule 144, due to the size of the block of shares. However, others think there is merit in Dr. Bajaj s observation that indicated DLOMs may be overstated because of elements of compensation present in restricted stock but not necessarily present in other closely held and family-owned companies. e. Other Approaches: i. Mandelbaum: Some, including the Service and the Eleventh Circuit in Estate of Jelke, cite the Mandelbaum factors as a standalone approach for determining the DLOM that is preferred in many instances because of its qualitative analysis and similarities to Rev. Rul , C.B See Service, Discount for Lack of Marketability, Job Aid for IRS Valuation Professionals, at pp , (Sept. 25, 2009), available at Others, including some judges on the Tax Court, state that Mandelbaum should not be given considerable weight because it is a non-precedential Tax Court Memorandum Opinion limited to its facts. See, e.g., Peracchio v. Commissioner, T.C. Memo ii. QMDM (Chris Mercer) 13 : 13 Discussed in Z. Christopher Mercer, Quantifying Marketability Discounts, Peabody Publishing, LP,

48 iii. 1. Summary: The Quantitative Marketability Discount Model calculates a matrix of discounts for lack of marketability based on specific variables including asset appreciation rate, holding period until liquidation and the required rate of return for a hypothetical investor of a non-marketable investment. The appraiser can then select a discount within the matrix that the appraiser believes most corresponds to the fact pattern associated with the interest being valued. 2. Considerations in the Application of the Model: The discounts from the method can vary significantly depending on the inputs used. Thus, the appraiser should clearly explain and support each input used. Others: 1. Many other methodologies for determining the discount for lack of marketability has been advanced by appraisers, although a full discussion is beyond the scope of this Outline Issues to Be Aware of With Respect to the DLOM: a. Do Not Ignore the Hypothetical Seller: By and large, appraisal reports in which DLOM is determined will invariably focus on the factors that affect the buyer (i.e., valuator never asks whether the indicated price is something the hypothetical seller would accept). This is foolish. The Mandelbaum factors should also be viewed from the perspective of the seller to determine the indicated DLOM. An appraisal report that considers both perspectives has a better chance of being considered reliable. b. Qualitative Analysis Important: As the forgoing studies illustrate, the DLOM can vary greatly based upon the study used. For this reason, it is important for appraisers to not only analyze the DLOM under the various studies but to justify the selected DLOM in the light of the Mandelbaum factors. c. Examine for Reasonableness: In reviewing an appraisal in which DLOM is calculated, practitioners should critically evaluate the report for its overall reasonableness and completeness. d. Understand the value that is being discounted: When using restricted stock studies, the publicly-traded price and price of restricted stock both represent non-controlling levels of value. Thus, the value to which the marketability discount would be applied should already be discounted for lack of control or 14 The IRS Job Aid mentions the following: (1) NICE (William Frazier) method outlined in William Frazier, Non- Marketable Investment Company Evaluation (NICE), Valuation Strategies (November/December 2006); and (2) NERA (David Tabak) outlined in Dr. David Tabak, A CAPM-Based Approach to Calculating Illiquidity Discounts. Working Paper: November 11, Other approaches have been advanced within the valuation community as well

49 represent a non-controlling level of value. However, the value of some assets (such as real estate or controlling interests in businesses) may already incorporate a length of time required to sell that is substantially larger than the public equity market, which should be considered before applying a further marketability discount. e. Mandelbaum v. Commissioner: In Mandelbaum v. Commissioner, T.C. Memo , which is further described above, the Tax Court determined a discount for lack of marketability of 30%. f. Estate of Jelke v. Commissioner: In Estate of Jelke v. Commissioner, T.C. Memo , the Tax Court allowed a discount for lack of marketability equal to 15%. g. Huber v. Commissioner: In Huber v. Commissioner, T.C. Memo , the Tax Court accepted a 50% discount for lack of marketability claimed by the taxpayer for gifted shares in a large privately held company with over $500 million in sales and approximately 250 shareholders, primarily from one extended family. Over the years, the company had annual valuations performed utilizing a 50% discount for lack of marketability. These valuations were used for many purposes including gifting to family members, charitable gifts, company stock redemptions, stock option grants and fixing compensation for board members. Over a six-year period, there were approximately 90 transactions and transfers involving company shares utilizing the annual valuations. The Tax Court viewed the variety of relationships among the shareholders in Huber as a positive indicator of the existence of arm s-length sales and rejected the IRS s suggestion that almost 250 shareholders would harmoniously accept an artificially low valuation of the Huber stock so that a few people who may or may not be related to them can pay less estate tax. h. Estate of Green v. Commissioner: In Estate of Green v. Commissioner, T.C. Memo , with both experts essentially agreeing to the undiscounted value of a privately-held bank, the primary focus of the Tax Court was on the discount for lack of marketability. The taxpayer s expert claimed a 40% discount for lack of marketability and the IRS s expert claimed a 25% discount for lack of marketability. Both experts relied primarily on restricted stock discount studies. Both experts began with the restricted stock studies discount averages, and then gave varying reasons as to why they moved off of the average discount in the studies. However, as neither expert had the underlying restricted stock transaction data, the Tax Court concluded that the reasons given for moving off of the discount average were not supportable. Accordingly, the Tax Court concluded at a 35% discount for lack of marketability. i. Lappo v. Commissioner: In Lappo v. Commissioner, the Tax Court

50 determined a discount for lack of marketability of 24%. j. Peracchio v. Commissioner: In Peracchio v. Commissioner, T.C. Memo , the Tax Court determined a 25% discount for lack of marketability. In doing so, the Tax Court criticized the analysis of both experts, each of whom relied on restricted stock studies. While the Tax Court stated that restricted stock studies certainly have some probative value in the context of marketability discount analysis, The taxpayer's expert was criticized for making no attempt whatsoever to analyze the data from these studies as they relate to the transferred interest. Rather, he simply lists the average discounts observed in several such studies. Similarly, the analysis of the IRS s expert was criticized. 5. Cases Applying DLOM: a. Temple v. U.S. No. 9:03-CV-165 (March 10, 2006): This case involving gifts in numerous asset holding entities centered on the appropriate methods to determine the discount for lack of marketability. The taxpayer s experts utilized the QMDM and the average discounts found in various restricted stock studies to establish the discount for lack of marketability. The IRS s expert utilized a comparative analysis with the underlying restricted stock data. The Court accepted the IRS s expert s methodology, stating that the expert endeavored to understand and incorporate the market dynamics of restricted stock sales while the Taxpayer s expert simply listed the studies and picked a discount based on the range of numbers in the studies The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner. B. Blockage & Market Absorption Discounts 1. Overview: Another factor which may affect the salability of a company s stock is if the price obtainable for a block of stock is affected by the size of the block of stock. A blockage discount is appropriate in such cases to account for the depressing effect of placing a large block of stock on the open market for sale at one time. Estate of Trompeter v. Commissioner, T.C. Memo In most respects, a blockage discount reflects the additional time it takes to sell property without depressing the property s fair market value by overwhelming the market with a large number of items of that type. a. When Blockage Discount Appropriate: A blockage discount is appropriate where a block of stock could not have been sold on the valuation date (or within a reasonable period thereafter) without an affect on the market price. Richardson v. Commissioner, 151 F.2d 102, 103 (2d Cir. 1945). i. Reasonable Period: Determining a reasonable period of time depends upon all the facts and circumstances. See Estate of Sawade v. Commissioner, T.C. Memo , aff d, 795 F.2d 45 (8th Cir. 1986). Periods of up to one

51 year have been found to be reasonable, id., but the period may be shorter or longer if factors such as market volatility and time limitations so dictate, see, e.g., Du Pont v. Commissioner, 2 T.C. 246 (1943); Estate of Sawade v. Commissioner, T.C. Memo b. Treasury Regulations Acknowledge Blockage Discount May Be Appropriate With Respect to Stocks and Bonds: Treas. Reg (e) allows estate to depart from the normal method of valuing stocks and bonds where a sizable block of securities is involved. It provides as follows: In certain exceptional cases, the size of the block of stock to be valued in relation to the number of shares changing hands in sales may be relevant in determining whether selling prices reflect the fair market value of the block of stock to be valued. If the executor can show that the block of stock to be valued is so large in relation to the actual sales on the existing market that it could not be liquidated in a reasonable time without depressing the market, the price at which the block could be sold as such outside the usual market, as through an underwriter, may be a more accurate indication of value than market quotations. c. Market Absorption as a Close Cousin of Blockage Discount: A discount closely related to a blockage discount, but which tends to be applied to real property and works of art, is a market absorption discount. Like a blockage discount, a market absorption discount reflects the fact that a market can only handle at one time so much of a particular type of property at a given price, and as too much of one type of property floods a market, the price of the property tends to decrease. See Estate of Aucker v. Commissioner, T.C. Memo (discussing the history of market absorption discounts in the context of real estate and works of art). d. Ways to Dispose of Large Blocks of Stock or Property: There are numerous ways to dispose of large blocks of stock, including: i. Selling shares of stock in a private placement; ii. Dribbling the stock or property into the open market in small lots which would not adversely affect the sales price; iii. Hiring an underwriter to conduct a secondary public iv. offering of stock; and Redeeming all or part of the securities from the issuer. See Shannon P. Pratt & Alina V. Niculita, Valuing a Business, The Analysis and Appraisal of Closely Held Companies, p. 467 (5th ed. New York, McGraw Hill, 2008). 2. Factors That Affect Blockage Discount: Courts have examined various factors to determine the amount of the blockage discount, including:

52 a. The mean market quotation for the security on the valuation date (Estate of Foote v. Commissioner, T.C. Memo (citing Estate of Christine v. Commissioner, T.C. Memo ); b. The size of the block in relation to the total outstanding stock (Id.); c. The trading activity in the stock on or near the valuation date (Id); d. The depth and trend of the market for the security (Id.); e. The market depth and trend as a whole (measured at and after the valuation date) (Id.); f. The opportunity cost of holding the property as inventory (Estate of O Keeffe v. Commissioner, T.C. Memo ); g. The carrying cost of holding the property as inventory (Id.); h. The 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 (Calder v. Commissioner, 85 T.C. 713, 722 (1985)); and i. The length of time necessary to liquidate (i.e., dispose of) the property (Id.). 3. Quantifying Blockage Discount: A blockage or market absorption discount can be quantified in a number of different ways depending upon the property to be sold (i.e., stock, real property, or collectibles). The process can be summarized as follows: a. Step 1: Make an assumption as to how the shares or property will be disposed (i.e., private placement, dribbled sales, or partial or full redemption), and explain why that assumption is reasonable. If the shares can be sold in the open market within a single day, but the block sale would result in downward pricing pressure, then the reduction in proceeds received (from what would have been received had the sales not been sufficiently large in magnitude to cause downward pricing pressure, then that reduction would represent the discount. If the shares can be sold in a private placement or as part of a negotiated redemption at a discount, then that discount would be applied. b. Step 2: Assuming the property in question will be dribbled into the market over an extended period of time to avoid causing downward pricing pressure: i. For stocks, analyze the historical trading volume and price volatility of the stock to determine (1) the number of shares that can be added to normal trading volume, and (2) the time over which the shares can be sold into the market without having an adverse effect on the market price of the shares. ii. For other types of property, analyze the historical trading volume and price volatility of the property 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 effect on the market price of the property

53 c. Step 3: Use the discounted cash flow method or a restricted stock study to quantify the blockage discount. i. Under the discounted cash flow method, an appraiser will project the cash flows expected to be received via an orderly liquidation of the property and discounting them at an appropriate rate of return. The periodic cash flows from the gradual sale should be discounted as should dividends received during the liquidation period. The blockage discount is the percentage difference between the present value of the projected cash flows and the proceeds received if the subject block was sold on the valuation date. ii. Restricted stock studies can also be used to calculate the blockage discount, if the amount of time it would take to sell the shares in the open market would approximate the typical holding period for restricted stock, though a discussion of this method is outside the scope of this Outline. For an explanation of how to calculate blockage discounts under the restricted stock method, see Robert A. Hauptman & Robert M. Kiefer, Blockage Discount Analysis: Are Larger Discounts Warranted (Spring 2010), available at blockage-discountanalyses-are-larger-discounts-warranted. d. Step 4: Reflect the blockage discount as a percentage and apply it to the block of property to be valued. 4. Issues to Be Aware of With Respect to Blockage Discount: The following issues may arise in the context of a blockage discount: a. Blockage Discounts v. Expenses to Sell Stock: As pretext, where a large block of stock is to be sold, the stock must sometimes be registered for securities law purposes. Appraisers will sometimes treat the cost of registering the stock as a part of the blockage discount. The Service and courts have rejected this position, and as such, expenses incurred to register the stock should be reflected not in the blockage discount but in a separate administrative expense under I.R.C. ' i. Rev. Rul : In Rev. Rul , C.B. 224, the Service took the position in valuing a block of stock too large to be sold in the open market without depressing the price, the relevant figure is the price that the public would pay to the underwriter for the stock, and not the price that the underwriter would pay to the estate. Thus, the Service concluded that underwriting fees should not be considered in determining the blockage discount, but should be deducted as an I.R.C administration expense. ii. Courts Views: Courts have generally agreed with the Service s view. See Gillespie v. United States, 23 F.3d 36, (2d Cir. 1994) (allowing blockage discount but

54 concluding that underwriting fees should not be taken into account in determining the fair market value of shares that were sold in registered secondary offering because the number of shares available would depress market price; allowing underwriting fees as administrative expense under I.R.C. ' 2053). b. No Aggregation Allowed in the Context of Gifts: In the context of gifts, the blockage discount should be applied to each gift separately without considering companion or consolidated donations. c. Reasonableness of Period of Time: The period of time over which the blockage discount is applied should be closely scrutinized for reasonableness on the basis of all the facts and circumstances. i. As noted, periods of up to one year have been found to be reasonable. See Estate of Sawade v. Commissioner, T.C. Memo , aff d, 795 F.2d 45 (8th Cir. 1986). At the same time, the period may be shorter or longer if factors such as market volatility and time limitations dictate. E.g., id.; Du Pont v. Commissioner, 2 T.C. 246 (1943). d. Isolate the Blockage Discount from Other Discounts: The appraiser should be sure to separate the blockage discount from other effects (e.g., DLOM) that might be contributing to the discount. e. Failure to Take Into Account Dividends: Some appraisers fail to take into account dividends in their discounted cash flow analysis. The dividends that will be paid during the liquidation period should be estimated and those dividends should be discounted, as appropriate, over the liquidation period. f. Control prerogatives of a block of stock: When valuing a large block of stock in a publicly-traded company which represents a controlling interest, since the owner of the block can achieve liquidity through a sale of the company in its entirety, it is more appropriate to value the block by (a) starting with the publiclytraded price and (b) applying a control premium (which already accounts for the amount of time required to market and sell a company).\ 5. Cases Applying Blockage Discount: a. Chapman Glen, Ltd. v. Commissioner: In Chapman Glen, Ltd. v. Commissioner, 140 T.C. 294 (2013), the Tax Court allowed a 15% market absorption discount to reflect the fact that nine groups of property were valued at the same time. b. Estate of Gimbel v. Commissioner: In Estate of Gimbel v. Commissioner, T.C. Memo , the Tax Court allowed a 14.2% blockage discount for roughly 3 million shares of Reliance Steel & Aluminum stock. c. Estate of Brocato v. Commissioner: In Estate of Brocato v. Commissioner, T.C. Memo , the Tax Court allowed an

55 11% blockage discount for seven properties in the same (San Francisco) market. d. Estate of Sturgis v. Commissioner: In Estate of Sturgis v. Commissioner, T.C. Memo , the Tax Court allowed a 20% market absorption discount for approximately 11,300 acres of undeveloped land. e. Carr v. Commissioner: In Carr v. Commissioner, T.C. Memo , the Tax Court allowed a 30% market absorption discount for 175 developed lots and allowed zero discount for roughly 437 undeveloped lots. f. Estate of Folks v. Commissioner: In Estate of Folks v. Commissioner, T.C. Memo , the Tax Court allowed a 20% market absorption discount for five leased lumberyards with the same tenant and in the same geographical area. g. Estate of Grootemaat v. Commissioner: In Estate of Grootemaat v. Commissioner, T.C. Memo , the Tax Court allowed a 15% market absorption discount for undeveloped lots totaling 302 acres. h. Calder v. Commissioner: In Calder v. Commissioner, 85 T.C. 713, (1985), the Tax Court allowed a market absorption discount to approximately 1,225 works of art created by one artist. i. Estate of O Keefe v. Commissioner: In Estate of O Keeffe v. Commissioner, T.C. Memo , the Tax Court allowed a blockage discount for approximately 400 works or groups of works of art. j. Rimmer v. Commissioner: In Rimmer v. Commissioner, T.C. Memo , the Tax Court allowed a market absorption discount for charitable contribution of collection of roughly 85,000 pieces of sheet music. k. Epping v. Commissioner: In Epping v. Commissioner, T.C. Memo , the Tax Court allowed a market absorption discount for charitable gift of mainly animal mounts (i.e., animal trophies). For additional cases addressing blockage and market absorption discounts, see Shannon P. Pratt & Alina V. Niculita, Valuing a Business, The Analysis and Appraisal of Closely Held Companies, p. 468 (5th ed. New York, McGraw Hill, 2008). C. Lack of Control Discount 1. Overview: a. Control an Element to Be Considered in Determining Value: i. General Remarks Concerning Control: In general, control is a separate element to be taken into account to determine the fair market value of an entity s securities, over and above the value that is attributable to the entity s underlying assets. Phillip Morris, Inc. & Consol. Sub. v. Commissioner, 96 T.C. 606 (1991), aff d, 970 F.2d 897 (2d Cir. 1992). 1. Discount or Premium: Lack of control may warrant

56 ii. iii. a control discount, if the base value is a controlling interest level of value (for example, a value derived from a comparison of controlling interests in companies or under the Cost Approach). At the same time, the presence of control (in all its forms) can warrant a premium if the base value is a noncontrolling interest level of value. What is Control: Control refer to the fact that the owner of the shares can unilaterally direct corporation action, select management, decide the amount of distribution, rearrange the corporation s capital structure, and decide whether to liquidate, merge, or sell assets. Estate of Newhouse v. Commissioner, 94 T.C. 193, (1990). 1. General Rule is Greater-Than 50% Interest: In most situations, a greater-than 50% voting interest in a company is deemed to be a controlling interest. The corollary, of course, is that a less-than 50% interest is deemed to be a minority interest. 2. Specifics of Agreements May Dictate Otherwise: Of course, the formation documents for a given company might establish different levels of control for purposes of determining whether a control premium applies (e.g., supermajority (greater-than %) needed to liquidate company). Drawbacks of Lack of Control: There are many drawbacks associated with a lack of control, including: 1. The inability to influence, direct, and control business operations; 2. The inability to control the allocation of assets and available resources; 3. The inability to modify the firm s capital structure; 4. The inability to select management; 5. The inability to set dividend policy; 6. The inability to merge or consolidate the company with another company (including related strategies and negotiations); and 7. The inability to liquidate the company. See Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other grounds, 152 F.3d 83 (2d Cir. 1998). iv. Effect of Factors on Lack of Control Discount: The inability of the purchaser to possess any of these factors (and thereby forfeit all or a part of the ability to maximize the value of the purchaser s stock) determines what the hypothetical buyer is willing to pay for the securities. b. The Service s Long-Standing Distrust of Lack of Control

57 Discounts in Family Entities: In Revenue Ruling , C.B. 187, the Service adopted the position that a lack of control discount was not appropriate when valuing an interest in familycontrolled entity. The Service reasoned that minority interests held by family members should be aggregated because a family is more likely to act as one unit. Following repeated losses on the issue, the Service renounced that position in Rev. Rul , C.B Factors That Affect Lack of Control Discount: Courts look to various factors to determine the amount of the control discount, including: a. Whether the interest would deliver operational control of the underlying entity or business to the purchaser (Estate of Maggos v. Commissioner, T.C. Memo ) (citing Estate of Chenoweth v. Commissioner, 88 T.C (1987)); b. Whether the interest would deliver control of the board of directors of the underlying entity to the purchaser; c. Whether the interest would deliver control to declare that dividends be paid or withheld; d. Whether the interest would deliver control to liquidate the corporation to the purchaser; e. The ability to influence, direct, and control business operations (see Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other grounds, 152 F.3d 83 (2d Cir. 1998)); f. The ability to control the allocation of assets and available resources (see id.); g. The ability to optimize or modify the firm s capital structure (see id.); h. The ability to select management (see id.); i. The ability to set dividend policy (see id.); j. The ability to merge or consolidate the company with another company (including related strategies and negotiations) (see id.); k. The ability to liquidate the company (see id.); and l. The purchaser s desire or need to acquire the company to complement his or her present operation (see Ludwick v. Commissioner, T.C. Memo ). 3. Quantifying the Lack of Control Discount: a. In General: There are three approaches to value a non-controlling interest: (1) the top-down method (computed by determining the control value and then applying a lack-of-control discount); (2) the horizontal method (computed by comparing other minority interest transactions and thus arriving at a non-controlling interest value directly); and (3) the bottom-up method (compute the minority interest value directly under the income approach by projecting cash flows that would be received by a non-controlling interest investor)

58 i. Preferred Methods: Most valuators prefer the top-down or horizontal methods, but all are acceptable. ii. Empirical Studies: Several empirical, published studies are used to determine an appropriate lack of control discount. The specific study used will generally depend on the nature of the entity being valued and its underlying assets. 1. Mergerstat Review Study: Factset annually publishes the Mergerstat Review, which is an extensive analysis of tender offers and completed transactions by industry. It analyzes the selling price five days prior the initial announcement of the sale. The study reports control premiums paid in acquisitions, which can be used to derive a lack of control discount. 2. Mergerstat Control Premium Study: Originally published by Houlihan, Lokey, Howard, and Zukin in 1986, the Factset Mergerstat/BVR Control Premium Study is a series of quarterly reports that quantify the difference in the premiums paid by synergistic buyers and buyers of all types. 3. Closed-End Fund Studies: Control premium studies are appropriate when determining the lack of control discount to apply to an operating business. However, when determining a lack of control discount for an entity that holds a portfolio of marketable securities, it is common practice to examine the discounts from closed-end funds (which are available from various data providers). Closed-end mutual funds typically own noncontrolling interests in publicly-traded securities, which are acquired at their fair market values (for equity investments, this typically reflects a marketable minority level of value). Investment decisions are made by the mutual fund s manager; not the individual investors. They differ from openended mutual funds since a shareholder of a closedend mutual fund cannot receive the liquidation value of his/her investment (i.e., his/her pro rata share of the fund s net asset value) at will by tendering his/her shares to the fund for repurchase; rather, liquidity can only be achieved through a sale on the open market. The vast majority of these closed-end mutual funds were priced by the market at less than their pro rata controlling interest value (i.e., net asset value), which represents the lack-ofcontrol discount demanded by the public markets

59 4. Partnership Profiles Data: On an annual basis, Partnership Profiles, Inc. publishes a study calculating the discount between trading prices of non-controlling interests in real estate limited partnerships and real estate investment trusts with estimated controlling interest values for the real estate limited partnerships and real estate investment trusts. This data is appropriate when the discount for lack of control is being applied to an entity that holds controlling interests in real property. The nature of the data is such that a detailed comparative analysis can be performed. However, the appraiser should keep in mind that the transaction prices are derived from a market which is not fully liquid (and thus the discounts may incorporate some lack of marketability). b. The Top-Down Method: i. Approach: The top-down method uses the market, income capitalization, and/or asset approaches to determine the entire value of an entity. It then determines an appropriate lack of control discount to arrive at a marketable minority value. The minority interest discount is determined by using studies such as those by the Mergerstat Review, or Mergerstat Control Premium Study, closed-end funds, or Partnership Profiles. c. The Horizontal Method: i. Approach: The horizontal method compares the subject entity to non-controlling interests in other comparable companies, which results in a non-controlling interest value. d. The Bottom-Up Method: i. Approach: The top-down method relies on the income capitalization approach to project the timing and amount of future distributions. It then projects the expected proceeds from the sale of the interest at the time the investment is sold. That value is then discounted to determine the present value of the future cash flows. The lack of control discount is implied in the indicated value. 4. Issues to Be Aware of With Respect to Lack of Control Discount: a. Isolate the Lack of Control Discount from Other Discounts: The appraiser should be sure to separate the lack of control discount from other effects (e.g., DLOM) that might be contributing to the discount. b. Evaluate Whether a Non-Controlling Interest Holds Veto Rights: In some entities, approval of a non-controlling interest may be required for certain extraordinary events, such as a sale of

60 materially all of the assets, sale or merger of the business, etc. These veto rights should have a downward effect on the lack-ofcontrol discount. c. Evaluate the Full Spectrum of Control: Empirical evidence suggests that controlling interests that lack full control over an enterprise (for example, Delaware corporations with percentage interests greater than 50%and less than 90%) warrant a discount from controlling interests with full control (such as a 100%interest). The Courts have generally supported the notion that modest discounts from fully controlling interest values are appropriate when the interest being valued is less than 100% Cases Applying Lack of Control Discount: a. Holman v. Commissioner: In Holman v. Commissioner, 130 T.C. 170, (2008), the Tax Court allowed minority interest discounts ranging from 4.63% to 14.34% with respect to three gifts of limited partnership interests. b. Estate of Jelke v. Commissioner: In Estate of Jelke v. Commissioner, T.C. Memo , the Tax Court allowed discounts for lack of control equal to 10%. c. Astleford v. Commissioner: In Estate of Astleford v. Commissioner, T.C. Memo , the Tax Court allowed discounts for lack of control and lack of marketability with respect to tiered partnership interests in a family limited partnership. d. Estate of Litchfield v. Commissioner: In Estate of Litchfield v. Commissioner, T.C. Memo , the Tax Court allowed lack of control discounts ranging from 11.9% to 14.8% for two S corporation holding companies. e. Moore v. Commissioner: In Moore v. Commissioner, T.C. Memo , the Tax Court allowed a 35% discount for lack of control on a minority interest in a partnership. f. Estate of McCormick v. Commissioner: In Estate of McCormick v. Commissioner, T.C. Memo , the Tax Court allowed minority interest discounts ranging between 18% and 32% with respect to a minority interest in a partnership. g. Estate of Maddox v. Commissioner: In Estate of Maddox v. Commissioner, 93 T.C. 228 (1989), the Tax Court denied lack of control discounts for an incorporated family farm valued under 15 For example, in Estate of Stirton Oman, a 20 percent marketability discount was applied to a 75.6 percent interest in a closely-held corporation; in Estate of Beatrice Ellen Jones Dunn, a 22.5 percent discount for lack of marketability and lack of super-majority control was applied to a percent interest in a closely-held corporation; in Estate of Charles Russell Bennett, a 15 percent lack of marketability discount was applied to a 100 percent interest in a real estate holding corporation; in Estate of Maxcy, a 15 percent discount for lack of marketability was applied to a percent interest in a real estate holding corporation; and in Estate of Jewell E. Gray, a 15 percent discount for lack of marketability was applied to an percent interest in a personal holding corporation, also see Von Hagke v. U.S. Estate of W.W. Jones II, in which an eight percent marketability discount was applied to an percent interest in a closely-held limited partnership)

61 I.R.C. ' 2032A. h. Janda v. Commissioner: In Estate of Janda v. Commissioner, T.C. Memo , the Tax Court allowed a combined 40% discount for lack of control and lack of marketability with respect to the value of gifts of stock of a closely held bank holding company to the donee s children. D. Lack of Voting Rights Discount: 1. Overview: Empirical evidence suggests that an additional discount to a non-controlling interest is applicable if the non-controlling interest lacks any voting rights. Generally, the incremental discount is relatively small in comparison to lack-of-control discounts, typically ranging from one to ten percent. a. SEC Study: In 1987 the SEC published a study that compared the prices of two identical classes of publicly traded common securities in the same company except that one had voting rights and the other did not. The SEC study reflected a mean indicated lack of control discount equal to between 5% and 8%. The study is SEC, Office of the Chief Economist, The Effects of Dual-Class Recapitalizations on the Wealth of Shareholders, pp (June 1987). b. A study by Houlihan Lokey Howard & Zukin 16 examined the price premiums of 18 pairs of voting and non-voting stocks. In the study, the price differential between voting and non-voting pairs of stock was examined using 30-day, 60-day, 120-day, 180-day, and 260- day moving averages of market prices. The results of the study ranged from a median premium of 2.73%for the 260-day moving average samples to a 1.15%median premium for the 60-day moving average sample. c. A study by Lease, McConnell, and Mickkelson 17 found a mean premium for voting rights of 5.44%using an analysis of 30 companies, d. A study by O Shea and Siwicki 18 discovered a mean premium of 3.8%for 43 companies. e. In a study by Zingales, 19 mean and median premiums for voting rights of 94 companies were determined to be 10.47%and 3.02%, respectively. E. Control Premium: 1. Overview: a. Control an Element to Be Considered in Determining Value: i. General Remarks Concerning Control: Control is a separate 16 The Houlihan Lokey Howard & Zukin Study, Lease, Ronald C., John J. McConnell, and Wayne H. Mikkelson, The Market Value of Control in Publicly- Traded Corporations, J. Fin. Econ., (1983), Kevin C. O Shea and Robert M. Siwicki, Stock Price Premiums for Voting Rights Attributable to Minority Interests, Business Valuation Review (December 1991): Zingales, Luigi. What Determines the Value of Corporate Votes? Quarterly Journal of Economics, November 1995, pp

62 ii. iii. element to be taken into account to determine the fair market value of shares of a company, over and above the value attributable to the company s underlying assets. Phillip Morris, Inc. & Consol. Sub. v. Commissioner, 96 T.C. 606 (1991), aff d, 970 F.2d 897 (2d Cir. 1992). 1. Discount or Premium: Lack of control may warrant a discount. The presence of control (in many forms) can warrant a premium. 2. Importance of Control Recognized in Rev. Rul : The Service recognized the importance of control in Rev. Rul , stating that control of a corporation, either actual or in effect may justify a higher value for a specific block of stock. What is Control: Control refer to the fact that the owner of the shares can unilaterally direct corporation action, select management, decide the amount of distribution, rearrange the corporation s capital structure, and decide whether to liquidate, merge, or sell assets. Estate of Newhouse v. Commissioner, 94 T.C. 193, (1990). 1. General Rule is Greater-Than 50% Interest: In most situations, a greater-than 50% voting interest in a company is deemed to be a controlling interest. The corollary, of course, is that a less-than 50% interest is deemed to be a minority interest. 2. Specifics of Agreements May Dictate Otherwise: Of course, the formation documents for a given company might establish different levels of control for purposes of determining whether a control premium applies (e.g., supermajority (greater-than %) needed to liquidate company). Benefits of Control: There are many potential benefits of control, including: 1. The ability to influence, direct, and control business operations; 2. The ability to control the allocation of assets and available resources; 3. The ability to optimize or modify the firm s capital structure; 4. The ability to select management; 5. The ability to set dividend policy; 6. The ability to merge or consolidate the company with another company (including related strategies and negotiations); and 7. The ability to liquidate the company. See Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other

63 grounds, 152 F.3d 83 (2d Cir. 1998). iv. Effect of Factors on Control Premium: The ability of the purchaser to possess any of these factors (and thereby gain the ability to unilaterally maximize the value of the purchaser s stock) may command a premium for what the hypothetical buyer is willing to pay for the securities. b. When Control Premium Appropriate: A control premium should be considered whenever a purchaser would be able to use the control in such a way to assure an increased economic advantage worth paying a premium for. Estate of Simplot v. Commissioner, 249 F.3d 1191, 1195 (9th Cir. 2001) (quoting Ahmanson Found. v. United States, 674 F.2d 761, 770 (9th Cir. 1981)), rev g and remanding, 112 T.C. 130 (1999). i. In Addition to Baseline Return: A control premium represents the expected additional value to the purchaser which, when realized, still allows for an adequate return on the purchaser s investment. Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other grounds, 152 F.3d 83 (2d Cir. 1998). c. Basis for Control Premium: Simply stated, a control premium reflects the fact that control of a business, in whatever form, can be valuable. In Estate of Salisbury v. Commissioner, T.C. Memo , the Tax Court summarized the purpose of the control premium as follows: The payment of a premium for control is based on the principle that the per share value of minority interests is less than the per share value of a controlling interest. A premium for control is generally expressed as the percentage by which the amount paid for a controlling block of shares exceeds the amount which would have otherwise been paid for the shares if sold as minority interests 2. Factors Affecting Control Premium: Courts have looked to many factors to determine the amount of the control discount, including: a. Whether the interest would deliver operational control of the underlying entity or business to the purchaser (Estate of Maggos v. Commissioner, T.C. Memo ) (citing Estate of Chenoweth v. Commissioner, 88 T.C (1987)); b. Whether the interest would deliver control of the board of directors of the underlying entity to the purchaser; c. Whether the interest would deliver control to declare that dividends be paid or withheld; d. Whether the interest would deliver control to liquidate the

64 corporation to the purchaser; e. The ability to influence, direct, and control business operations (see Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other grounds, 152 F.3d 83 (2d Cir. 1998)); f. The ability to control the allocation of assets and available resources (see id.); g. The ability to optimize or modify the firm s capital structure (see id.); h. The ability to select management (see id.); i. The ability to set dividend policy (see id.); j. The ability to merge or consolidate the company with another company (including related strategies and negotiations) (see id.); k. The ability to liquidate the company (see id.); and l. The purchaser s desire or need to acquire the company to complement his or her present operation (see Ludwick v. Commissioner, T.C. Memo ). 3. Quantifying the Control Premium: a. In General: A control premium is generally expressed as the percentage by which the amount paid for a controlling block of shares exceeds the amount which would have otherwise been paid for the shares if sold as minority interests. Estate of Salsbury v. Commissioner, T.C. Memo A control premium is not based on a percentage of the value of the stock held by all or a particular class of minority shareholders. Id. b. Step 1: Review control premium studies of comparable companies, such as the Control Premium Studies issued by Mergerstat or BVR. c. Step 2: Develop a comparable control premium based upon the size of the subject stock and the comparable companies. d. Step 3: Apply the control premium to the shares in question. 4. Issues to Be Aware of With Respect to Control Premium: The following issues may arise in the context of a blockage discount: a. The Value of a Controlling Interest is Not Necessarily Already Part of the Valuation for the Shares: The appraiser should not simply assume that the value of a controlling interest in the shares of a company is part of the value of the entire business. In other words, a control premium may represent a payment over and above the shareholder s share of company assets. The Tax Court agreed in Nestle Holdings, Inc. v. Commissioner, T.C. Memo , aff d in part and rev d in part on other grounds, 152 F.3d 83 (2d Cir. 1998)). b. The Control Premium Should Only be Applied to a Non- Controlling Interest Value. For example, if valuing a company under the cost approach (such as with a real estate entity), the value will represent a controlling interest value already

65 5. Cases Applying Control Premium: a. Estate of Newhouse v. Commissioner: In Estate of Newhouse v. Commissioner, 94 T.C. 193, 251 (1990) the Tax Court held that a 44.4%-interest in a closely held business was not a controlling interest. See also Estate of Wright v. Commissioner, T.C. Memo (rejecting that a control premium applies to a 23.8% interest in a closely held corporation); but see Estate of Schneider- Paas v. Commissioner, T.C. Memo (applying a control premium where the decedent owned a 39% ownership interest in a German close corporation). b. Estate of Maggos v. Commissioner: In Estate of Maggos v. Commissioner, T.C. Memo , the Tax Court declined to apply a control premium because it found that the control premium and lack of marketability discount was offsetting. c. Estate of True v. Commissioner: In Estate of True v. Commissioner, the Tax Court held that a control premium applied to a 58.16% interest in a trucking company. d. Rakow v. Commissioner: In Rakow v. Commissioner, T.C. Memo , the Tax Court applied a 45% control premium for a construction company. e. Estate of Winkler v. Commissioner: In Estate of Winkler v. Commissioner, T.C. Memo , the Tax Court found that a 10% block of voting stock had special characteristics that warranted a 10% control premium. f. Estate of Salsbury v. Commissioner: In Estate of Salsbury v. Commissioner, T.C. Memo , the Tax Court applies a 38.1% control premium for a 52% voting interest in a company that manufactured animal health care products. g. Estate of Desmond v. Commissioner: In Estate of Desmond v. Commissioner, T.C. Memo , the Tax Court applied a 25% control premium a decedent s 81.93% interest in a closely held corporation

66 IV. Entity-Level Discounts A. Key Person Discount 1. Overview: a. Basis for Discount: Companies, especially closely held companies, often depend upon a key person to generate sales or profits for the company. Where a corporation is significantly dependent upon the services of one person, and where that person is no longer able to perform services for the corporation by reason of death or incapacity, a hypothetical purchaser would expect some form of discount below fair market value when purchasing the stock of the corporation to compensate for the loss of the key employee. Estate of Feldmar v. Commissioner, T.C. Memo i. Key Person Defined: According to the Service, A key person is an individual whose contribution to a business is so significant that there is certainty that future earning levels will be adversely affected by the loss of the individual. Some courts have accounted for this depressing effect on value by applying a key person discount. See Dep t of the Treasury, Internal Revenue Service, Valuation Training for Appeals Officers, Training (Rev. May 1997), available at (last visited Jan. 6, 2015). ii. Importance of Key Person Also Recognized in Rev. Rul : The Service recognized the importance of key persons in Rev. Rul , ' 4.02, stating as follows: The loss of the manager of a so-called one-man business may have a depressing effect upon the value of the stock of the business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business and the absence of management-succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may be factors which offset, in whole or in part, the loss of the manager's services. For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager s services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager s services in valuing the stock of the enterprise

67 iii. Empirical Evidence of Key Person Discount: Two studies support the propriety of the key person discount: 1. Larson/Wright (1996, 1998, 2001): This study examined compared the equity value of numerous small companies in the public sectors market. It supports that a key person discount applies in less than 50% of cases, and when it is appropriate, that the approximate discount is in the range of 4% to 6%. 2. Bolten/Wang (1996): This study reviewed the Wall Street Journal from August to November It analyzed the announcements of senior management changes above the vice president level, compared those departures to the depth of management, and found that the stock of (1) small, public firms fell roughly 8.65%, and (2) large firms fell roughly 4.83%. A small company was defined as those with capitalization below $280 million and a large company was defined as those with capitalization above $280 million. The study concludes that lack of management depth and potential loss of a key person negatively impacts valuation. The study also found that the amount of the discount increases as the depth of the team decreases. b. Attributes of a Key Person: A number of attributes can affect the key person discount. Among the key person s attributes which should be evaluated are the following: i. The key person s relationships with customers and clients; ii. The key person s relationship with vendors; iii. The key person s intellectual property, including new product development; iv. The key person s experience; and v. The key person s management abilities. See Kevin R. Yeanoplos, Unlocking the Mysteries of Key Person Value, available at BVR%20-%20Key%20Person.pdf c. Interplay of Personal Goodwill: Although a complete discussion of personal goodwill is outside the scope of this Outline, it is worth noting that a part of the value of a company may be attributed to the personal goodwill of a shareholder. In this regard, the value of the associated personal goodwill may be an asset of the shareholder and not an asset of the corporation. This concept, of course, is closely related to the key person discount. 2. Factors That Affect the Key Person Discount: The following factors may

68 affect whether (and to what extent) to apply a key person discount applies: a. The nature of the business and of its assets, as well as the extent to which the business or assets will be impaired by the loss of the key person (Rev. Rul , ' 4.02); b. The services the key employee renders and the company s degree of dependence on him or her, including the key person s: (1) individual responsibilities and participation in operations; (2) contacts, experience, and managerial skills, and (3) level of involvement with customers, clients, and vendors (Kevin R. Yeanoplos, Unlocking the Mysteries of Key Person Value, available at 20-%20Key%20Person.pdf); c. The likelihood of loss, including: (1) the impact of losing the key person on the valuation; (2) the probability of losing the key person; and (3) the extent to which the key person is responsible for the company s profitability and revenue-generation (Id.); d. The depth and quality of management other than the key person, including: (1) the ability of current management to assume responsibilities; (2) the ability of the company to hire outside the organization, as well as the related cost of that experience and the cost of disrupting the company s operations; and (3) whether there is a succession plan in place (Id.); e. The value of irreplaceable factors such as personal goodwill and relationships with customers, clients, and vendors (Id.); f. The inability of the company to borrow to continue its operations as a result of a lost opportunity to guarantee debt or otherwise (Id.); g. Whether the loss of a key person is compensated for by insurance or otherwise, but only to the extent the purchaser can compel the company to keep the life insurance in effect (Rev. Rul , ' 4.02); and h. Whether the company would need to increase marketing expenses to offset the loss of the key person (Estate of Mitchell v. Commissioner, T.C. Memo , aff g in part, rev g in part, and remanding in part on other grounds, 250 F.3d 696 (9th Cir. 2001)). 3. Quantifying the Key Person Discount: The key person discount should be a relatively straightforward calculation using a method under the income capitalization approach (i.e., the discounted cash flow method): a. Step 1: Calculate the present value of the company s cash flows with the key person; b. Step 2: Calculate the present value of the company s cash flows without the key person; c. Step 3: Account for life insurance that the purchaser can compel the company to keep in effect; and d. Step 4: The difference between the present value of the company s

69 cash flows with and without the key person, including allowable life insurance, should approximate the key person discount. However, a key person discount (reflected as a percentage) should not simply be applied across all years. i. Problems With Percentages: It is not advisable to simply apply a percentage discount to the entity s value because each component in the discounted cash flow analysis should be evaluated on a year-by-year basis to determine the extent of the key person discount. As a practical matter, over time, the loss of the key person should be greater in earlier years and less in later years. As such, the cash flows of the company should be evaluated on an annual basis to determine the effect of the loss of the key person in each year. ii. Cite to Qualitative Factors and Analysis: A key person discount, perhaps more than most other types of discounts, is inherently subjective. In order to minimize the chance of a court or a tax authority from rejecting the discount, the following should be included in the appraisal report: 1. The key person s attributes; 2. The factors examined in determining the key person discount to be applied; 3. The valuation method ( with the key person and without the key person ); and 4. How (if at all) the indicated key person discount will change from year-to-year. 4. Issues to Be Aware of With Respect to the Key Person Discount: a. Common in Estate Tax Cases: A key person discount is most likely to apply to stock owned by an estate when the decedent was the key person. This is not to say that key person discounts cannot apply in non-estate tax cases, just that estate tax cases are the norm. b. Insurance on Key Person s Life Should Not Affect the Key Person Discount: The Service has argued that a key employee discount should not be applied where the corporation has life insurance on the life of the key person. See, e.g., Estate of Feldmar v. Commissioner, T.C. Memo The Tax Court rejected this view in various cases, reasoning that: (1) a minority shareholder could not compel the corporation to continue to purchase the life insurance, see Furman v. Commissioner, T.C. Memo ; and (2) the life insurance is a non-operating asset of the corporation, see Estate of Feldmar v. Commissioner, T.C. Memo c. Beware of Double-Counting: It is common for appraisers to reduce the valuation multiple(s) (under the Market Approach) or increase the discount rate (under the Income Approach) as a result of a lack

70 of management depth for a small, privately-held company. To the extent a key person discount is applied, only the component not already considered in the valuation of the company should be applied. 5. Cases Applying Key Person Discount: a. Estate of Mitchell v. Commissioner: In Estate of Mitchell v. Commissioner, T.C. Memo , aff g in part, rev g in part, and remanding in part on other grounds, 250 F.3d 696 (9th Cir. 2001), the Tax Court allowed a 10% key person discount. In this regard, the Court stated as follows: Mr. Mitchell embodied [John Paul Mitchell Systems ( JPMS )] to distributors, hair stylists, and salon owners. He was vitally important to its product development, marketing, and training. Moreover, he possessed a unique vision that enabled him to foresee fashion trends in the hair styling industry. It is clear that the loss of Mr. Mitchell, along with the structural inadequacies of JPMS, created uncertainties as to the future of JPMS at the moment of death. b. Estate of Feldmar: In Estate of Feldmar v. Commissioner, T.C. Memo , the Tax Court allowed a 35% discount for the loss of a key employee. The Court said as follows: [United Equitable Corporation ( UEC )] was founded by decedent in Throughout the company s history, decedent had been heavily involved in the daily operation of UEC. Decedent was the creative driving force behind both UEC s innovative marketing techniques, and UEC s creation of, or acquisition and exploitation of, new products and services. The Service argued that no key person discount should be allowed on account of life insurance on the decedent and the corporation s ability to rely on existing management. The Tax Court rejected the Service s arguments because the life insurance was a non-operating asset of the corporation and because the evidence did not support that existing management could adequately replace the decedent. c. Estate of Rodriguez v. Commissioner: In Estate of Rodriguez v. Commissioner, T.C. Memo , the Tax Court agreed that a key person discount was appropriate to discount a company, Los Amigos. The Tax Court said: The evidence shows that decedent was the dominant force behind Los Amigos. He worked long hours supervising every aspect of the business. At the time of his death, Los Amigos customers and suppliers were genuinely and understandably concerned about the future of the business without decedent. In fact, Los Amigos soon lost one of its largest accounts due to an inability to maintain quality. The failure was due to decedent s absence from operations. Profits fell dramatically without decedent to run the business. No one was trained to take decedent s place. d. Estate of Yeager v. Commissioner: In Estate of Yeager v

71 Commissioner, T.C. Memo , the Tax Court allowed a 10% discount for the loss of a key person. The Tax Court stated as follows: Until his death, the decedent was president, chief executive officer, and a director of Cascade Olympic, Capital Cascade, and Capitol Center. He was the only officer and director of these corporations who was involved in their day-to-day affairs. The decedent was also president of Center Offices until The presence of the decedent was critical to the operation of both Cascade Olympic and the affiliated corporations. B. Discount for Contingent Liabilities 1. Overview: a. In General: Another entity-level discount that may apply is one for contingent liabilities. It is indisputable that potential liabilities of a company can affect the value of the company. These contingent liabilities can impact financial and tax reporting, including the value of a company. b. Types of Contingent Liabilities Which May Give Rise to Discount: There are many types of contingent liabilities which may result in a discount, including: i. Environmental liabilities; ii. Product warranty liabilities; or iii. Pending litigation liabilities. 2. Factors That Affect the Discount for Contingent Liabilities: Many factors may affect the discount for a contingent liability, including: a. The cost to remediate, settle, or litigate a claim; b. The likelihood of the claim coming to fruition; and c. The amount set up as a reserve for financial accounting purposes. 3. Quantifying the Discount for Contingent Liabilities: The contingent liability can be evaluated in a number of different ways. Preliminarily, if the comparable sales method is used, the existence of contingent liabilities may be already reflected in the comparables (assuming the comparables are true comparables). This may be the case if certain contingent liabilities, such as product warranties, occur normally in the course of business for companies within the subject company s industry. To the extent the contingent liability must be separately measured, accepted practice is to use a variant of the discounted cash flow method known as Expected Value Analysis (one might also come across the terms scenario analysis, decision trees, and (as a highly specific subset) Monte Carlo analysis to describe similar methodologies). Under an Expected Value Analysis, the Fair Market Value of a contingent liability should reflect the costs, potential delays, and uncertainty of the liability at the end of the process of gathering relevant information, resolving any litigation, and paying any amount due. It is common practice to value a contingent liability explicitly, but it can also be embedded in a discounted cash flow method valuation of the entity. Under the Expected Value Analysis, the amount of the contingent liability can be reflected as follows:

72 a. Step 1: The appraiser works carefully with legal counsel familiar with the merits of the case to develop a set of likely scenarios, the length of time associated with each scenario, and to set probabilities associated with each scenario. Since the legal issues associated with many contingent liabilities are highly complex and specialized, often the appraiser will not have the necessary expertise to develop the potential scenarios (which may be multistep in nature) or to assign the appropriate probabilities, and will have to coordinate with legal counsel familiar with the contingent liability to develop the appropriate scenarios and probabilities. b. Step 2: The anticipated costs of the contingent liability (i.e., those to remediate, settle, or litigate a claim, or those arising from a judgment associated with the claim) should be estimated for each of the scenarios. along with the year those payments will arise. c. Step 3: The risk associated with the contingent liability should be considered in the discount rate selected for the contingent liability and should reflect the rate of return that is commensurate with the risk realized in involving those cash flows. There is some controversy within the appraisal community regarding the appropriate discount rate selected for a contingent liability (i.e., whether a risk-free rate or a rate consistent with the variability of the cash flows) but this is a relatively technical issue that is beyond the scope of this Outline. Note: For other methods which may be used to value contingent liabilities, such as the binomial option pricing model, the Monte Carlo method, or the insurance method, see Marcus A. Ewald, It All Depends: Recognition and Valuation of Contingent Liabilities, available at 4. Issues to Be Aware of With Respect to the Discount for Contingent Liabilities: a. Comparable Sales May Already Reflect Contingent Liabilities: Some appraisal reports will use the comparable sales method to value a company and then separately state discounts for contingent liabilities. However, if the comparables are true comparables, the existence of contingent liabilities may already be reflected in the comparables selected. Practitioners should scrutinize whether the cost of contingent liabilities are already reflected in the comparable. To the extent a separate discount is appropriate, the appraiser should explain why. b. The revised Treasury Regulations under 2053 generally do not allow deductions of contingent liabilities directly on the estate tax return, except when the liability is integrally related to one or more material assets of the Estate. Specifically, (b)(3)

73 provides that an item may be entered on the return for deduction though its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be paid. No deduction may be taken on the basis of a vague or uncertain estimate. However, the actual cost can be deducted later, if a protective claim had been filed. It should be noted that 2053 does not affect assets of an estate, so if the subject of the valuation is stock in a closely-held business, for example, a contingent liability could still be considered as a factor in valuing the stock as an asset of the estate (with the contingent liability resulting in a decrease in the value). 5. Cases Applying Discount for Contingent Liabilities: a. Estate of Klauss v. Commissioner: In Estate of Klauss v. Commissioner, T.C. Memo , the Tax Court allowed a discount for contingent liabilities such as pending products liability litigation and environmental claims. b. Payne v. Commissioner: In Payne v. Commissioner, T.C. Memo , rev d on other grounds, 224 F.3d 415 (5th Cir. 2000), the Tax Court allowed a 50% contingent liability discount with respect to the value of stock the taxpayer received. As support for the amount of the discount, the Court looked to the cost of legal fees owed with respect to the claim. c. Estate of Desmond v. Commissioner: In Estate of Desmond v. Commissioner, T.C. Memo , the Tax Court allowed a 10% discount to reflect the contingent environmental liability of a paint company. d. Estate of Mitchell v. Commissioner: In Estate of Mitchell v. Commissioner, T.C. Memo , aff d in part, vacated in part, and remanded in part on other grounds, 250 F.3d 696 (9th Cir. 2001), the Tax Court allowed a $1.5 million discount for a pending executive compensation lawsuit. e. Estate of Foote v. Commissioner: In Estate of Foote v. Commissioner, T.C. Memo , the Tax Court rejected a discount with respect to a potential lawsuit because, the Court found, the nature of the lawsuit was highly speculative. C. Portfolio Discount 1. Overview: A portfolio discount is appropriate when a company holds nondiversified assets that would not be attractive to a hypothetical buyer. Generally, it is believed that investors will pay more for pure plays that specialize in a single industry, or a relatively narrow range of products. By investing in pure plays, the investor can choose the amount, level and type of diversification that meets their individual investment needs. a. Example of When Discount Appropriate: The Tax Court allowed a 10%-portfolio discount in Estate of Piper v. Commissioner, 72 T.C. 1062, 1082 (1979). There, the parties agreed an investment company s portfolio was less than its indicated asset value because

74 of the nondiversified nature of the company s holdings. However, the parties disagreed as to the amount of the discount. The Court resolved the issue using the formula discussed immediately below. 2. Factors That Affect the Portfolio Discount: There are not many factors that will contribute to a portfolio discount other than the entity s holdings and whether those holdings are adequately diversified. 3. Quantifying the Portfolio Discount: The amount of the portfolio discount can be quantified as follows: a. Step 1: Determine the net asset value of a range of comparable nondiversified investment companies. b. Step 2: Determine the net asset value of a range of closed-ended investment companies. c. Step 3: Correlate the values of the two types of companies and determine the indicated mean and median discounts indicated. d. Step 4: Do not necessarily rely on the average discount indicated by the nondiversified investments. See Estate of Piper, 72 T.C. at Instead, the appraiser should engage in a qualitative analysis to reconcile the different range of indicated discounts to decide on the appropriate discount. 4. Issues to Be Aware of With Respect to the Portfolio Discount: a. Isolate the Portfolio Discount from Other Discounts: The appraiser should be sure to separate the portfolio discount from other effects (e.g., DLOM) that might be contributing to the discount. b. The appraiser must carefully explain why the particular mix of assets of a given company is less attractive than comparable companies considered in the selection of the discount. 5. Cases Applying Portfolio Discount: a. Estate of Piper v. Commissioner: In Estate of Piper v. Commissioner, 72 T.C. 1062, 1082 (1979), the Tax Court allowed a portfolio discount of 17% was applied to an investment company that owned a nondiversified portfolio of real estate and stock. b. Estate of Maxcy v. Commissioner: In Estate of Maxcy v. Commissioner, T.C. Memo , the Tax Court allowed a portfolio discount equal to 15% discount with respect to a company that owned citrus groves, cattle and horses, a ranch, undeveloped land, and mortgages. D. Discount for Built-In Capital Gain 1. Overview: a. Willing Buyer Considers Tax Effects in Purchasing C Corporation: In formulating a price to pay for a company, a hypothetical willing buyer considers (among other things) the tax effects of an investment in that corporation. An area that might arise in the context of an asset sale of a C corporation is the built-in capital gains tax associated with appreciated nonoperating assets held by the corporation. This built-in gains tax applies, of course, as a result of contingent tax liabilities for C corporations that hold

75 20 See Pratt and Niculita, ibid. appreciated assets. i. Historically Litigated: Valuation discounts associated with the valuation of appreciated C corporation nonoperating assets under the asset approach has historically been an area of considerable litigation. ii. Nomenclature: The discount for built-in gains tax is also known as the discount for trapped-in capital gains tax liability and the discount for embedded capital gains tax liability. It can also be referred to as a corporate structure discount. b. How it Applies: Under the asset approach to valuing appreciated C corporation nonoperating assets, the corporation may incur a capital gains tax on disposition of the asset. c. Pre-1986 Case Law: Prior to 1986, under the General Utilities Doctrine, tax law permitted a corporation to liquidate and distribute the proceeds from asset sales to shareholders without being required to pay corporate capital gains taxes. However, this option was eliminated by the Tax Reform Act of Accordingly, for valuation dates prior to 1986, the Tax Court generally denied discounts for potential capital gains taxes at the entity level where there was no evidence that (1) a liquidation of the corporation was planned, or (2) the liquidation could not have been incurred without incurring a capital gains tax at the corporate level. See, e.g., Ward v. Commissioner, 87 T.C. 78, (1986); Estate of Andrews v. Commissioner, 79 T.C. 938 (1982); Estate of Piper v. Commissioner, 72 T.C (1979). However, the Courts began to take a different view following passage of the Tax Reform Act of 1986, since this eliminated this simple option for corporations to avoid the built-in capital gains tax. d. Following passage of the Tax Reform Act of 1986, the Courts have generally agreed that a discount for built-in capital gains should be applied. However, there has been dispute in the precise manner in which it should be calculated. In some cases (Dunn v. Commissioner in the 5 th Circuit Court of Appeals, Jelke v. Commissioner in the 11 th Circuit Court of Appeals) the Courts ruled that a deduction of the full built-in capital gains tax liability was appropriate as a matter of law. However, in Eisenberg v. Commissioner, while agreeing that a discount for built-in capital gains would be appropriate (since a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of the corporation s built-in capital gains tax ), the Court noted that the ability of a willing buyer to defer or avoid the tax must be considered in calculating the appropriate adjustment. The circuit split on the issue of what the amount of the built-in

76 capital gains tax discount should be is summarized nicely in the petition for a writ of certiorari in Estate of Jelke v. Commissioner. See Petition for Writ of Certiorari, Commissioner v. Estate of Jelke, 129 S. Ct. 168 (No ). i. Dollar-for-Dollar Methodology - Fifth and Eleventh Circuits: 1. Estate of Jelke v. Commissioner: In Estate of Jelke v. Commissioner, 507 F.3d 1317, 1331 (11th Cir. 2007), the U.S. Court of Appeals for the Eleventh Circuit held that-using the net asset method to value closely held C corporation stock and regardless of whether a sale or liquidation of corporate investment assets was contemplated as of the valuation date-it was still appropriate to assume, as a matter of law, that all corporate investment nonoperating assets would be liquidated on the valuation date and therefore that a built-in capital gains tax discount equal to 100% of the built-in capital gains taxes that would be due on a sale of the appreciated assets should be allowed. 2. Estate of Dunn v. Commissioner: Similarly, in Estate of Dunn v. Commissioner, 301 F.3d 339, (5th Cir. 2002), rev g, T.C. Memo , the U.S. Court of Appeals for the Fifth Circuit ruled that the likelihood of liquidation has no place in valuing the corporation, though the likelihood of liquidation does play a part in appraising the related block of stock. ii. Fair Market Value Methodology Second Circuit and Other Tax Court Rulings: 1. Estate of Davis v. Commissioner: In Estate of Davis v. Commissioner, 110 T.C. 530 (1998), the Tax Court held that even though no liquidation of the company or sale of the assets was planned or contemplated as of the valuation date, a hypothetical willing buyer and a hypothetical willing seller would not have agreed upon a price that did not take into account the company s built-in capital gains tax liability. The court stated that a dollar-for-dollar subtraction of the built-in capital gains tax liability was not appropriate under circumstances where no liquidation of a company or sale of its assets was planned or contemplated on the valuation date. However, the court ruled that some amount of a reduction in value should be part of the lack-of-marketability discount applied to the

77 iii. iv. entity. Therefore, the court concluded on a reduction equal to approximately 11%of the net asset value and one-third of the built-in capital gains tax liability. 2. Eisnenberg v. Commissioner: In Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir. 1998), the U.S. Court of Appeals for the Second Circuit held: The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the market value of the property he considers buying We find that even though no liquidation was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of the corporation s built-in capital gains tax. However, in remanding the case to the tax court, the appellate court provided guidance to the tax court to decide the actual reduction in value that indicated the subtraction of the entire built-in gains tax liability without consideration of the ability of a willing buyer to defer or avoid the tax would be incorrect. 3. Estate of Litchfield v. Commissioner: In Estate of Litchfield v. Commissioner, T.C. Memo , the Tax Court accepted discounts equal to 91% of the built-in-gain tax (federal and state) for a C corporation and 52% for an S corporation that were based on discounted cash flow analyses that included projections of payments of the tax liabilities at some future date. 4. Estate of Richmond v. Commissioner: In Estate of Richmond v. Commissioner, T.C. Memo , the Tax Court prepared its own discounted cash flow analysis to estimate appropriate adjustment for corporate taxes and concluded on a 15% discount (equal to 43% of potential federal and state tax liability associated with the unrecognized built-in gains). Practice Point: It is important for practitioners to ensure that the appraiser has sufficient information to determine the future plans for the corporation (i.e., that a liquidation is planned). It is also important for practitioners to be able to prove at trial that future event (e.g., with testimony of the corporation s management or otherwise). Practice Point: The built-in capital gains tax does not apply

78 to S corporations, partnerships, or limited liability companies. 2. Factors That Affect the Discount for Built-In Capital Gain: a. What is the nature of the subject company (e.g., asset holding company, operating company, etc.); b. What is the nature of the assets held by the corporation (e.g., operational assets, non-operational assets, and income-producing assets); c. The extent to which (if at all) the corporation can dispose of the assets without triggering the built-in gains tax; d. The ability of the company to convert to an S-Corporation (such an option may not be feasible if the company has excessive passive investment income, a complex capital structure, or ineligible shareholders); e. The magnitude of the built-in gains tax relative to the net asset value of the company; f. The Federal, state, and local tax rates on corporate income (both ordinary and capital gain income), as well as the Federal, state, and local tax rates on individual ordinary income, dividend income, and capital gain income; g. The likelihood that the subject corporation will be liquidated in the future; and h. What are the characteristics of the ownership interest being valued (e.g., preferred or common stock, voting or nonvoting stock, and control or minority interest)? 3. Quantifying the Discount for Built-In Capital Gain: a. Approach to Calculate Built-In Capital Gain Discount: If the builtin capital gains tax liability is calculated as the fixed dollar amount of the liability as a matter of law, then the calculation is an accounting calculation. If the liability is calculated on a fair market value basis, many Courts have employed a discounted cash flow analysis based on projections of future liquidity events resulting in the realization of the built-in gain and payment of the tax liability. The net present value of the built-in capital gains tax liability is as follows: i. Step 1: Estimate the corporation s capital transactions for future years, including the value of the subject assets at the time the corporation will sell the nonoperating assets giving rise to the built-in gains tax; ii. Step 2: Calculate the corporation s capital gains taxes that will then be owed; iii. Step 3: Discount those future tax liabilities to their present value and allow for a dollar-for-dollar reduction in calculating the asset-based value of the corporation, if that is a lesser amount than the present value calculation. b. Variables: The calculation of a built-in capital gains discounts

79 depends upon the following variables: i. The corporation s capital transactions for future years (i.e., at what rate will the corporation s capital transactions grow from the current rate); ii. The effect, if any, inflation will have on the transactions; iii. The future capital gains tax rates; and iv. The discount rate. 4. Issues to Be Aware of With Respect to a Discount for Built-In Capital Gain: a. Generally No Built-In Capital Gains Discount for S Corporations: A built-in capital gains tax is generally not appropriate for S corporations because an S corporation does not pay an entity level tax. See Estate of Luton v. Commissioner, T.C. Memo ; Dallas v. Commissioner, T.C. Memo ; but see Estate of Litchfield v. Commissioner, T.C. Memo , n.11 (allowing a built-in capital gains tax discount for an S corporation). There are exceptions for S-corporations that were formally C-corporations with appreciated assets that have not yet cleared the 10-year recognition period, as well as S-corporations in specific jurisdictions (for example, New York City does not recognize S- corporations, and California imposes a 1.5% corporate tax). Thus, to the extent an S corporation is involved, the appraiser should consider whether to tax-affect the S corporation s earnings if a discount for built-in capital gains tax is determined to not be appropriate. b. Detriment to Value for Corporate Structure: For asset-holding companies (such as those holding entities) where the value of the company is determined using the Cost Approach, the values of the underlying assets will often reflect the price paid by investors who would not be subject to double-taxation. For example, real estate is commonly held individually or through pass-through entities such as limited liability companies or partnerships. The tax benefits of this structure relative to C-corporations would be expected to be incorporated in the market prices of the assets. If an appraiser estimates a discount that incorporates the value to deferring the recognition of the gain, then the detriment to holding the asset within the C-corporation in the meantime (including doubletaxation of ordinary income and future gains) should also be considered. c. Will Liquidation Occur or Can the Transaction Be Structured to Avoid Built-In Capital Gain: Appraisers sometimes fail to consider whether there is evidence that a liquidation was planned or that the liquidation could not have been accomplished without incurring a capital gains tax at the corporate level. An appraisal report should disclose whether a liquidation is contemplated, and if so, the basis for that conclusion

80 E. Valuation of S Corporations 1. Overview: Another area that has been hotly debated is the valuation impact of an operating company being a pass-through entity (commonly S corporations but also limited liability companies and partnerships) relative to the company being a C corporation. 2. Tax-Affecting: S Corporations and other pass-through entities generally do not pay corporate income tax at the entity level; however, their shareholders / members / partners must pay individual income taxes on their pro rata share of the entity s earnings, whether they receive cash distributions or not (in contrast, shareholders of C corporations only pay taxes on dividends actually received). Historically, many appraisers valued S corporations by tax-affecting (applying a hypothetical corporate tax rate) the pretax earnings of the S corporation, since most publicly traded companies (which are often used for comparison purposes in developing a valuation multiple under the Guideline Public Companies Method or a discount rate under the Income Approach) are C corporations. However, in Gross v. Commissioner, the Tax Court noted that shareholders benefit from a reduction in the total tax burden from the enterprise and that these tax savings should be considered in valuing the S corporation. 3. Tax Court s Criticisms of Tax-Affecting: Historically, the Tax Court has been inconsistent as to whether it is best to tax-affect an S corporation s earnings. a. Cases Opposing Tax-Affecting: The Tax Court has in some cases been critical of tax-affecting S corporations and rejected the practice as unsound. See, e.g., Estate of Gallagher v. Commissioner, T.C. Memo , 101 T.C.M. (CCH) 1702 (2011); Estate of Adams v. Commissioner, T.C. Memo , 83 T.C.M. (CCH) 1421 (2002); Gross v. Commissioner, T.C. Memo , 78 T.C.M. (CCH) 201 (1999), aff d, 272 F.3d 333 (6th Cir. 2001). b. Cases In Favor of Tax-Affecting: At the same time, in other cases, the Tax Court has endorsed tax-affecting as the correct approach. See, e.g., Wall v. Commissioner, T.C. Memo , n.19, 81 T.C.M. (CCH) 1425 (2001) (holding that tax-affecting is appropriate). 4. Evolution of Valuator s Views: The valuation of S corporations is complicated, and the valuation community has developed many different models and approaches to handle the benefit associated with the S corporation. The complexities arise from the following: (a) While S corporations do not pay entity-level taxes, their shareholders would typically pay taxes on pass-through earnings at an ordinary income tax rate, while shareholders of C corporations pay taxes on cash flow actually received at the lower dividend tax rate. This differential tax treatment at the individual taxpayer level, assuming full distributions, would partially offset the advantage to the S Corporation of not paying entity-level tax. (b) Owners of pass-through entities pay income taxes on the entire amount of

81 the company s net income, regardless of the level of distributions, while the shareholders of C corporations pay income taxes only on the portion of the company s net income that is distributed to them as dividends. Thus, in the event that an S Corporation generates significant earnings but does not pay distributions, such an ownership form may be detrimental to the shareholders relative to the company being a C corporation. (c) The Internal Revenue Code imposes certain restrictions that limit the companies which are eligible to be an S Corporation. As a result of these factors, most valuators do not believe that a valuation which either (a) simply tax affects the earnings of the company without regard to the passthrough status or (b) considers only pre-tax income 21, is appropriate. a. Other Courts: The Delaware Chancery Court has also endorsed tax-affecting of S corporations in Del. Open MRI Radiology Assocs., P.C. v. Kessler, C.A. No. 275-N (Del. Ch. Apr. 16, 2006), available at Cases/Delaware-Open-MRI-Radiology-v-Kessler-DE-Chancery- Ct-2006.pdf. It is worth noting that the Delaware Chancery Court s approach for tax-affecting differs from that of the other courts, but the point is still worth noting that many in the valuation industry believe the Tax Court s decisions in Estate of Gallagher and Gross are wrong as a matter of law. 5. The Risk Concerning Tax-Affecting: An appraiser s insistence on taxaffecting may, depending upon whether the appraisal report is presented to a Service s appraiser or judge who disagrees with tax-affecting, be perceived as an error that impugns the report s reliability. 6. What Should Practitioners Do? How should a practitioner handle an appraisal report written by an appraiser who insists that tax-affecting is appropriate to value an S corporation? a. Defer to the Appraiser and Counsel for a Reconciliation: If an appraiser believes it is appropriate to tax-affect an S corporation s earnings, the practitioner should defer to the appraiser s judgment. However, the practitioner should also counsel the appraiser to: i. Reconcile his or her valuation to explain why tax-affecting is appropriate under the assignment; ii. Calculate the specific benefit associated with the passthrough nature of the entity, or explain why there is no benefit; and iii. If the case may be litigated in Tax Court, state the appraiser s awareness of the Tax Court s precedent against tax-affecting and the appraiser s opinion of value as if the 21 For criticism of considering only pretax income without any form of tax-affecting, see, e.g., Shannon P. Pratt & Roger J. Grabowski, Cost of Capital in Litigation: Applications and Examples, 77 (John Wiley & Sons, 2d ed. 2010) (expressing the opinion that cases rejecting tax-affecting represent bad case law and a misinterpretation of fair market value ); Charles J. Russo, Lasse Mertins & Charles L. Martin, Jr., Business Valuation Transaction Prices and Tax-Affecting S Corporations, available at /3/1/2/9/ /bus_valuation_premiums_s_corporations_2012.pdf (discussing empirical evidence to support taxaffecting)

82 value of the S corporation is not tax-affected. b. Benefit of Approach: In this regard, the appraisal report protects the client s interests regardless of whether the reviewing party agrees or disagrees with tax-affecting. It is important for the practitioner and the appraiser to remember that the appropriate valuation method (i.e., whether or not to tax-affect) is a legal conclusion reserved to the trier of fact. The practitioner and the appraisal should also remember that the purpose of the expert is to assist the trier of fact. An appraiser who states separate opinions of value, one tax-affecting and one not, stands a greater chance of the Court recognizing him or her as a credible expert

83 V. Property-Type Discounts A. Fractional Interest Discounts 1. Overview: a. Basis for the Discount: Real and other types of property are often held jointly as tenants-in-common. 22 Tenancy-in-common ownership generally gives co-tenants or co-owners the right to occupy, use, operate, lease, and partition the property. Such joint ownership is rarely as valuable as fee simple ownership because of the lack of control inherent in dealing with multiple owners, each of whom simultaneously retains each of these rights. Thus, a hypothetical buyer would expect a discount from the proportionate share of the fair market value of the property. 2. Factors That Affect the Fractional Interest Discount: There are a number of factors that support a fractional interest discount, including: a. The extent to which the co-owners have liability for the actions of their co-owners; b. The extent to which decisions affecting the property require the unanimous consent of all co-owners; c. The extent to which the ability to use the property as collateral to secure a loan is impaired; d. The extent to which each co-owner or co-tenant has the right to use the property; and e. The right of the co-owners to bring a suit for partition. See Lance Hall, The New Paradigm: Life After the Elimination of Valuation Discounts, 76 TAXES 43 (May 1998). i. Partition Suits as Especially Problematic: Partition suits, which can take years to perfect, may discourage potential buyers from purchasing the property because of (1) the length of time for such a suit, and (2) the ability of a court to order the property sold for less than fair market value. 3. Quantifying the Fractional Interest Discounts: There are no published, empirical studies reflecting the indicated fractional interest discounts. As such, an appraiser s qualitative analysis of the foregoing factors, viewed in the light of the case law discussed below, should serve as the basis for the valuation. 4. Partition Analysis: Generally, the holder of a tenancy-in-common interest has the right to sue to have the property partitioned or sold. This right, which is generally not applicable to minority interests in entities, could provide a tenancy-in-common interest holder with a means to force a liquidation of their investment and pursue other opportunities. The IRS has often taken the position that the costs to partition (including actual 22 Undivided interest ownership can also include joint tenancy and tenancy in the entirety. However, these forms of co-ownership include the right of survivorship, and the Courts have found that no discount is applicable for estate tax purposes for these interests. Therefore, the focus in this section is on tenancy-in-common ownership. For an overview of the different forms of undivided interest ownership, see Lance S. Hall, Undivided Interest Discounts, Tax Valuation (April/May 2007)

84 costs paid and the time frame required to complete the partition process) should be considered in determining the appropriate discount. However, it is important to note that there is significant uncertainty with a partition action, including the ultimate costs, time frame required, and selling price (including whether the selling price will be at a distressed level), and different assumptions could result in significantly different implied discounts. 5. Issues to Be Aware of With Respect to the Fractional Interest Discount: a. Effective Control: If one co-owner (i.e., a parent) exhibits de facto control over a jointly held property, a fractional interest discount may not be appropriate. E.g., Estate of Adler v. Commissioner, T.C. Memo (discussed below). b. Qualitative Analysis Important: Because there are no published, empirical studies reflecting the indicated fractional interest discounts, an appraiser s qualitative analysis of the above-noted factors is of utmost importance. 6. Cases Applying Fractional Interest Discounts: a. Estate of Henry v. Commissioner: In Estate of Henry v. Commissioner, 4 T.C. 423 (1944), the Tax Court applied a 10% discount for a fractional 1/3 interest in undeveloped farm land. b. Estate of Campanari v. Commissioner: In Estate of Campanari v. Commissioner, 5 T.C. 488 (1945), the Tax Court allowed a 12.5% discount for a 1/3 interest in real estate. In this regard, the Court focused on the fact that the purchaser of a minority interest subjected himself or herself to the wishes of the co-owners and lacked control in management, operation, and leasing of the properties. c. Estate of Sels v. Commissioner: In Estate of Sels v. Commissioner, T.C. Memo , the Tax Court allowed a 60% discount for fractional interests in 11 tracts of timberland. d. Estate of Busch v. Commissioner: In Estate of Busch v. Commissioner, T.C. Memo , the Tax Court allowed a 10% fractional interest discount to an undivided ½ interest in real estate in California. e. Estate of Beard v. Commissioner: In Estate of Baird v. Commissioner, T.C. Memo , the Tax Court allowed a 60% discount to 16 undivided fractional interests in timberland. f. Ludwick v. Commissioner: In Ludwick v. Commissioner, T.C. Memo , the Tax Court allowed a fractional interest discount by reflecting the discount for partition in the discount rate. g. Estate of Adler v. Commissioner: In Estate of Adler v. Commissioner, T.C. Memo , the Tax Court held that fractional interest discounts were not appropriate because the decedent effectively controlled the properties notwithstanding the fact that he had transferred undivided one-fifth interest in the

85 property to his children 39 years earlier. h. Estate of Amlie v. Commissioner: In Estate of Amlie v. Commissioner, T.C. Memo , the Tax Court allowed fractional interest discounts equal to 15% on two properties as reported on the estate s estate tax return. i. Estate of Elkins v. Commissioner: In Estate of Elkins v. Commissioner, 140 T.C. 86 (2013), aff d in part and rev d in part, 767 F.3d 443 (5th Cir. 2014), the Tax Court allowed a nominal 10% discount for 64 valuable pieces of jointly-owned art. The U.S. Court of Appeals for the Fifth Circuit agreed that fractional interest discounts were appropriate, but held that the discount should be in the range of 50% to 80%

86 VI. Multiple Discounts A. Overview: An area often overlooked by appraisers and practitioners is how to account for multiple discounts. This Section addresses basic concepts as to how to apply multiple discounts to the valuation of an interest in a closely held business. B. Do Not Improperly Layer Discounts: 1. Step 1: Determine the Discounts and Premiums That Apply: Determine the various discounts that may apply and compute each discount separately. 2. Step 2: Apply Entity-Level Discounts Before Owner-Level Discounts: Next, apply entity-level discounts. 3. Step 3: Then, apply owner-level discounts. 4. Step 4: Do Not Aggregate Discounts: Do not aggregate all discounts into one overall discount. Instead, apply each discount, recompute the value of the business interest, and then apply the next discount. 5. Example: Your appraiser determines that discounts of 5% for key person, 12% for lack of control, and 22% for lack of marketability apply to a minority, nommarketable interest. The appraiser uses the discounted cash flow method to determine that the net asset value of the entity is $1 million and the owner s interest that you are valuing is a 25% interest. 1. First, apply the 5% key person discount at the entity-level to derive the controlling, marketable interest of the entity as $950,000 (calculated as 5% times $1 million). 2. Second, determine the pro rata share of the owner s 25% interest in the entity as $237,500 (calculated as $950,000 times 25%). This is the marketable, controlling value of the owner s 25% interest. 3. Third, apply the 12% lack of control discount to derive the noncontrolling, marketable interest equal to $209,000 (calculated as $237,500 times (100% minus 12%)). 4. Fourth, apply the 22% lack of marketability discount to derive the non-controlling, non-marketable interest equal to $163,020 (calculated as $209,000 times (100% minus 22%)). 5. In sum, although the various discounts total 39% (5% plus 12% plus 22%), the effective discount is actually % (calculated as {1 [(1 0.05) x (1 0.12) x (1 0.22)]}. Note: You do not simply take the aggregate; you apply each one separately. C. Multi-Tiered Entities 1. The IRS s View: The IRS often argues that valuation discounts at levels below the top (parent) tier of a multi-tiered structure are inappropriate. Courts have generally, but not uniformly, rejected this position. 2. The Tax Court s View: The Tax Court has applied two layers of lack of control and lack of marketability discounts where a taxpayer held a minority interest in an entity that in turn held a minority interest in another 60-86

87 entity. See Astleford v. Commissioner, T.C. Memo (citing Estate of Piper v. Commissioner, 72 T.C. 1062, 1085 (1979); Janda v. Commissioner, T.C. Memo ; Gow v. Commissioner, T.C. Memo , aff d, 19 Fed. Appx. 90 (4th Cir. 2001); Gallun v. Commissioner, T.C. Memo ). a. Result Less Certain When Lower Tiered Entity Was a Significant Portion of Parent Entity s Assets: The Tax Court rejected multiple discounts to tiered entities where the lower level interest constituted a significant portion of the parent entity's assets. See Martin v. Commissioner, T.C. Memo (minority interests in subsidiaries comprised 75% of parent entity's assets); see also Estate of O Connell v. Commissioner, T.C. Memo (rejecting discount for lower tiered entities where the lower level interest was the parent entity s principal operating subsidiary ), rev d on other grounds, 640 F.2d 249 (9th Cir. 1981). VII. Recently Proposed Regulations Under I.R.C. ' 2704 A. The Enactment of I.R.C. ' 2704: 1. Background: In November of 1990, in response to perceived abuses with respect to the valuation of transfers of interests in corporations, partnerships, and trusts, Congress enacted a series of special valuation rules found in I.R.C. '' 2701 through See Omnibus Budget Reconciliation Act of 1990, Pub. L , ' 11602(a), 104 Stat , as amended; see also H. Conf. Rept , at 1137 (1990), C.B. 560, 606. This Outline focuses on I.R.C. ' Key Rules of I.R.C. ' 2704: I.R.C. ' 2704, entitled Treatment of certain lapsing rights and restrictions, provides the following rules: 1. I.R.C. ' 2704(a)(1) generally provides that the lapse of a voting or liquidation right is taxed as a transfer subject to the estate, gift, or generation-skipping transfer tax, as the case may be. i. Calculation of the Amount of the Transfer: Under I.R.C. ' 2704(a)(2), the amount of the transfer is the difference between (i) the fair market value of all interests held by the transferor (determined as if the voting or liquidation rights were nonlapsing), and (ii) the fair market value of such interests after the lapse. 2. I.R.C. ' 2704(b)(1) generally provides that when an interest in a family-controlled corporation or partnership is transferred to a member of the transferor s family, any restriction which limits the ability of the entity to be liquidated but which can be removed by a member of the family is disregarded when valuing the transferred 23 These rules were enacted in conjunction with the repeal of I.R.C. ' 2036(c), which generally provided that if a person transferred property having a disproportionately large share of the potential appreciation in an enterprise while retaining an interest or right in the enterprise, then the transferred property would be included in the transferor's gross estate, or upon the disposition of either the transferred property or the retained interest, the transferor would be deemed to have made a gift. Kerr v. Commissioner, 113 T.C. 449, (1999), aff d, 292 F.3d 490 (5th Cir. 2002)

88 interest for estate, gift, or generation-skipping transfer tax purposes, as the case may be. i. Applicable Restriction Defined: Under I.R.C. ' 2704(b)(2), an applicable restriction is defined as a restriction that effectively limits the ability of the entity to liquidate, but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or the transferor s family, either alone or collectively. Importantly, I.R.C. ' 2704(b)(3)(B) excepts from the definition of an applicable restriction any restriction imposed, or required to be imposed, by any Federal or State law. 3. I.R.C. ' 2704(b)(4) authorizes the U.S. Department of the Treasury ( Treasury Department ) and the Service to issue Regulations disregarding other restrictions in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor s family if such restriction has the effect of reducing the value of the transferred interest for purposes of [the estate, gift, or generation-skipping transfer taxes] but does not ultimately reduce the value of such interest to the transferee. i. Recent Regulations Proposed: As detailed below, the Treasury Department and the Service recently expanded the types of other restrictions that may be disregarded under I.R.C. ' The Statute: I.R.C. ' 2704 provides in relevant part as follows: 26 U.S.C Treatment of certain lapsing rights and restrictions (a) Treatment of lapsed voting or liquidation rights (1) In general. For purposes of this subtitle, if (A) (B) there is a lapse of any voting or liquidation right in a corporation or partnership, and the individual holding such right immediately before the lapse and members of such individual s family hold, both before and after the lapse, control of the entity, such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate of the decedent, whichever is applicable, in the amount determined under paragraph (2). (2) Amount of transfer. For purposes of paragraph (1), the amount determined under this paragraph is the excess (if any) of

89 (A) (B) the value of all interests in the entity held by the individual described in paragraph (1) immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing), over the value of such interests immediately after the lapse. (3) Similar rights The Secretary may by regulations apply this subsection to rights similar to voting and liquidation rights. (b) Certain restrictions on liquidation disregarded (1) In general. For purposes of this subtitle, if (A) (B) there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor s family, and the transferor and members of the transferor s family hold, immediately before the transfer, control of the entity, any applicable restriction shall be disregarded in determining the value of the transferred interest. (2) Applicable restriction. For purposes of this subsection, the term applicable restriction means any restriction (A) (B) which effectively limits the ability of the corporation or partnership to liquidate, and with respect to which either of the following applies: (i) (ii) The restriction lapses, in whole or in part, after the transfer referred to in paragraph (1). The transferor or any member of the transferor s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. (3) Exceptions. The term applicable restriction shall not include (A) any commercially reasonable restriction which arises as

90 part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either, or (B) any restriction imposed, or required to be imposed, by any Federal or State law. (4) Other restrictions The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. * * * 4. Regulatory Authority: Notably, I.R.C. ' 2704(b)(4) gives to the Service and the Treasury Department broad authority to issue regulations that restrictions other than lapsed voting or liquidation rights may also be disregarded when valuing transfers of interests in an entity if the restriction merely reduces the value of the interest for transfer tax purposes, but does not ultimately reduce the value of the interest to the transferee. B. Proposed Regulations Under I.R.C. ' 2704: 1. Issuance of Proposed Regulations: On August 4, 2016, the Service issued proposed regulations under I.R.C. ' See 81 Fed. Reg (Aug. 4, 2016). 2. Reason for Enacting Proposed Regulations: The Service s Notice of Proposed Rulemaking states that the Treasury Department and the Service have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments. 81 Fed. Reg (Aug. 4, 2016). Specifically, the Treasury Department and the Service noted the following abuses which prompted the issuance of the revised regulations: a. Current Regulations Do Not Apply to Ability to Liquidate a Transferred Interest in an Entity: The Treasury Department and the Service were first concerned that a restriction on the ability to liquidate an individual interest is not an applicable restriction under the current regulations. Id. b. Current Regulations Do Not Account for Recently Revised State Laws Governing Limited Partnerships: The Treasury Department and the Service were next concerned by the fact that existing regulations excepted from the definition of an applicable restriction a restriction on liquidation that is no more restrictive than that of

91 the State law that would apply in the absence of the restriction. Id. In this regard, the Government noted that many State statutes governing limited partnerships have been revised to (i) allow liquidation of the entity only on the unanimous vote of all owners (unless otherwise provided in the agreement), and (ii) prevent a limited partner from withdrawing from a partnership unless the agreement provides otherwise). Id. The practical effect of these State regulations, says the Treasury Department and the Service, is that the provisions of a partnership agreement restricting liquidation generally fall within the regulatory exception for restrictions that are no more restrictive than those under State law, and thus do not constitute applicable restrictions under the earlier regulations. Id. c. Avoiding the Application of I.R.C. ' 2704 Through Assignees: Third, the Treasury Department and the Service noted that taxpayers have attempted to avoid I.R.C. ' 2704(b) through the transfer of a partnership interest to an assignee rather than to a partner. These taxpayers, relying on the regulatory exception for restrictions that are no more restrictive than those under State law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have (and thus may not exercise) the rights or powers of a partner, argue that an assignee s inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under State law. As such, these taxpayers argue that the assignee status of the transferred interest is not an applicable restriction. Id. d. Transfers of Nominal Interests to Nonfamily Members to Avoid Application of I.R.C. ' 2704: Finally, the Treasury Department and the Service noted that taxpayers have avoided the application of I.R.C. ' 2704(b) by transferring a nominal partnership interest to a nonfamily member, such as a charity or an employee, to ensure that the family alone does not have the power to remove a restriction. Id. 3. Underlying Principles of the Proposed Regulations: The Treasury Department and the Service made the following substantive conclusions: a. A restriction on the ability to liquidate the transferred interest may adversely affect the transfer tax value of an interest but does not reduce the value of the interest to the family-member transferee; b. A restriction attendant upon the nature or extent of the property to be received in exchange for the liquidated interest, or the timing of the payment of that property, does not reduce the value of the interest to the family-member transferee; c. The grant of an insubstantial interest in the entity to a nonfamily member should not preclude the application of I.R.C. ' 2704(b) because, in reality, such nonfamily member interest generally does not constrain the family s ability to remove a restriction on the

92 liquidation of an individual interest. 4. Summary of Key Rules: A summary of the key provisions of the proposed regulations is as follows: a. Broader Class of Entities to Which I.R.C. ' 2704 Applies: The proposed I.R.C. ' 2704 regulations broaden the class of entities to which I.R.C. ' 2704 applies to include not only corporations and partnerships, but also limited liability companies and other entities and business arrangements (regardless of whether they are regarded or disregarded for federal tax purposes). b. Transfers Within Three Years of Death: The proposed I.R.C. ' 2704 regulations treat as an additional transfer the lapse of voting and liquidation rights for transfers made within three years of death of interests in family-controlled entities. The effect of these provisions is to substantially limit the lack of control discounts for these deathbed transfers. This bright line rule makes it easier for both practitioners and the IRS to apply. c. Transferee s Status as an Assignee: The proposed I.R.C. ' 2704 regulations eliminate any discount based on the transferee s status as a mere assignee and not a full owner and participant in the entity. d. Restrictions on Liquidation That Are Not Mandated by Federal or State Law: The proposed I.R.C. ' 2704 regulations disregard restrictions on liquidation that are not mandated by federal or State law when determining the fair market value of the transferred interest. e. Disregard Nominal Nonfamily Owners Ability to Block the Removal of Covered Restrictions: The proposed I.R.C. ' 2704 regulations disregard the ability of most nonfamily memberowners to block the removal of covered restrictions unless the nonfamily member: (1) has held the interest for more than three years; (2) owns a substantial interest in the entity and has the right, upon six months notice, to have his or her interest redeemed or bought-out for cash or property (not including a promissory note issued by the entity, its owners, or anyone related to the entity or its owners). 5. Detailed Explanation of Operative Provisions: a. Entities to be Covered Under I.R.C. ' 2704: The proposed regulations clarify that I.R.C. ' 2704 applies to foreign and domestic corporations, partnerships, limited liability companies, and other entities and business arrangements under Treas. Reg. ' (a), regardless of whether the entities are regarded or disregarded for federal tax purposes. The proposed regulations also note that the determination of whether an entity is a corporation, partnership, or limited liability company is determined under local law. See Prop. Treas. Reg. ' (b)(5)(i), (iv). b. Control for Purposes of I.R.C. ' 2704: The proposed regulations

93 clarify, in Treas. Reg. ' , that control of a limited liability company or of any other entity or arrangement that is not a corporation, partnership, or limited partnership would constitute the holding of at least 50% of either the capital or profits interests of the entity or arrangement, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement. See Prop. Treas. Reg. ' (b)(5)(iv). Further, for purposes of determining control, under the attribution rules of existing Treas. Reg. ' , an individual, the individual s estate, and members of the individual s family are treated as holding interests held indirectly through a corporation, partnership, trust, or other entity. See 81 Fed. Reg (Aug. 4, 2016). c. Lapses Under I.R.C. ' 2704 (Assignee Interests and the Three- Year Look-back Rule): The proposed regulations would amend Treas. Reg. ' (a) to confirm that a transfer that results in the restriction or elimination of any of the rights or powers associated with the transferred interest (referred to as an assignee interest ) is treated as a lapse within the meaning of I.R.C. ' 2704(a). See Prop. Treas. Reg. ' (a)(5). Thus, a transfer to an assignee would be subject to I.R.C. ' 2704(a) even if the transferor can continue to exercise voting or management rights associated with the interests. Id. Perhaps most importantly, a new three-year look-back period will apply to certain transfers made within three years of death. Under that rule, Treas. Reg. ' (c)(1) narrows the exception in the definition of a lapse of a liquidation right to transfers occurring three years or more before the transferor s death that do not restrict or eliminate the rights. See Prop. Treas. Reg. ' (c)(1). Thus, the threeyear rule would treat any transfer within three years of death which results in the transferor losing a liquidation or voting right, as a deemed transfer of the lapsed voting or liquidation right even if the rights associated with the ownership of the transferred interest are not restricted (e.g., children who receive gifts of stock and continue to have the right to vote the stock) associated with the ownership of the transferred interest. d. Restrictions Imposed or Required to be Imposed: The proposed I.R.C. ' 2704 regulations would remove the exception in Treas. Reg. ' (b) that limits the definition of applicable restriction to limitations that are more restrictive than the limitations that would apply in the absence of the restriction under the local law generally applicable to the entity. See Prop. Treas. Reg. ' (b)(2), (4)(ii). e. Disregarded Restrictions: The proposed I.R.C. ' 2704 regulations would create a new class of restrictions (known as disregarded restrictions ). See Prop. Treas. Reg. ' Under Prop

94 ii. Treas. Reg. ' , in the case of a family-controlled entity, any disregarded restriction on an owner s right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members, without regard to certain interests held by nonfamily members, may remove or override the restriction. See 81 Fed. Reg (Aug. 4, 2016). i. Disregarded Restrictions Defined: Under the proposed regulations, a disregarded restriction includes one that: 1. Limits the ability of the holder of the interest to liquidate the interest; 2. Limits the liquidation proceeds to an amount that is less than a minimum value (which is defined as the interest s share of the net value of the entity on the date of liquidation or redemption (i.e., fair market value as determined under I.R.C. ' 2031 or 2512 reduced by the outstanding debts of the entity); 3. Defers the payment of the liquidation proceeds for more than six months; or 4. Permits the payment of the liquidation proceeds in any manner other than in cash or other property (and excluding other certain promissory notes). Lack of Control Discounts Limited: The practical effect of these new classes of disregarded restrictions is to significantly limit the availability of lack of control discounts for family-owned entities. f. Coordination With Charitable Deductions: The proposed I.R.C. ' 2704 regulations confirm that I.R.C. ' 2704(b) does not apply to transfers to nonfamily members and thus has no application in valuing an interest passing to a charity or to a person other than a family member. See 81 Fed. Reg (Aug. 4, 2016). Thus, if part of an entity interest includible in the gross estate passes to family members and part of that interest passes to nonfamily members, and if (taking into account the proposed rules regarding the treatment of certain interests held by nonfamily members) the part passing to the decedent s family members is valued under I.R.C. ' 2704(b), then the proposed regulations provide that the part passing to the family members is treated as a property interest separate from the part passing to nonfamily members. Id. 6. Effective Date and Comments: a. Effective Date: The provisions of the proposed I.R.C. ' 2704 regulations that apply to voting and liquidation rights would apply to rights and restrictions created after October 8, 1990, but only to transfers occurring after the date that the regulations are finalized. b. Comments and Hearing: Comments to the proposed I.R.C. '

95 regulations are due by November 2, 2016, and a public hearing is set for December 1, C. Takeaways From and Challenges to the I.R.C. ' 2704 Regulations: 1. In General: The proposed I.R.C. ' 2704 regulations would significantly change the valuation of interests in family-controlled entities for estate, gift, and generation-skipping transfer tax purposes. These changes are most pronounced with respect to the lack of control discounts that traditionally applied to family owned business and entities. 2. Proposed, Not Final Regulations: It is important to remember that the regulations have only been proposed, and are not final. Proposed regulations provide guidance concerning the Treasury Department s and the Service s interpretation of a Code section. a. Courts Approach to Proposed Regulations: The status of the regulations as proposed means that courts should view them as carrying no more weight than a position advanced in a brief. See Gen. Dynamics Corp. v. Commissioner, 108 T.C. 107, 120 (1997). b. IRS s Approach to Proposed Regulations: The status of the regulations as proposed means that revenue agents should follow the proposed regulations during audits to the extent they are taxpayer favorable. See Internal Revenue Manual ( I.R.M. ), pt (Jan. 1, 2006). Where, as here, the regulations may be taxpayer adverse, the proposed regulations have no force and effect. i. The I.R.M. s Statements on Proposed Regulations: I.R.M., pt. 32,1,1,2,2 (Aug. 11, 2004), entitled Notice of Proposed Rulemaking, states as follows: 1. A Notice of Proposed Rulemaking (NPRM) announces to the public that an agency is considering modifying regulations as published in the Code of Federal Regulations (CFR) or issuing rules on matters not addressed in existing regulations. In either circumstance, an NPRM sets out the proposed regulatory text. NPRMs contain a preamble that explains the rules and requests public comments on the suggested changes. NPRMs may also contain a Notice of Hearing. Unlike Treasury Decisions (TDs), NPRMs do not have full force and legal effect unless and until they are adopted as final regulations. Prior to adoption, proposed regulations may be withdrawn or modified at any time. 2. Taxpayers generally may not rely on proposed regulations for planning purposes, except if there are no applicable final or temporary regulations in force and there is an express statement in the proposed regulations that taxpayers may rely on them currently. If there are

96 applicable final or temporary regulations in force, taxpayers may only rely on proposed regulations for planning purposes in the limited circumstance if the proposed regulations contain an express statement permitting taxpayers to rely on them currently, notwithstanding the existence of the final or temporary regulations. 3. If there are no final or temporary regulations currently in force addressing a particular matter, but there are proposed regulations on point, the Office of Chief Counsel generally should look to the proposed regulations to determine the office s position on the issue. The Office of Chief Counsel ordinarily should not take any position in litigation or advice that would yield a result that would be harsher to the taxpayer than what the taxpayer would be allowed under the proposed regulations. c. Taxpayers Approach to Proposed Regulations: The status of the regulations as proposed means that taxpayers may, but need not, rely on them. Accord I.R.M., pt (Jan. 1, 2006) ( Taxpayers may rely on a proposed regulation, although they are not required to do so. ). i. Interplay With Penalties: The question will naturally arise whether taxpayers should expect a penalty to be imposed if they choose not to follow the proposed regulations, and instead follow, for example, the general valuation rules that require property to be valued at fair market value. Courts will generally not impose a penalty where the issue to be resolved is one of first impression involving unclear or inconsistent statutory or regulatory language. Accord Bunney v. Commissioner, 114 T.C. 159, 267 (2000). Thus, taxpayers who are the first to challenge the proposed regulations may be able to avoid accuracy-related penalties if the IRS s position is sustained. But, as a practical matter, the more cases that the Court decides with respect to the unclear or inconsistent statutory or regulatory language, the more apt courts are to impose accuracy-related penalties. Compare Kaufman v. Commissioner, T.C. Memo (following remand from the Court of Appeals, imposing the accuracy-related penalty despite resolving an issue of first impression), with 1982 East, LLC v. Commissioner, T.C. Memo (not imposing an accuracy-related penalty where the regulations were perceived to be unclear and ambiguous)

97 3. Deference to Regulations Under Mayo: However, if the proposed I.R.C. ' 2704 regulations are finalized in substantially the same form, they are likely to be accorded significant weight in view of Congress express delegation of authority to issue those regulations. The exception to this general rule of deference is if the Court finds the regulation to be arbitrary, capricious, or manifestly contrary to the statute. See Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, (2011); Chevron, U.S.A., Inc. v. Natural Res. Def. Council Inc., 467 U.S. 837, (1984)

98 VIII. Audits of Valuation Discounts and ADR Alternatives A. Overview: 1. Audits of Valuation Discounts Emphasized: Valuation discounts issues tend to disproportionately arise in the estate and gift tax context. Estate and gift tax auditors return for tax authorities more dollars per capita than any other subdivision of tax, and as such, audits in estate and gift tend to be emphasized. Additionally, the Service has identified valuation discounts and premiums as presenting an opportunity for abuse, and for this added reason, it is likely that valuation discounts and premiums claimed in connection with estate and gift tax returns will be audited. 2. Routine Questions in the Context of Audits of Closely Held Businesses: Estate and gift tax auditors routinely ask themselves questions similar to the following in connection with audits of closely held business valuations: a. Does the governing entity instrument contain requirements for determining the sales price of the closely held business interest? If so, did you adhere to those standards? b. Does the closely held business have an established practice for determining the fair market value of the closely held business interest if not disclosed in the agreements? If so, were you consistent in following that approach on the estate or gift tax return? c. Are there rights of first refusal which might result in a reduction of the fair market value? d. Is the value determines on the basis of a reliable appraisal? Review the entity's tax returns and financial statements to determine the fair market value of the shares. e. Have you reviewed for appropriate discounts (e.g., lack of marketability, lack of control, built in gains, key person, etc.)? Is the discount reasonable in the light of existing case law? f. Was there a bargain sale of the company? B. Sample IDR Requests 1. DLOM: The IRS routinely requests certain information when examining business interests for which a DLOM is claimed. The following requests, taken from the IRS Job Aid for IRS valuators with respect to DLOM, are typical of an IDR: a. History of dividend payments [cash dividends are a liquid return on investment, which might lower lack of marketability risk]; b. Salaries and bonuses paid to the Officers of the company, over the five years leading up to the valuation date [especially in companies that don t pay dividends, Officers compensation can provide cash flow to shareholders, which might lower lack of marketability risk]; c. Compensation and/or fees paid to the Directors of the company, over the five years leading up to the valuation date [especially in companies that don t pay dividends, Directors fees can provide 60-98

99 cash flow to shareholders, which might lower lack of marketability risk]; d. List of all marketable securities (description, number, cost value) shown on the latest financial statements [cash-equivalent securities might lower liquidity risk on a company-wide basis]; e. List of all non-marketable securities and investments (description, number, cost value) shown on the latest financial statements [can provide information on how long it might take to liquidate nonmarketable assets]; f. Breakdown of adjusted cost basis for each of the marketable and Nonmarketable assets owned by the company on the valuation date [can provide information on built-in capital gains tax expense to liquidate the company] g. Indicate if the adjusted cost basis of any of the company s marketable or non-marketable assets reflects a carry-over cost basis, pursuant to an I.R.C. ' 1031 (or similar type) tax-deferred exchange [can provide information on whether the company pursues available tax-deferral strategies]; h. Current list of shareholders/partners showing the name of each shareholder/partner and the class and number of shares owned by each shareholder as of the valuation date [can provide information on relative ownership distribution and total number of shareholders]; i. Copies of notes receivable (and/or notes payable) between the company and any shareholders, over the five years leading up to the valuation date [loans to/from shareholders might be relevant to evaluating lack of marketability risk]; j. Company articles of incorporation and amendments, by-laws and amendments or partnership agreements and amendments [by-laws might address restrictions or procedures for transfer of shares]; k. Copy of all shareholder agreements (such as buy/sell agreements, stock option agreements stock purchase agreements, etc.) that have been in effect during the five years prior to the valuation date [shareholder agreements might address restrictions or procedures for transfer of shares]; l. All documents pertaining to any sale of the company, a division or unit of the company, or shares (interests) in the company during the five years prior to the valuation date [recent sales/transfers might be might be relevant to evaluating lack of marketability risk]; m. Board of Directors Meeting Minutes, for five years leading up to valuation date [Board meetings might address shareholder requests for sale/transfer of shares]; n. Complete financial statements of the company for the five fiscal or calendar years prior to the valuation date, including balance sheets, income statements and cash flow statements [can provide

100 additional information for evaluating lack of marketability risk]; o. Complete income tax returns for the five fiscal or calendar years prior to the valuation date, including any audit adjustments [tax returns might include details that are not stated within the regular financial statements]; p. Brief history and/or description of the company or the company s business (may already be included in an appraisal report) [can provide additional information for evaluating lack of marketability risk]; and q. Brief statement of duties of subject shareholder s participation in company operations [can provide additional information for evaluating lack of marketability risk]. C. The 30-Day Letter and Administrative ADR 1. In General a. The 30-Day Letter: Once an audit has run its course and there are unagreed changes to a proposed deficiency, depending upon the time before the expiration of the statute of limitations, taxpayers will normally be afforded the opportunity to have the Service s Office of Appeals review those unagreed upon issues. The vast majority of cases, especially those in which valuation are at issue, will be resolved with Appeals. i. Tax Court s Views on Settling Valuation Cases: The Tax Court is clear that it wants parties to settle valuation cases. See, e.g., Messing v. Comm r, 48 T.C. 502, 512 (1967) ( Too often in valuation disputes the parties have convinced themselves of unalterable correctness of their positions and have consequently failed successfully to conclude settlement negotiations a process clearly more conducive to the proper disposition of disputes such as this. The result is an overzealous effort, during the course of the ensuing litigation, to infuse a talismanic precision into an issue which should frankly be recognized as inherently imprecise and capable of resolution only by a Solomon-like pronouncement. ); see also Buffalo Tool & Die Mfg. Co. v. Comm r, 74 T.C. 441, (1980) As the Court repeatedly admonished counsel at trial, the issue is more properly suited for the give and take of the settlement process than adjudication. The existing record reeks of stubbornness rather than flexibility on the part of both parties. We are convinced that the valuation issue is capable of resolution by the parties themselves through an agreement which will reflect a compromise Solomon-like adjustment, thereby saving the expenditure of time, effort, and money by the parties and the Court a process not likely to produce a better result. Indeed, each of the parties should keep in mind that, in the final analysis, the Court

101 may find the evidence of valuation by one of the parties sufficiently more convincing than that of the other party, so that the final result will produce a significant financial defeat for one or the other, rather than a middle-of-the-road compromise which we suspect each of the parties expects the Court to reach. If the parties insist on our valuing any or all of the assets, we will. We do not intend to avoid our responsibilities but instead seek to administer to them more efficiently a factor which has become increasingly important in light of the constantly expanding workload of the Court. ). ii. Service s Commitment to Settling Valuation Cases: The Service, in turn, has counseled its Appeals officers to always strive to settle valuation cases in view of the judicial distaste for such issues. See Dep t of the Treasury, Internal Revenue Service, Valuation Training for Appeals Officers, Training (Rev. May 1997), available at (last visited Jan. 6, 2015). b. Trials Generally Disfavored: Trials are a vital part of tax controversy. Though sometimes necessary, they usually result from a failure of imagination and are rarely in the client s best interest. Alternative dispute resolution is a legitimate alternative to a trial that is advisable with respect to almost all valuation cases in which valuation discounts are at issue. In connection with full or partially unagreed cases, there are many alternatives to trial offered by the IRS, including: i. Fast Track Settlement; ii. Fast Track Mediation; iii. Post-Appeals Mediation; and iv. Arbitration. 2. Fast Track Settlement a. In General: Fast Track Settlement ( FTS ) is a jointly administered program offered by the Service s Small Business/Self-Employed Unit ( SBSE ) and Appeals to expedite case resolution at the earliest opportunity. I.R.M., pt (Jan. 6, 2014). b. Purposes of FTS: FTS is intended to enable taxpayers and the Service to work together in resolving disputed issues while the case remains in SBSE jurisdiction. Id. FTS is designed to streamline the settlement process of cases because the taxpayer, the taxpayer s representative, the examiner, the manager, and an Appeals mediator actively participate in the outcome. Id. c. How it Works: The Appeals officer, acting as a mediator, effectively leads and conducts the session as a mediator would. Id

102 d. Time of Completion: The FTS is estimated to be complete within 60 days. FTS is a relatively new option, available nationally beginning on July 1, I.R.M., pt (Jan. 6, 2014). e. How to Request: A request for FTS should be made by submitting a package to an Appeals Team Manager (ATM) that includes the following information: i. Signed Form 14017, Application for Fast Track Settlement; ii. A summary of issues; iii. The taxpayer's written position and response to the examiner; and iv. In the case of a family limited partnership valuation issue, Form 6180A, Form 886-A, the taxpayer's appraisal, and the Service's appraisal. See I.R.M., pts (Jan. 6, 2014) and (Oct. 1, 2012). f. When Available: FTS is generally available for all non-docketed SBSE cases with no regard to dollar amount. However, the following cases are specifically excluded from FTS: i. Docketed cases; ii. Cases with numerous issues, whether simple or complex, which will require longer than 60 days to resolve; iii. Cases where SBSE or the taxpayer are unable to meet during the 60-day time frame; iv. High profile, sensitive taxpayers or issues; v. Cases where the taxpayers have failed to respond to Service communications and no documentation has been previously submitted for consideration (a/k/a no-show cases ); vi. Non-filer cases; vii. viii. Frivolous filers; and Whipsaw issues (i.e., issues for which resolution as to one party might result in inconsistent tax treatment in the absence of another party s participation). g. Termination of FTS: A taxpayer s request to participate in the FTS process can be terminated or withdrawn at any time. I.R.M., pt (Jan. 6, 2014). h. Cases That Settle in FTS: If the parties resolve the issue(s) raised in the FTS process and the examiner s group manager or territory manager agrees with the settlement, Appeals will prepare and execute the appropriate agreement form and a brief Appeals Case Memorandum. I.R.M., pt (Jan. 6, 2014). Once the disputed issues are resolved or the decision is made that a resolution cannot be reached, the Appeals Official solicits signatures of the taxpayer and SBSE representative on a report (known as the Fast Track Session Report ). Id. The Fast Track Session Report lists the issues in dispute as well as the resolution of the issues. Id. Both parties are given a copy of this report and are also notified the settlement is not final until the necessary

103 closing documents or waivers are signed. Id. i. Cases That Do Not Settle in FTS: If the parties are unable to resolve an issue, the taxpayer will retain all standard appeal rights and the examiner will close the case as Unagreed. When Appeals receives an unagreed case after an FTS session, Appeals assigns it to a different Appeals Officer (assuming of course that a 90-day letter is not issued first). I.R.M., pt (Jan. 6, 2014). 3. Fast Track Mediation a. In General: Fast Track Mediation ( FTM ) is a program designed by the Service to expedite case resolution and expand the range of dispute resolution options available to taxpayers. I.R.M., pt (Jan. 6, 2014). However, because of dollar limitations, FTM is not particularly well-suited for estate and gift tax cases where valuation discounts are at issue. b. How it Works: Appeals officers assigned to FTM cases are trained in mediation resolution. The mediator does not have settlement authority and cannot render a decision regarding any issue in dispute. Id. c. Time of Completion: FTM is designed to be completed within an average of 30 to 40 days. Id. d. How to Request: A request for FTM should be made by submitting an package to an Appeals Team Manager that includes the following information: i. Form 13369,Agreement to Mediate (If the Form 13369, is signed by a person pursuant to a Power of Attorney executed by the taxpayer, a copy of Form 2848, Power of the Attorney and Declaration of Representative, must be attached to the agreement); ii. The examiner s summary of the issues and tentative tax computation (e.g., Form 886A and Form 1273); and iii. The taxpayer s written position. See I.R.M., pt (Jan. 6, 2014). e. Cases Available: As relevant to non-frivolous tax disputes, the following cases are excluded from FTM: i. Cases over $100,000. Due to the possibility of complex issues in cases over $100,000, further review is required by the Service to determine whether such cases are eligible for mediation; ii. Docketed issues where resolution depends on an assessment of the hazards of litigation (i.e., cases pending before a court of law in which the issue is presently before the court); iii. iv. Compliance Coordinated Issues (CCI) and Appeals Coordinated Issue Program cases; and Cases in which there is an absence of legal precedents

104 and/or conflicts. See I.R.M., pt (Jan. 6, 2014). f. Differences Between FTS and FTM: As compared with FTM, FTS differs from FTM in that the Appeals officer has the authority to settle an FTS case, including the use of hazards of litigation. I.R.M., pt (Jan. 6, 2014). Also, as noted, there are no dollar limitation restrictions on cases that can be brought under FTS. Id. 4. Post-Appeals Mediation a. In General: Post-Appeals Mediation ( PAM ) is a formal mediation procedure for cases in the Appeals administrative process that is conducted by third parties. I.R.M., pt (Aug. 27, 2010). PAM is a nonbinding process that uses the service of a mediator or mediators, as neutral third parties, to help Appeals and the taxpayer reach a negotiated settlement. Id. b. How it Works: Generally, an Appeals officer serves as a mediator and Appeals pays for all expenses associated with the use of the mediator. Rev. Proc , 9.01, I.R.B superseding Rev. Proc , I.R.B. 462; but see I.R.M., pt (Aug. 27, 2010) (referring Service personnel to Rev. Proc , presumably because the I.R.M. has not been updated as of the date of this article).. Additionally, the taxpayer may (at his or her own expense) elect to use a co-mediator who is not employed by the Service. i. Conference: The Appeals Team Manager will confer with the Appeals Officer of Tax Policy and Procedure before deciding to approve or deny a mediation request. Rev. Proc , 7.02(3). ii. Time of Response: The Appeals Team Manager will generally respond within two weeks after receiving the mediation request. iii. Written Agreement Required: Assuming the request is approved, the taxpayer and Appeals will enter into a written agreement to mediate substantially in the form attached as Exhibit 2 to Rev. Proc See Rev. Proc , c. How to Request: To invoke the PAM procedures, the taxpayer should send a written request to the appropriate Appeals Team Manager and a copy to the appropriate Appeals Area Director (these individuals are listed in Exhibit 1 of the revenue procedure). Rev. Proc , 7.02(1). The mediation request should include the following: i. The taxpayer s name, taxpayer identification number, and address (and, if applicable, the name, title, address, and telephone number of a different contact person, such as an authorized representative); ii. The name of the Team Case Leader, Appeals Officer,

105 and/or Settlement Officer; iii. The taxable period(s) involved; iv. A description of the issue for which mediation is requested, including the dollar amount of the adjustment or, if applicable, the offer in compromise amount in dispute; and v. A representation that the issue is not an excluded issue under the revenue procedure. See Rev. Proc , 7.02(2). d. Availability of PAM: The availability of PAM is defined in Rev. Proc , I.R.B. 1014, superseding Rev. Proc , I.R.B But see I.R.M., pt (Aug. 27, 2010) (referring Service personnel to Rev. Proc , presumably because the I.R.M. has not been updated as of the date of this article). Rev. Proc instructs that [m]ediation may be used to resolve issues in cases that qualify under this revenue procedure while they are under consideration by Appeals. This procedure may be used only after Appeals settlement discussions are unsuccessful and, generally, when all other issues are resolved but for the issue(s) which mediation is being requested. Rev. Proc , Mediation is available under the revenue procedure for the following types of cases: i. Legal issues; ii. Factual issues; iii. Compliance Coordinated Issues or Appeals Coordinated Issues, which are published online at iv. Early referral issues when an agreement is not reached, provided that the early referral issue meets the requirements for mediation; v. Issues for which a request for competent authority assistance has not yet been filed; vi. Unsuccessful attempts to enter into a closing agreement under I.R.C. 7121; vii. Offer in compromise issues (as defined in the revenue procedure); and viii. Trust fund recovery penalty issues (as defined in the revenue procedure). See Rev. Proc , e. Unavailability of PAM: Mediation is not available under the revenue procedure for the following types of cases: i. Cases in which mediation is improper under 5 U.S.C. 572 or 575, which generally provide the authority and guidelines for use of alternative dispute resolution in the administrative process; ii. Issues designated for litigation; iii. iv. Issues docketed in any court; Collection cases, except for certain offer in compromise and trust fund recovery penalty cases as detailed in the

106 revenue procedure; v. Issues for which mediation would not be consistent with sound tax administration, including but not limited to issues governed by closing agreements, res judicata, or controlling Supreme Court precedent; vi. vii. viii. Frivolous issues; Whipsaw issues, or issues for which resolution with respect to one party might result in inconsistent treatment in the absence of participation of another party, such as, but not limited to, issues on a joint return where both spouses do not agree to participate in the same mediation proceeding or where one spouse is claiming innocent spouse treatment under I.R.C. ' 6015; Cases in which the taxpayer did not act in good faith during settlement negotiations, such as, but not limited to, cases in which the taxpayer failed to timely respond to document requests or offers to settle, or failed to address arguments and precedents raised by Appeals; ix. Cases that were previously mediated through a different alternative dispute resolution program within Appeals, such as FTS or FTM; and x. Issues that have been otherwise identified in subsequent guidance issued by the IRS as excluded from the mediation program. See Rev. Proc , Arbitration a. In General: The Appeals Arbitration Program ( AAP ) is a voluntary arbitration program designed to improve tax administration, provide customer service, and reduce the burden on taxpayers. I.R.M., pt (Aug. 27, 2009). The availability of the AAP is marked by Rev. Proc , I.R.B b. How to Request: Arbitration is optional and voluntary. Rev. Proc , To invoke the AAP procedures, the taxpayer s representative should send a written request to the appropriate Appeals Team Manager and a copy to the Chief, Appeals, th Street, NW, Suite 4200 East, Washington, D.C , Attn: Office of Tax Policy and Procedure. Rev. Proc , The arbitration request should include the following: i. The taxpayer s name, taxpayer identification number, and address (and, if applicable, the name, title, address, and telephone number of a different contact person, such as an authorized representative); ii. iii. iv. The name of the Team Case Leader, Appeals Officer, and/or Settlement Officer; The taxable period(s) involved; A description of the issue for which arbitration is requested, including the dollar amount of the adjustment or, if

107 applicable, the offer in compromise amount in dispute; and v. A representation that the issue is not excluded under the revenue procedure. See Rev. Proc , c. When Available: Arbitration is available under the AAP for cases within Appeals jurisdiction that have a limited number of factual issues unresolved following settlement discussion with Appeals. Rev. Proc , 1. Arbitration is available under the AAP for i. Only for factual issues; ii. For factual issues for which a request for competent iii. authority assistance has not yet been filed; and For factual issues unresolved at the conclusion of unsuccessful attempts to enter into a closing agreement under I.R.C Rev. Proc , d. When Not Available: Arbitration is not available for the following types of issues: i. Legal issues; ii. Cases in which arbitration is not available under 5 U.S.C. 572 or 575 (discussed above); iii. iv. Issues docketed in any court; Issues designated for litigation; v. Collection cases, except for certain offer in compromise and trust fund recovery penalty cases as detailed in the revenue procedure; vi. Issues for which mediation would not be consistent with sound tax administration (discussed above); Frivolous issues; Whipsaw issues (discussed above); Cases in which the taxpayer did not act in good faith during settlement negotiations; and x. Issues that have been otherwise identified as excluded from the AAP. See Rev. Proc , vii. viii. ix. e. Written Agreement Required: If the arbitration request is approved, the taxpayer and Appeals will enter into a written agreement to arbitrate in substantially the form attached as Exhibit 1 to the revenue procedure. Rev. Proc ,

108 IX. Litigating Valuation Discounts A. Overview of a Valuation Trial 1. A Valuation Trial Is About Proving Value: Fundamentally, a valuation trial is about establishing the value of something for federal tax purposes. That something can be anything: real property; an interest in real property (e.g., fractional interest); intellectual property (e.g., patents, copyrights, trademarks), personal property (e.g., artwork, a sports memorabilia collection, or a rare automobile); a business; investments; financial instruments; or even a person s image and likeness. As noted at the outset of this Outline, the determination of value necessarily implicates valuation discounts and premiums in many valuation cases. 2. Typically Involves Mixed Questions of Law and Fact: A determination of value is ultimately a factual inquiry in which the trier of fact must weigh the relevant evidence and draw appropriate inferences. Commissioner v. Scottish Am. Inv. Co., 323 U.S (1944). At the same time, valuation often presents mixed questions of law and fact. This is because, in the typical valuation case, the trier of fact is called upon to make a legal conclusion about the rights inherent in property, and from those various legal conclusions derive the value of property for federal tax purposes. Whitehouse Hotel Ltd. P ship v. Commissioner, 755 F.3d 236, 242 (5th Cir. 2014); see also United States v. Woods, 571 U.S., 134 S. Ct. 557, 566 (2013) ( we doubt that value is limited to factual issues and excludes threshold legal determinations. ). 3. The Trier of Fact May Need Help to Understand the Evidence: Valuation trials are usually complex, and while some judges are conversant in valuation, many more are not. Fed. R. Evid. 702 anticipates complex valuation trials and allows judges to receive expert testimony if the expert s scientific, technical, or other specialized knowledge will help the judge to understand the evidence or decide a fact in issue. a. Fed. R. Evid. 702: Fed. R. Evid. 702 authorizes an expert witness to testify before a Court. That rule provides as follows: A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if: (a) the expert s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a facts in issue; (b) (c) the testimony is based on sufficient facts or data; the testimony is the product of reliance principles and methods; and

109 (d) the expert has reliably applied those principles and methods to the facts of the case. 4. The Role of the Court, the Expert, and the Attorney: a. Role of the Court: In valuation cases, including those in which valuation discounts are at issue, the judge is normally the trier of fact who examines the evidence (including expert reports) to ultimately find facts and apply the law to those facts. b. Roles of the Expert: Experts qualified to testify in a court proceeding owe a duty to the court that transcends the duty to his or her client insofar as the expert must present his or her opinion, as well as the facts, data, and analysis on which he or she relied, neutrally and candidly. Experts who breach their duty to the Court in order to advance their client s litigation position compromise their usefulness. Crimi v. Commissioner, T.C. Memo c. Role of the Attorney: A good attorney lets the expert do his or her job (value the property), provides relevant information, ensures that all procedural requirements have been met to admit the expert s report into evidence, and ensures that sufficient facts are in the record to make as persuasive an argument as possible on brief. A valuation trial is rarely won in the courtroom. 5. When to Retain an Expert in Connection With a Valuation Trial: As a general rule, it is appropriate to hire an expert in a litigation matter whenever doing so will help the trier of fact (or the attorney) understand the evidence or to determine a fact in issue. See Fed. R. Evid. 702 (discussed below). As a practical matter, you will almost always want to use an expert to establish property s value for federal tax purposes. B. Selecting an Expert 1. Overview: As noted, an attorney tasked with establishing the value of property for federal tax purposes will likely rely on an expert appraiser. 2. Using the Same Appraiser Who Prepared the Appraisal to Support the Tax Reporting Position: Practitioners may want to use the appraisal who prepared the appraisal to support a tax reporting position as the sole expert or as a joint expert. While it is generally a good idea not to abandon an earlier appraiser in litigation, practitioners should be mindful that variations in value between the appraisal to support the tax reporting position and the appraisal to support the litigation will be ripe for crossexamination and may impugn that expert s credibility. 3. Area of Expertise: The expert can be qualified in any of a number of subject areas, but the following most typically apply in a valuation case: business valuation, personal property, machinery and technical specialties, real property, gems and jewelry, or appraisal review and management. 4. Factors to Consider in Selection: a. Daubert Challenges: The primary area of interest in selecting an expert, and the one most often overlooked, is the expert s ability to withstand a Daubert challenge from the opposing party

110 b. Overall Reliability and Reasonableness: The second area of interest in selecting an expert is whether he or she is sufficiently reliable and reasonable for a court to rely upon his or her value opinion. Various factors may bear on the appraiser selected, including the following adapted with permission from David Laro, Shannon P. Pratt, and Michael R. Devitt, Qualified Appraiser, Qualified Appraisal: Practice, Procedure, Legal Analysis, and Theory (John Wiley & Sons, forthcoming 2015): i. Is the appraiser experienced in appraising property of the type to be valued (e.g., closely held businesses, real estate in a specific geographic region or for a particular use, conservation easements, and others)? ii. Is the appraiser certified in the correct area of valuation (note, appraisers are generally certified in the following six areas: business valuation, personal property, machinery and technical specialties, real property, gems and jewelry, or appraisal review and management)? iii. Is the appraiser sufficiently credentialed with designations from an accredited professional organization (e.g., Member of the Appraisal Institute (MAI), Senior Real Property Appraiser (SRPA), Accredited Senior Appraiser (ASA), Accredited in Business Valuation (ABV), Accredited Member (AM), Accredited by the Institute of Business Appraisers (AIB), or a Chartered Business Valuator (CBV))? iv. Is the appraiser a member of an accredited professional organization, such as the American Society of Appraisers (ASA), the Appraisal Institute (AI), the National Association of Certified Valuation Analysts (NACVA), the Institute of Business Appraisers (IBA), the Society of Real Estate Appraisers, the American Institute of Real Estate Appraisers, and the American Institute of Certified Public Accountants (AICPA), among others? v. Is the appraiser neutrally detached from the property to be valued and the transaction at issue so as to offer an unbiased opinion of value? vi. How long has the individual been performing valuations? vii. How much time does the appraiser spend valuing property of the type to be valued? viii. What resources do the appraiser or firm have available to perform relevant economic and industry research? ix. What are the academic and professional qualifications of the appraiser? x. What is the appraiser s track record for withstanding challenges to its appraisers? xi. Has the appraiser been used previously and has he or she

111 provided a favorable opinion of value? xii. Is the appraiser being recommended by a trusted adviser such as an attorney or accountant? xiii. Is the cost of the appraisal warranted in the light of the complexity of the assignment? C. Procuring the Expert Witness Reports 1. Protecting Privilege a. Structure Communications Between Attorney and Expert: As noted below, draft reports and communications between the attorney and the expert are generally privileged from disclosure. Therefore, it is important to (1) have the attorney engage the appraiser on behalf of the client-taxpayer, and (2) send all correspondence between the expert and the client through the attorney. b. Client Communications Sent From Client to Attorney to Expert Lose Privilege: Practitioners should keep in mind that when a client sends a confidential communication to an attorney and the attorney then sends that correspondence to the expert, privilege has been broken, and the expert may be called to testify as to that communication. c. Court Rules Generally Protect Drafts and Communications Between Attorneys and the Expert From Discovery: The rules of the courts most likely to hear a valuation case protect from discovery (1) an expert s communications with counsel, and (2) drafts of the expert s reports. No similar privilege has yet been recognized for communications and draft reports exchanged between the expert and the client-taxpayer. i. Tax Court: Tax Ct. R. Prac. & Proc. 70(c)(3) protects (1) drafts of any expert witness report required under Rule 143(g), regardless of the form in which the draft is recorded, and (2) communications between a party s counsel and any witness required to provide a report under Rule 143(g), regardless of the form of the communication. There are, of course, exceptions to the general rule. (1) Exceptions: Pursuant to Tax Ct. R. Prac. & Proc. 70(c)(3), communications between the party s attorney and the witness are discoverable to the extent the communications: (a) relate to compensation for the expert s study (b) or testimony; identify facts or data that the party s attorney provided and that the expert considered in forming the opinions to be expressed; or (c) identify assumptions that the party s attorney provided and that the expert relied

112 on in forming the opinions to be expressed. ii. District Court: Fed. R. Civ. P. 26(b)(3)(A) and (B) generally protect from discovery draft reports and communications between the party s attorney and any witness required to provide a report, regardless of the form of the communication. There are, of course, exceptions to the general rule. (1) Exceptions: Pursuant to Fed. R. Civ. P. 26(b)(4), communications between the party s attorney and the witness are discoverable to the extent the communications: (a) relate to compensation for the expert s study or testimony; (b) identify facts or data that the party s attorney provided and that the expert considered in forming the opinions to be expressed; or (c) identify assumptions that the party s attorney provided and that the expert relied on in forming the opinions to be expressed. d. Strategies to Protect Privilege: To keep expert material privileged: i. Step 1: Have the Attorney Engage the Expert: As a first best practice, have the attorney engage the expert on behalf ii. of the client-taxpayer. Step 2: Use the Attorney as the Intermediary for All Correspondence With the Expert: Send all correspondence between the expert and the client through the attorney. In this regard, have the expert direct all correspondence to the attorney and have the client-taxpayer address all correspondence to the client. D. Attorney Involvement From Report Preparation to Litigation 1. Overview: As noted above, an attorney in a valuation case should allow the expert to value the property, provide relevant information, and ensure that all procedural requirements have been met to admit the expert s report into evidence. Necessarily, the attorneys function may change during the different states of the expert report process. 2. Fact-Gathering: a. In General: After the expert has been engaged, the expert will begin to collect information and gather facts relevant to the assignment. b. The Importance of the Attorney s Role: Attorneys can (and should be) be an indispensable resource in the fact-gathering process because they are often intimately familiar with the client, the property to be valued, how the property was acquired (e.g., purchase, gift, bequest, or formation), and the terms of any offers with respect to the property in question

113 c. Type of Information to be Collected: Among the information likely to be collected from an attorney in connection with an appraisal are the following: i. The valuation date (i.e. as of what date is an opinion of value required); ii. The property to be appraised; iii. The client and the intended users of the appraisal; iv. The purpose of the appraisal (i.e., for federal income, estate, or gift tax purposes); v. The standard of value to be used (i.e., fair market value [as required for federal tax purposes], market value, liquidation value, or some other measure of value); and vi. The existence of formation documents establishing the rights in certain property or the existence of sideagreements which may affect those rights The Report Preparation Process: a. Attorney Involvement Limited: Recall from discussions above that Tax Ct. R. Prac. & Proc. 143(g) & Fed. R. Civ. P. 26(a)(2)(B) require an expert to prepare a written report. As a general rule, attorneys should be not be involved with the preparation of the expert s report other than to (1) answer the expert s questions, (2) ensure that the expert has all necessary information relative to his or her assignment, and (3) ensure that the report complies with the procedural requirements to have the report admitted into evidence. b. Be Mindful of Deadlines and Allow Time for Review: Experts tend to reject both substantive and procedural criticisms of their report. But this does not mean criticisms should not be given and, if appropriate, remedied. Set firm deadlines for the expert to submit his or her report to you and the client for review. Provide comments and feedback as soon as practicable. c. Best Practice to Provide a Copy of the Procedural Requirements to Have the Report Submitted: It is advisable for the attorney, in addition to explaining the procedural requirements from his or her perspective, to send a copy of the relevant rules for the expert s consideration. Doing so will allow the expert to ensure that his or her report is compliant with the applicable standards of appraisal practice (e.g., USPAP) and the Court s rules. d. Extent of Attorney Involvement Clarified in Committee Notes: The Advisory Committee Notes to Fed. R. Civ. P. 26(a)(2)(B) provides as follows: 24 Obviously, the attorney should provide the expert with copies of all relevant formation and side agreements affecting the rights in the property. HOWEVER, as a matter of best practice, to the extent any privileged document is provided to the appraiser, the attorney should secure the consent of the client because providing that document will break privilege. Among the types of documents that might be requested, and should be provided, are the following: (1) articles of incorporation; (2) corporate bylaws; (3) operating agreements; (4) rights of first refusal; (5) buy-sell agreements; and (6) leases, including any options associated therewith

114 Rule 26(a)(2)(B) does not preclude counsel from providing assistance to experts in preparing the reports, and indeed,... this assistance may be needed. Nevertheless, the report which is intended to set forth the substance of the direct examination, should be written in a manner that reflects the testimony to be given by the witness and it must be signed by the witness. 4. The Report Review Process: a. In General: The expert should circulate a draft of his or her report in advance of the expert report submission date. b. Role 1: Ensure Report is Legally and Procedurally Correct: First, the lawyer should advise the appraiser to ensure that the appraisal is legally and procedurally sound. This entails the attorney explaining to the appraiser the correct standard of value to be used, the statutory and regulatory requirements required, and to ensure that the expert witness is familiarized with applicable court rules for admissibility. c. Role 2: Confirm the Report is Factually and Empirically Correct: The lawyer should confirm that the appraisal is factually and empirically sound, that computations therein are correct, and that the assumptions underlying the appraised value are reasonable and appropriate. To the extent the attorney disagrees with any assumptions relied upon in the appraisal, the attorney should help the appraiser to understand why the assumptions may not be reasonable. The attorney should never simply instruct the appraiser to change his or her conclusions, but should counsel the appraiser to examine the facts and circumstances from the perspective of the reviewing court or governmental authority. d. Role 3: Confirm That All Relevant Facts Reasonably Foreseeable on the Date of Valuation Have Been Considered: Third, the lawyer should check that the appraiser considered all relevant facts in reaching his or her conclusion of value, regardless of the impact of those facts on the ultimate value. To the extent the appraisal is deficient in its consideration of these facts, the attorney should help the appraiser to understand how other facts may affect the report. 5. Sanctions for Improper Attorney Assistance: a. Trial Courts Granted Broad Discretion: The Daubert Court gave trial courts broad discretion to determine the reliability and admissibility of expert reports. b. Sanctions Allowed: An attorney who impermissibly assists an expert to prepare his or her report may be subjected to the following sanctions: i. Denying the admissibility of the expert witness' report;

115 ii. Denying the witness the opportunity to testify; iii. Disqualifying the expert; iv. Disregarding all or a portion of the witness' report or testimony; v. Imposing monetary sanctions against the faulting party and/or that party's counsel; vi. Granting a new trial; vii. Dismissing the petition or complaint; viii. Entering a default judgment; or ix. Contempt. See Stuart M. Hurwitz & Richard Carpenter, "Can an Attorney Participate in the Writing of an Expert Witness' Report in the Tax Court?", 100 J. TAX N 358 (2004); see also Trigon Ins. Co. v. United States, F.R.D. 277 (E.D. Va. 2001) (barring a consulting firm from participating in a case and sanctioning the faulting party for allowing litigation consultants to participate significantly in drafting the expert witness report); Bank One Corp. v. Commissioner, 120 T.C. 174 (2003), aff d in part and vacated in part sub nom. J.P. Morgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006) (holding that an expert witness rebuttal report was not admissible because it was tainted in its preparation by the significant participation of taxpayer s counsel). E. Using the Appraiser to Negotiate With Tax Authorities: An attorney may want to provide a copy of an expert report to opposing counsel in connection with settlement negotiations. Practitioners should keep in mind that doing so, should (it seems) be a waiver of privilege. However, the Tax Court has recently ruled that a draft report tendered in connection with settlement negotiations does not lose its privilege under Fed. R. Evid. 408 and Tax Ct. R. Prac. & Proc. 70(c)(3). 15 West 17th Street, LLC v. Commissioner, No (Order filed June 13, 2014). F. Available Forums 1. Choice of Forum: Valuation cases, including those in which valuation discounts and premiums are at issue, may be litigated before the Tax Court, the Federal District Courts, and the Court of Claims. Each court has a number of advantages and disadvantages. a. The primary advantage to litigating a valuation case in Tax Court is that the taxpayer does not need to prepay the liability. Moreover, Tax Court judges, by virtue of their specialized training and skill, are most likely to understand valuation issues, including valuation discounts and premiums. b. District Court: Taxpayers can also choose to litigate their cases in the appropriate federal District Court. The primary drawbacks to this option is that (1) the taxpayer must first prepay the tax, and (2) the cost of trying a valuation in District Court tends to be higher than in Tax Court. These costs tend to eliminate many valuation trials from District Court. However, if the attorney would prefer a

116 jury trial, he or she will need to advise their client to prepay the tax and file a complaint in the appropriate federal District Court. Additionally, consideration should be given to the doctrine of variance (discussed below). c. Court of Claims: Taxpayers can also choose to litigate before the Court of Claims. Again, the taxpayer must prepay the tax and the doctrine of variance applies. 2. The Role of the Doctrine of Variance in Refund Actions: Refund courts prohibit reliance on legal theories and factual bases that vary from those set forth in the administrative refund claim. See e.g., Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000). If the refund claim is not adequately developed at the administrative level or if the practitioner expects to deviate from it in litigation, then a refund forum may be ill-advised and Tax Court rights should be adequately protected and pursued. G. Discovery of the Opposing Party s Expert Witness Material 1. Overview of Discovery: a. In General: Discovery is the pretrial phase of litigation in which a party may obtain evidence from an opposing party by using various discovery devices, such as depositions, interrogatories, and requests for production of documents, among others. Discovery may extend to materials relied upon by experts, though discoverable information is severely restricted if prepared in connection with the current litigation. As a practical matter, there are also various statutory discovery devises through which taxpayers can obtain information from the Service without resorting to court-sanctioned discovery. b. Broadly Construed: Court rules regarding discovery are broadly construed to allow parties to obtain discovery with respect to any nonprivileged matter that is relevant to any party's claim or defense. See Fed. R. Civ. P. 26(b)(1) ( Parties may obtain discovery regarding any nonprivileged matter that is relevant to any party s claim or defense. ); Tax Ct. R. Prac. & Proc. 70(b) ( The information or response sought through discovery may concern any matter not privileged and which is relevant to the subject matter involved in the pending case. ). At the same time, discovery can be limited by common law doctrines and court rules. c. Discovery of Opposing Party s Expert Materials Coveted: Not surprisingly, litigants find it important to discover, and perhaps to use at trial, information, opinions, and conclusions of an opposing party s expert witness. d. Objectives of Discovery: Discovery serves a number of important objectives, including encouraging settlements of cases, preventing false claims from going to trial, narrowing the issues to be tried, preventing the concealment of evidence relevant to the case, eliminating surprise, and allowing attorneys to prepare for

117 effective cross-examination and rebuttal of evidence. 2. Expert Reports Prepared in Advance of Trial v. Reports Prepared to Support a Tax Reporting Position: The rules which apply to discovery and the manner in which those rules apply depends upon whether the information sought to be discovered, typically an expert s report, was prepared in advance of litigation or to support a tax reporting position. 3. Limitations on Discovery: a. Attorney-Client Privilege: i. Overview: In general, attorney-client privilege protects confidential communications between an attorney and the attorney s client from discovery. Attorney-client applies to communications made in confidence by a client to an attorney for the purpose of obtaining legal advice, and also to confidential communications made by the attorney to the client if such communications contain legal advice or reveal confidential information on which the client seeks advice. Upjohn Co. v. United States, 449 U.S. 383, 389 (1981). ii. As Applied to Expert Material: As discussed above, the attorney-client privilege does not create a blanket exemption from discovery of all communications between an attorney and an expert witness even though the communications may concern the client. In this regard, Tax Ct. R. Prac. & Proc. 70(c)(3) and Fed. R. Civ. P. 26(b)(4) both generally protect communications between a party s counsel and any witness required to provide a report. b. Work-Product Privilege: i. Overview: The work-product doctrine may also protect from discovery certain documentary items, including expert witness reports, prepared in anticipation of litigation. The work product doctrine generally protects documents, interviews, statements, memoranda, correspondence, briefs, mental impressions, and tangible things prepared by an attorney in anticipation of litigation or trial. Hickman v. Taylor, 329 U.S. 495, (1947). ii. iii. Broader Scope That Attorney-Client Privilege: The scope of protections afforded by the work product doctrine is broader than those offered by the attorney-client privilege. Thus, the work product doctrine, unlike the attorney-client privilege, may prevent discovery of an expert s report when the expert has been hired by the attorney as his or her agent to assist in the preparation of anticipated litigation. As Applied to Expert Material: The work product doctrine was adopted in Tax Ct. R. Prac. & Proc. 70(c)(3) and Fed. R. Civ. P. 26(b)(4) both of which protect from discovery draft reports prepared in connection with litigation

118 c. Unfairness Doctrine: A third limitation on discovery is a judicial limitation generally known as the Doctrine of Unfairness, which provides that the party seeking discovery should not be able to obtain from an adverse party s expert information that is readily available for independent evaluation. 4. Discovery of Material Through I.R.C. 7517, I.R.C. 7602, and FOIA a. Importance: In any valuation case, and in tax cases generally, practitioners should know what the Government knows (and more). There are a variety of mechanisms for practitioners to obtain this information independent of available discovery devises. b. I.R.C Requests in Estate and Gift Tax Cases i. Background: I.R.C allows taxpayers to obtain copies of any documents the Service relies on with respect to a determination of value for estate, gift, or generationskipping transfer tax purposes. ii. Making I.R.C Requests: In connection with the valuation of any estate, gift, or generation-skipping transfer tax return cases, therefore, it is advisable to make a written request under I.R.C for all documents the Service relies on to support such deficiency determination. iii. The Statute: I.R.C provides as follows: (a) General rule If the Secretary makes a determination or a proposed determination of the value of an item of property for purposes of the tax imposed under chapter 11, 12, or 13 [i.e., those with respect to the estate, gift, or generationskipping transfer taxes], he shall furnish, on the written request of the executor, donor, or the person required to make the return of the tax imposed by chapter 13 (as the case may be), to such executor, donor, or person a written statement containing the material required by subsection (b). Such statement shall be furnished not later than 45 days after the later of the date of such request or the date of such determination or proposed determination. (b) Contents of statement A statement required to be furnished under subsection (a) with respect to the value of an item of property shall (1) explain the basis on which the valuation was determined or proposed, (2) set forth any computation used in arriving at such value,

119 and (3) contain a copy of any expert appraisal made by or for the Secretary. (c) Effect of statement Except to the extent otherwise provided by law, the value determined or proposed by the Secretary with respect to which a statement is furnished under this section, and the method used in arriving at such value, shall not be binding on the Secretary. c. I.R.C. 7602(c) Requests: i. Background: Pursuant to I.R.C. 7602(c)(2), the Service is required to provide a taxpayer with a list of third-party contacts periodically and additionally, when requested by the taxpayer. See I.R.M., pt (Nov. 1, 2009). ii. Make Requests Under I.R.C. 7602(c): Practitioners should make regular requests to the Service with respect to third parties to whom summonses have been issued to provide a copy of all records produced to the Service. iii. The Statute: I.R.C. 7602(c) provides as follows: (1) General notice An officer or employee of the Internal Revenue Service may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made. (2) Notice of specific contacts The Secretary shall periodically provide to a taxpayer a record of persons contacted during such period by the Secretary with respect to the determination or collection of the tax liability of such taxpayer. Such record shall also be provided upon request of the taxpayer. (3) Exceptions This subsection shall not apply (A) to any contact which the taxpayer has authorized;

120 (B) if the Secretary determines for good cause shown that such notice would jeopardize collection of any tax or such notice may involve reprisal against any person; or (C) with respect to any pending criminal investigation. d. FOIA Requests i. Background on FOIA: In all valuation cases, and all tax cases generally, practitioners should send to the Service Disclosure Office a Freedom of Information Request Act, 5 U.S.C. 552, et seq. ( FOIA ). ii. Reason for Making the FOIA: Often, but not always, a FOIA response will give the practitioner insight into the reasons that the Service determined a certain adjustment in the taxpayers income, estate, or gift tax for a particular year. Additionally, FOIA might help certain taxpayers show that procedural due process requirements were not met (e.g., I.R.C. 6751's written supervisory approval of a penalty determination). In this regard, a FOIA response can be of considerable value when taking an issue before Appeals or before a federal court. iii. How to Make: There is no required form for making a FOIA request. We advise that such request be made in writing to the Service s Disclosure Office. FOIA requests can be sent by fax or by mail as follows: (1) By Fax: FOIA requests can be faxed to (877) ; or (2) By Mail: FOIA requests can be sent by mail to the following address: Internal Revenue Service IRS FOIA Request Stop 93A Post Office Box Atlanta, GA iv. The FOIA Response: Under FOIA, the Service must determine within 20 business days after the date a FOIA request is received whether and to what extent to comply with the FOIA request. 5 U.S.C The Service can extend the 20-day period by an additional 10 days in unusual circumstances. See, e.g., 5 U.S.C. 552 (a)(6)(b)(i)-(iii). Such unusual circumstances include, but are not limited to, the need to collect information from field offices, the need to review large numbers of documents,

121 and the need to consult with other agencies. 5 U.S.C. 552 (a)(6)(b)(i). v. Administrative and Judicial Reviews of FOIA Responses: Taxpayers can appeal a denial of a FOIA request, either in whole or in part, administratively to the Service. If an administrative FOIA appeal before the Service is denied, a complaint against the Service seeking disclosure of the requested information may be filed to the appropriate federal District Court. 5 U.S.C. 552(a)(4)(B); Treas. Reg (c)(13). vi. Make FOIA Requests Early and Often: Practitioners should make regular FOIA requests to the Service and request third parties to whom summonses have been issued to provide a copy of all records produced to the Service. This will allow the practitioner to monitor the case and ensures that he or she has all information in the Government's possession. 5. Discovery of Materials Through Court-Sanctioned Discovery: a. Tax Court: i. In General: Tax Ct. R. Prac. & Proc. 70(c)(3) protects (1) drafts of any expert witness report required under Rule 143(g), regardless of the form in which the draft is recorded, and (2) communications between a party s counsel and any witness required to provide a report under Rule 143(g), regardless of the form of the communication. There are, of course, exceptions to the general rule. ii. Exceptions: Pursuant to Tax Ct. R. Prac. & Proc. 70(c)(3), communications between the party s attorney and the witness are discoverable to the extent the communications: (1) relate to compensation for the expert s study or testimony; (2) identify facts or data that the party s attorney provided and that the expert considered in forming the opinions to be expressed; or (3) identify assumptions that the party s attorney provided and that the expert relied on in forming the opinions to be expressed. b. District Court: i. In General: Fed. R. Civ. P. 26(b)(3)(A) and (B) generally protect from discovery draft reports and communications between the party s attorney and any witness required to provide a report, regardless of the form of the communication. There are, of course, exceptions to the general rule. ii. Exceptions: Pursuant to Fed. R. Civ. P. 26(b)(4), communications between the party s attorney and the

122 witness are discoverable to the extent the communications: (1) relate to compensation for the expert s study or testimony; (2) identify facts or data that the party s attorney provided and that the expert considered in forming the opinions to be expressed; or (3) identify assumptions that the party s attorney provided and that the expert relied on in forming the opinions to be expressed. H. Qualifying the Expert, Satisfying Daubert, and Daubert Challenges 1. In General: As discussed more fully below, an expert s direct testimony in Tax Court cases is generally received in the form of his or her written report and an expert s direct testimony is generally received in the District Courts and the Court of Claims without a written report. 2. Qualifying Your Expert: Regardless of the forum chosen, the attorney will need to qualify the potential expert as an expert before expert testimony can be given. As a practical matter, doing so requires that the practitioner prove that the expert s testimony is relevant to the question of value and otherwise reliable. a. Trial Judge Will Ensure the Relevance and Reliability of the Expert s Testimony: In Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 589 (1993), the Supreme Court stated that trial court judges are the gatekeepers of expert evidence who must ensure that any and all scientific testimony or evidence admitted is not only relevant, but reliable. Although Daubert has historically not been emphasized in tax cases (most likely because the risk of jury confusion does not exist in a bench trial), recent Tax Court cases confirm that Daubert compliance is also required in tax cases. See, e.g., Boltar v. LLC v. Commissioner, 136 T.C. 326, (2011) (emphasizing the importance of Daubert in tax cases notwithstanding the fact that tax cases are most commonly conducted as bench trials). b. Means of Satisfying Daubert: i. Satisfy Daubert Through Questioning: If the stipulation process fails, a tax practitioner satisfies Daubert by establishing that his or her proffered expert (1) will offer testimony that is based upon sufficient facts and data, (2) will offer testimony that is the product of reliable principles and methods, and (3) has applied the principles and methods reliably to the facts of the case. Daubert, 509 U.S. at (1) Daubert Factors: The Daubert Court specifically noted four factors which a trial judge should consider in determining whether scientific testimony is admissible under Fed. R. Evid These factors are as follows:

123 (a) Whether the proposed theory or technique can and has been tested; (b) Whether the theory or technique has been subjected to peer review and publication; (c) Whether there exists a known or potential rate of error for the theory or technique applied; (d) Whether the theory or technique has gained general acceptance in the particular filed in which it belongs. (2) Additional Factors to be Considered: Six years after Daubert was decided, the Supreme Court issued Kuhmo Tire Co. v. Carmichael, 526 U.S. 137, (1999), in which it confirmed that the Daubert factors apply to testimony concerning technical and other specialized knowledge, as well as to scientific testimony. In the years following Kuhmo Tire, courts have looked to the following factors in addition to the traditional Daubert factors: (a) Whether the experts are proposing to testify about matters growing naturally and directly out of research they have conducted independent of the litigation, or whether they have developed their opinions expressly for purposes of testifying; (b) Whether the expert has unjustifiably extrapolated from an accepted premise to an unfounded conclusion; (c) Whether the expert has adequately accounted for obvious alternative explanations; (d) (e) (f) (g) Whether the expert is being as careful as he would be in his regular professional work outside his paid litigation consulting; Whether the field of expertise claimed by the expert is known to reach reliable results for the type of opinion the expert would give Whether the theory or method offered by the expert has been put to any non-judicial use; and Whether the expert s opinion fails to square with the judge s opinion and common sense. [See David Laro, Shannon P. Pratt, and Michael R. Devitt, Qualified Appraiser, Qualified Appraisal: Practice, Procedure, Legal Analysis, and Theory (John Wiley &

124 Sons, forthcoming 2015).] ii. Can the Parties Stipulate That Daubert is Satisfied? Some practitioners believe that the parties can stipulate that the proffered expert is Daubert compliant. While this may help the process, Daubert compliance or noncompliance is within the scope of the trial court s discretion, and as a practical matter, most judges will insist that Daubert compliance be shown. iii. District Courts May Limit Testimony as to the Qualifications Issue and Look to an Expert s CV: Some District Court judges will limit expert testimony with respect to an expert s qualifications and instead rely on the expert s curriculum vitae (CV) where there is not a qualifications issue. 3. Daubert Challenges a. Voir Dire: When the counsel offers his or her witness as an expert, opposing counsel should be given the opportunity (or should request the opportunity) to voir dire the witness. A Daubert challenge is properly made only after a voir dire of the witness to test the reliability of that witness qualifications to testify as an expert. b. Daubert Challenges: As noted, a Daubert challenge is properly made by showing in the voir dire process that the proffered expert does not possess the skills, knowledge, and/or experience to testify as an expert. Thus, attorneys in tax cases should examine the particular expert s reliability in the light of the Daubert factors, and if appropriate, challenge the witness status as an expert. I. Timing, Procedure for Receiving, and Submission of Expert Reports 1. In General: Expert witnesses usually offer their opinion in a written report submitted to the Court ahead of trial. See Tax Ct. R. Prac. & Proc. 143(g) (expert report generally due 30 days before trial); Fed. R. Civ. P. 26(a)(2)(D) (generally due 90 days before trial and rebuttal reports generally due within 30 days of opposing party s disclosure). The procedures vary as between the Tax Court and the District Court. 2. Tax Court: a. Timing of Report: Tax Ct. R. Prac. & Proc. 143(g) requires an expert witness to prepare and submit a written report to the Court and to the opposing party no later than 30 days before trial. b. Procedure for Receiving Report and Additional Testimony: The parties must submit their expert reports within 30 days of trial. The presiding judge typically reviews the parties expert reports before trial. At trial, the report is marked as an exhibit, identified by the expert witness, and received in evidence as the expert witness direct testimony upon the Court s finding that the witness is qualified to testify as an expert. Additional direct testimony may be allowed to clarify or emphasize matters with respect to that

125 expert's report. Following the additional direct testimony, if any, the witness is tendered for cross-examination by the opposing party. (Note: There are a number of alternatives to the traditional cross-examination process, including concurrent witness testimony (or hot tubbing), a full discussion of which is outside the scope of this Outline). c. Contents of Report: The Tax Court recently amended Tax Ct. R. Prac. & Proc. 143(g) to require that an expert report contain the same information required under Fed. R. Civ. P. 26(a)(2)(B). See Press Release dated July 6, 2012, pp As amended, Tax Ct. R. Prac. & Proc. 143(g) requires that an expert report contain the following: i. A complete statement of all opinions the witness expresses and the basis and reasons for them; ii. The facts or data considered by the witness in forming them; iii. Any exhibits used to summarize or support them; iv. The witness qualifications, including a list of all publications authored in the previous 10 years; v. A list of all other cases in which, during the previous 4 years, the witness testified as an expert at trial or by deposition; and vi. A statement of the compensation to be paid for the study and testimony in the case. d. Expert Not Allowed to Testify Without Written Report: The Court typically does not allow an expert to testify without a written report where the testimony is based on third-party contacts, comparable sales, statistical data, or other detailed, technical information. Tax Ct. R. Prac. & Proc. R. 143(g)(3). This is so say that an expert will generally not be allowed to testify as such without a written report. e. Expert Report Not Admissible Without Proper Foundation: Also, the expert must testify to lay the proper foundation to have an expert report admitted into evidence. In Estate of Tanenblatt v. Commissioner, T.C. Memo , the Tax Court excluded the taxpayer s expert report because the taxpayer s expert did not appear at trial to lay the proper foundation. i. Practice Point: As the Court s opinion in Estate of Tanenblatt noted, the taxpayer s expert did not testify due to a fee dispute with the appraiser. T.C. Memo (slip op. at 11). If faced with an appraiser who refuses to testify on account of a fee dispute, practitioners should remember that they have the power to subpoena their own expert witness in connection with a trial proceeding. The courts will enforce that subpoena upon a proper motion, and the expert s failure to appear may subject him or her to

126 being held in contempt. Practitioners should also keep in mind that an expert who is not paid his or her customary fee tends to be far less cooperative and helpful than one who is fully paid before trial. 3. District Courts: a. Contrasted With Tax Court: For whatever reason, Tax Court litigation ties its discovery cut-off dates to the date of trial (i.e., discovery is back-ended). By contrast, District Court litigation sets discovery cut-off date dates by reference to the initial Fed. R. Civ. P. 26(f) conference. For this reason, as explained below, practitioners presenting a valuation trial in District Court must identify the need for expert testimony in District Court litigation much earlier than in Tax Court litigation. b. Rule 26 Disclosures: i. Background: Recall Fed. R. Civ. P. 26(f) requires each party, without awaiting a discovery request, to provide the following information to the other parties: (1) The name, address, and telephone number of each individual likely to have discoverable information, along with the subject of that information, that the disclosing party may use to support its claims or defenses; (2) A copy, or a description by category and location, of all documents, electronically stored information, and tangible things that the disclosing party has in its possession, custody, or control, and may use to support its claims or defenses; (3) A computation of each category of damages claimed by the disclosing party, who must also make available for inspection and copying, all unprivileged and unprotected documents or other evidentiary material on which each computation is based; and (4) For inspection and copying, any insurance agreement under which an insurance business may be liable to satisfy all or part of a possible judgment in the action or to indemnify or reimburse for payments made to satisfy the judgment. ii. Initial Disclosure of Expert Testimony: In addition to the foregoing initial disclosure items, a party must also disclose to the other parties the identity of any witness the party may use at trial as an expert witness. Fed. R. Civ. P. 26(a)(2)(A). iii. Timing of Initial Disclosures: The initial disclosures, including the initial disclosure of expert testimony, must be made within 14 days of the parties Fed. R. Civ. P. 26(f)

127 conference. iv. Initial Production of Expert Report: Unless otherwise stipulated to by the parties or directed in a scheduling order (as is common and usually a function of local practice), the expert witness disclosure must be accompanied by a written report which is prepared and signed by the expert witness. Fed. R. Civ. P. 26(a)(2)(B). Similar to Tax Ct. R. Prac. & Proc. 143(g) with respect to content, Fed. R. Riv. P. 26(a)(2)(B) requires that the report include the following information: (1) A complete statement of all opinions the witness will express and the basis and reasons for them; (2) The facts or data considered by the witness in forming them; (3) Any exhibits that will be used to summarize or support them; (4) The witness qualifications, including a list of all publications authored in the previous 10 years; (5) A list of all other cases in which, during the previous four years, the witness testified as an expert at trial or by deposition; and (6) A statement of the compensation to be paid for the study and the testimony in the case. v. Additional Disclosures Within 30 Days of Trial: In addition, under Fed. R. Civ. P. 26(a)(3), the parties must disclose to the adverse party the following within 30 days before trial: (1) The name, address, and telephone number of each witness, separately identifying those the party expects to present and those it may call if the need arises; (2) The designation of those witnesses whose testimony the party expects to present by deposition and, if not taken stenographically, a transcript of the pertinent parts of the deposition; and (3) An identification of each document or other exhibit, including summaries of other evidence, separately identifying those items the party expects to offer and those it may offer if the need arises. vi. Exclusion If Failed to Disclose: Fed. R. Civ. P. 37(c)(1) provides that the failure to disclose expert information in a timely manner may result in disallowance of that information or witness to supply evidence on a motion, at a hearing, or at a trial, unless the failure was substantially justified or is harmless. vii. Report Generally Not Provided to District Court: The

128 District Courts do not require that a written expert report be submitted to the trier of fact. Instead, while the parties are generally required to exchange expert reports ahead of trial, the District Courts generally require an expert to testify as to his or her opinion and the basis for that opinion. (1) Reports as Direct Testimony in Select District Court Cases: District Court judges may, in a bench trial, be amenable to receiving the expert s direct testimony in the form of a written report. Each District Court judge will likely approach this issue differently. 4. Court of Claims: a. Parallels District Courts: The Rules for the Court of Claims parallel the Federal Rules of Civil Procedure in that they require an expert witness to prepare a report and a party to disclose that report to the opposing party as part of that party s initial disclosures. See R. Ct. Fed. Cl. 26(a)(2). The Court of Claims does not, however, require the parties to submit a copy of their written report during trial. J. Preparing Rebuttal Reports in Advance of Trial 1. In General: Both the Tax Court and the District Courts allow for rebuttal reports to be submitted in reply to an expert s report. The procedure in each court varies slightly. 2. Tax Court: Tax Ct. R. Prac. & Proc. 143(g) allows rebuttal reports to be submitted in response to the opposing party s expert report(s). The Tax Court s rules do not explain when the rebuttal report must be submitted to the Court, and experience has shown that each judge has his or her own preferences as to how to receive rebuttal reports. a. Check Standing Pretrial Order or Scheduling Order: Some judges specify in their standing pretrial order or scheduling order when, if at all, rebuttal reports are to be provided to the Court. b. Request Telephone Conference With Opposing Counsel and the Court in Absence of Court Order Addressing the Issue: To the extent the Court s pretrial order does not address when such reports are to be exchanged, it is generally advisable to request a telephone conference with the Court for purposes of discussing trial scheduling and how the judge wants to receive any rebuttal reports. 3. District Court: Fed. R. Civ. P. 26(a)(2)(D) provides that evidence intended to contradict or rebut evidence on the same subject as proffered by the opposing party should be disclosed to the opposing party within 30 days after receipt thereof. Because written reports are generally not submitted to the trier of fact, rebuttal testimony, if any, is elicited through crossexamination and rehabilitation of the experts. a. District Court Judges May Permit Rebuttal Reports: District Court judges may, in a bench trial, be amenable to receiving the expert s

129 rebuttal testimony in the form of a written report. Again, this issue should be discussed during the pretrial scheduling conference. 4. The Attorney s Role With Respect to Rebuttal Reports - Moving and Submitting a Rebuttal Report: a. Role 1: Confirm That the Opposing Party s Expert Report is Legally and Procedurally Correct: First, the lawyer should confirm that the opposing party s expert report is procedurally correct, and if deficient, move in limine with respect to that report (discussed below). b. Role 2: Instruct Your Client s Expert to Ensure That the Opposing Party s Expert Report is Factually and Empirically Sound: Second, the lawyer should rely upon his expert to confirm that the rebuttal report is factually and empirically sound, that the computations therein are correct, and that underlying assumptions are reasonable and appropriate. If the report is deficient, these deficiencies (and the reasons they were made) should be explored on crossexamination and addresses in your expert s rebuttal report. c. Role 3: Confirm That All Relevant Facts Were Considered: Third, the lawyer should confirm that the opposing party s expert considered all relevant facts in reaching his or her opinion. If the report is deficient, these deficiencies (and the reasons they were made) should be explored on cross-examination and addresses in your expert s rebuttal report. K. Burden of Proof Allocation of the Burdens of Production and Persuasion 1. General Allocation of the Burden of Proof: As a general rule, the Service s deficiency determinations are presumed correct. Taxpayers generally bear the burden of proof in tax proceedings (i.e., taxpayers must prove the deficiency determinations are wrong in order to prevail). E.g., Tax Ct. R. Prac. & Proc. 142(a)(1). The Government generally bears the burden of proof with respect to any new matter, increase in deficiency, or affirmative defenses pleaded in the answer. See, e.g., id. The Government also bears the burden of proving fraud by clear and convincing evidence. I.R.C I.R.C Allows Burden of Proof to Shift: I.R.C. 7491(a) provides that the burden of proof may be shifted to the Government in any court proceeding if a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer. Thus, for the burden of proof to shift to the Government, the taxpayer must introduce credible evidence with respect to the issue and establish that: a. The taxpayer has complied with the requirements under the I.R.C. to substantiate any item; b. The taxpayer has maintained all records required under the Code and cooperated with reasonable requests by the Government for witnesses, information, documents, meetings, and interviews. I.R.C. 7491(a). 3. The Anomalous Result of I.R.C. 7491: Note that the taxpayer must first

130 come forward with credible evidence before the burden of proof (which is really the burden of persuasion) can shift to the Government. Thus, as a practical matter, the taxpayer under I.R.C has the initial burden of production to come forward with credible evidence. Only then can the burden of persuasion shift to the Government. Compare Estate of Addell v. Commissioner, T.C. Memo (burden of proof did not shift to the Service under I.R.C because taxpayer did not produce credible evidence to shift the burden of persuasion). This is relevant for purposes of when to make the motion to shift the burden of proof. L. Concurrent Evidence, Concurrent Testimony, and Hot-Tubbing 1. Courts Distrust Towards Partisan Experts a. The Supreme Court s Recognition of Partisan Experts Dates as Far Back as 1858: The Supreme Court has long-recognized the partisanship of experts and the shortcomings in the traditional adversarial process. In Winans v. New York & Erie R.R. Co., 62 U.S. 88 (1858), the Supreme Court observed as follows about experts: Experience has shown that opposite opinions of persons professing to be experts may be obtained to any amount; and it often occurs that not only many days, but even weeks, are consumed in cross-examinations, to test the skill or knowledge of such witnesses and the correctness of their opinions, wasting the time and wearying the patience of both court and jury, and perplexing, instead of elucidating, the questions involved in the issue. b. Experts Are Not Supposed to Be Hired Guns, But Often Are: The Tax Court has counseled more recently that [e]xperts are not supposed to be hired guns ; they lose their usefulness and credibility to the extent to which they become mere advocates for the side that hired them. Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, (1998). These warnings notwithstanding, parties often place experts in the courtroom for the sole purpose that they advocate for their client s position from a valuation perspective. This bias has been at the heart of the traditional adversarial process. 2. Shortcomings in the Traditional Adversarial Process a. Overview: As discussed above, the traditional adversarial process in valuation cases centers around one party qualifying his, her, or its witness as an expert and having that witness provide direct testimony as to the value of certain assets. Opposing counsel then cross-examines the expert witness, ostensibly to discredit the expert s credibility or the reliability of his or her valuation technique and conclusions. This procedure is then mimicked by the other party in what one author has termed an orchestrated dance

131 See Michael R. Devitt, A Dip in the Hot Tub: Concurrent Evidence Techniques for Expert Witnesses in Tax Court Cases, 118 J. TAX N 213 (Oct. 2012); see also Marvin J. Garbis, Aussie Inspired Musings on Technological Issues - Of Kangaroo Courts, Tutorials & Hot Tub Cross-Examination, 6 GREEN BAG 141 (2003) (the first published article introducing the hot tub concept to the United States). b. Shortcomings in the Traditional Model: Courts, and the Tax Court in particular, have expressed their dissatisfaction with the cottage industry of experts. See Boltar, L.L.C. v. Commissioner, 136 T.C. 326, 335 (2011); Crimi v. Commissioner, T.C. Memo Concurrent Witness Testimony as a Welcome Alternative a. Overview: The concurrent witness model has so far been used in three reported Tax Court cases (one of which was affirmed by the Court of Appeals for the Third Circuit). As discussed below, this model offers a welcome alternative to the sometimes deficiency traditional adversarial model. i. The Tax Court has thus far implemented the concurrent witness procedure in three reported decisions and with the consent of both parties: Rovakat, LLC v. Commissioner, T.C. Memo , aff d, 529 Fed. Appx. 124 (3d Cir. 2013); Crimi v. Commissioner, T.C. Memo ; and Buyuk, LLC v. Commissioner, T.C. Memo Also, the Tax Court used concurrent witness testimony in Pohlad v. Commissioner, docket No (T.C. filed June 6, 2013), with nine experts. After two hours of hot tubbing and three days of trial, the case settled. b. The Concurrent Witness Model: The Tax Court in Rovakat, LLC v. Commissioner, T.C. Memo , described the concurrent witness model as follows: With the agreement of the parties, [the Court] directed the experts to testify concurrently. To implement the concurrent testimony, the Court sat at a large table in the middle of the courtroom with all three experts, each of whom was under oath. The parties counsel sat a few feet away. The Court then engaged the experts in a three-way conversation about ultimate issues of fact. Counsel could, but did not, object to any of the experts testimony. When necessary, the Court directed the discussion and focused on matters that the Court considered important to resolve. By engaging in this conversational testimony, the experts were able and allowed to speak to each other, to ask questions, and to probe weaknesses in any other expert's testimony. The discussion that followed was highly focused, highly structured, and directed by the Court

132 c. Advantages and Disadvantages of the Concurrent Witness Model: The benefits of the concurrent witness testimony process are many, but include the following: i. Narrowing the Issues: Concurrent witness testimony allows the Court to more easily and efficiently identify the issues on which the experts agree and disagree, and in turn, to narrow those issues of fact and law necessary to decide the property s fair market value. ii. Allows Judges to Instantly Reconcile Competing Expert Testimony: Concurrent witness testimony provides judges with a forum to immediate reconcile competing expert testimony. iii. More Effectively Use the Experts Technical and Specialized Knowledge: Concurrent witness testimony allows the Court to utilize the experts technical and specialized knowledge to narrow the valuation issues for the Court's decision. iv. Gets to the True Value of the Property: Concurrent witness testimony is a proven method for narrowing valuation issues requiring the Court s decision. Experience proves that when experts are able to freely converse with a Judge, they are often able to reach agreement amongst themselves as to issues in dispute. This agreement between the experts, in turn, means the Judge need not decide those issues unless he or she thinks it more prudent. v. Exposes Defects and Tones Down Extreme Positions: Concurrent witness testimony allows defects in a party s expert s position to be exposed and generally yields a vi. healthy toning down of extreme positions. Reduces Partisanship Bias: Concurrent witness testimony has provided courts with an effective medium to reduce partisan bias. vii. Reduce Experts, Parties, and Court s Resources: Concurrent witness testimony has also proven to significantly reduce the time and expense of litigation. viii. Judges Must (or Should) Be Conversant in Valuation: For the concurrent witness model to work as intended, the judge must be (or at least should be) conversant in valuation issues so that an informed discussion can occur. d. Empirical Evidence Supports Concurrent Testimony is Favorable: i. Crimi v. Commissioner: Empirical evidence overwhelmingly supports the benefits of using concurrent witness testimony. For example, in Crimi v. Commissioner, T.C. Memo , the experts reports disagreed as to the highest and best use of the subject property. The

133 ii. Service s experts at first opined that the subject property s highest and best use was limited to conservation and the taxpayers' expert at first opined that the subject property's highest and best use was development as a 59-lot subdivision. During the Court s implementation of the concurrent witness procedure, the Service s taxpayers experts agreed that the highest and best use of the subject property was for use as a 44-lot subdivision. In deciding the highest and best use of the subject property, the Crimi court deferred to the experts agreement and found that the highest and best use of the subject property was for use as a 44-lot subdivision. Crimi v. Commissioner, T.C. Memo (slip op. at 65-72). In Pohlad v. Commissioner, docket No Judge Jacobs used the concurrent witness testimony process with nine (yes, nine) experts. After two hours of hot tubbing and three days of trial, the case settled. e. Evidentiary Basis for Concurrent Witness Testimony Model i. In General: There is ample authority for the Court, in addition to its own inherent powers, to instruct witnesses to testify concurrently. ii. Fed. R. Evid. 611(a): Fed. R. Evid. 611(a) instructs that the Court should exercise reasonable control over the mode and order of examining witnesses and presenting evidence so as to, in addition to other objectives, make those procedures effective for determining the truth and avoid wasting time. As such, courts have ample authority under the Federal Rules of Evidence to direct the expert witnesses to testify concurrently. iii. Tax Ct. R. Prac. & Proc. 131: Tax Ct. R. Prac. & Proc. 131 authorizes the Court to issue such orders as are necessary to facilitate the orderly and efficient disposition of a case calendared for trial. As such, the Tax Court has ample authority under its rules to direct expert witnesses to testify concurrently. f. How to Have Concurrent Witness Testimony Implemented i. Upon Joint Motion of the Parties: As noted above, the concurrent witness testimony process has only been undertaken on three occasions with the consent of both parties. Where the parties both consent, and the trial judge is amenable, a joint motion to have the experts testify concurrently is appropriate. ii. Upon One Party s Motion: So far, the Tax Court has been unwilling to allow experts to testify concurrently without the consent of both parties. See, e.g., 15 West 17th Street, LLC v. Commissioner, No (Order Denying

134 Taxpayer Motion in Limine to Implement Concurrent Witness Testimony Procedure filed June 13, 2013). It is unclear whether each Judge will adopt the rule that both parties must consent to the procedure or if another Judge, presumably one who finds the process beneficial, will allow the parties to testify concurrently over the object of another party. M. Court-Appointed Experts 1. Overview: Another tool available to federal judges, though one rarely used, is the Judge s authority to appoint his or her own experts under Fed. R. Evid The authors are aware of one reported decision in which the Tax Court appointed its own expert; namely, Bank One Corp. v. Commissioner, 120 T.C. 174 (2003), aff d in part, vacated in part, and remanded sub nom. J.P. Morgan Case & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006). 2. The Evidentiary Basis for Court-Appointed Experts a. Fed. R. Evid. 706: Fed. R. Evid. 706 provides as follows: (a) Appointment Process. On a party s motion or on its own, the court may order the parties to show cause why expert witnesses should not be appointed and may ask the parties to submit nominations. The court may appoint any expert that the parties agree on and any of its own choosing. But the court may only appoint someone who consents to act. (b) Expert s Role. The court must inform the expert of the expert s duties. The court may do so in writing and have a copy filed with the clerk or may do so orally at a conference in which the parties have an opportunity to participate. The expert: (1) must advise the parties of any findings the expert makes; (2) may be deposed by any party; (3) may be called to testify by the court or any party; and (4) may be cross-examined by any party, including the party that called the expert. (c) Compensation. The expert is entitled to a reasonable compensation, as set by the court Having Court-Appointed Experts

135 a. Within the Discretion of the Judge, But Parties May State Their Consent to the Process: The authority to appoint a court-appointed expert is undeniably in the hands of the presiding Judge. Fed. R. Evid At the same time, however, practitioners may inform the Judge of their willingness to consent to a court-appointed expert if it would be helpful to the Judge. The Judge is then free to accept that offer or deny it. b. How a Court-Appointed Expert is Employed: The concept of court-appointed experts may be foreign to most tax attorneys, and as such, it may be helpful to understand how that process is implemented. In Bank One Corp. v. Commissioner, 120 T.C. 174, (2003), aff d in part, vacated in part, and remanded sub nom. J.P. Morgan Case & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006), Judge Laro described the process of appointing the Court s chosen experts, J. Darrell Duffie ( Duffie ) and Barry S. Sziklay ( Sziklay ) as follows: First, in September 2000, before the commencement of trial, the Court informed the parties counsel that [the Court] believed that: (1) The cases involved a significant, complex, and novel big-dollar issue that was widespread in the financial industry and (2) in deciding this issue, it would be helpful to the Court to obtain opinions from one or more experts appointed by the Court under rule 706 of the Federal Rules of Evidence. One week later, the Court met with counsel to discuss the mechanics of retaining one or more Court-appointed experts. At that time, the Court suggested to counsel that: (1) They could provide to the Court either separate lists or a joint list of potential experts or (2) the Court could conduct its own investigation into potential experts. The parties agreed that the Court should conduct its own investigation. Subsequently, the Court, with the permission of the parties, compiled a short list of potential experts that might be suitable for Court appointment and, outside the presence of counsel but with both counsels consent, interviewed each of these potential experts posing questions regarding their expertise, availability, cost, and potential conflicts of interest. Following these interviews, the Court chose Duffie and Sziklay. The Court informed the parties as to [its] choice and discussed with the parties a consensus of questions to be posed to the experts for their opinions. Later, on October 30 and 31, 2000, the parties met with the Court in chambers and agreed to stipulate the duties and

136 procedures that the Court would use in appointing the experts. On November 20, 2000, the Court filed the parties stipulation as to that matter....on the same day, the Court issued an order appointing the experts and directed each party to submit to the Court for filing a list of specific questions for the Court s experts. On December 4, 2000, the Court filed respondent s proposed questions for the Court-appointed experts. On December 5, 2000, the Court filed petitioner s proposed questions for the Courtappointed experts. The Court also filed on December 5, 2000, a supplement by respondent to his proposed questions. After the conclusion of the testimony by all other witnesses, including the parties experts, Duffie and Sziklay were each furnished with the complete trial record up to that point, and they each submitted a written report. Thereafter, petitioner submitted a joint rebuttal report on behalf of [petitioners experts], and later, after that report was excluded from evidence, separate rebuttal reports on behalf of each expert. Respondent submitted to the Court the separate rebuttal reports of [his experts]. The Courtappointed experts then submitted their rebuttal reports. The trial was resumed, at which time the parties cross-examined the Court-appointed experts and presented the rebuttal testimony of their own experts

137 X. Conclusion This Outline introduced readers to core valuation concepts with an emphasis on valuation discounts and premiums. It distinguishes between valuation discounts and premiums which are most properly applied at the owner-level, the entity-level, and to real property. It explained the effect that recently proposed Treasury Regulations under I.R.C. ' 2704 may have on valuation discounts claimed in connection with tax cases. This Outline also discusses the likelihood that valuation discounts and premiums will be audited by tax authorities, including the Service. Finally, it offers strategies for resolving those examinations, whether through alternative dispute resolution or traditional litigation

138 BUSINESS VALUATION & FINANCIAL ADVISORY SERVICES Valuation Implications of the Proposed Changes to Section 2704 by Z. Christopher Mercer, FASA, CFA, ABAR Executive Summary In this white paper, we examine the recently proposed changes to Section 2704 of the Internal Revenue Service Code from business and valuation viewpoints. The express goal of the Proposed Changes is to eliminate, or virtually so, valuation discounts in family partnerships (and operating companies, as well). The instruments of change are a loosened definition of control (to broaden the number of families having control), almost total family attribution of control for every transfer, and a hypothetical put right to the partners in family partnership to facilitate the elimination or reduction of valuation discounts in fair market value determinations. A review from business and valuation perspectives finds that the Proposed Changes, if adopted as published, will affect, but not eliminate valuation discounts. MERCER CAPITAL Memphis Dallas Nashville

139 Valuation Implications of the Proposed Changes to Section 2704 by Z. Christopher Mercer, FASA, CFA, ABAR // In This Whitepaper Attribution of Complete Control to the Extended Family 1 Applicable Restrictions and Disregarded Restrictions 2 The Put Right of Proposed Section Fair Market Determinations under the Proposed Changes 4 An Example to Focus on Relevant Valuation Issues 5 What is Fair Market Value? 8 Fair Market Value Method 1 9 Fair Market Value Method 2 10 Additional Considerations Regarding Fair Market Value of Family Partnerships 11 Conclusions 13 About the Author 13 Copyright 2016 Mercer Capital Management, Inc. All rights reserved. It is illegal under Federal law to reproduce this publication or any portion of its contents without the publisher s permission. Media quotations with source attribution are encouraged. Reporters requesting additional information or editorial comment should contact Barbara Walters Price at This article does not constitute legal or financial consulting advice. It is offered as an information service to our clients and friends. Those interested in specific guidance for legal or accounting matters should seek competent professional advice. Inquiries to discuss specific valuation matters are welcomed. To learn more about Mercer Capital, visit our web site at Mercer Capital

140 The Department of the Treasury and the Internal Revenue Service published a document titled Estate, Gift, and Generation Skipping Transfer Taxes: Restrictions on Liquidation of an Interest on August 2, The document is also published in the Federal Register. Both documents provide certain proposed changes to Section 2704, provide discussion surrounding the history of Section 2704, and discuss the proposed changes. We refer to the documents as providing the Proposed Changes to Section The express intent of the Proposed Changes is to eliminate, or virtually so, the typical valuation discounts that are applied in fair market value determinations of limited partnership interests in family partnerships. This paper will raise some questions about whether the Proposed Changes actually do so. The Treasury and IRS believe that they have the authority to issue the Proposed Changes if the restriction has the effect of reducing the value of the transferred interest for transfer tax purposes but does not ultimately reduce the value of the interest to the transferee. The premise of the Proposed Changes is, therefore, that restrictions on transfer do not ultimately reduce the value of the interest to the transferee. Ultimately is a long time. It is not uncommon with family partnerships that interest holders receive less than net asset value for their interests. This happens through the operation of buy-sell agreement provisions and otherwise. This whitepaper is based on a preliminary review of the Proposed Changes. Any discussion of authority to issue the Proposed Changes is beyond this author s background as a businessman and valuation expert. Accordingly, issues are addressed only from business and valuation perspectives. In addition, this paper quotes extensively from the proposed regulation and other sources. The text we emphasize appears in bold. Attribution of Complete Control to the Extended Family The Proposed Changes include the aggregation of ownership interests or voting rights of a family to determine if the family controls a partnership (or S corporation or C corporation or limited liability company, as clarified). For purposes of section 2701, a controlled entity is a corporation, partnership, or any other entity or arrangement that is a business entity within the meaning of section (a) of this chapter, immediately before a transfer, by the transferor, applicable family members, and/or any lineal descendants of the parents of the transferor or the transferor s spouse. (Proposed (i)) The aggregation of control of a family partnership considers all ownership, whether direct or indirect. This is a sweeping definition of a controlled entity. This suggests that brothers of the same mother or father are family members for purposes of aggregating control. What actually constitutes control under the Proposed Changes? The threshold has been lowered. The proposed definition of control of an entity would constitute the collective holding of at least 50 percent of either the capital or profits interests of the entity, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity. This apparently means, in a family situation, that if two siblings each hold 50% of a family entity, control is attributed to both of them, whereas before, neither would have been deemed to be a controller Mercer Capital

141 Further, under the Proposed Changes, the family members are assumed to exercise their control to allow any relevant restrictions on transfer or liquidation to be eliminated. Applicable Restrictions and Disregarded Restrictions Applicable restrictions are to be disregarded. For purposes of subtitle B, if an interest in a corporation or partnership (an entity) whether domestic or foreign, is transferred to or for the benefit of a member of the transferor s family, and the transferor and/or members of the transferor s family control the entity immediately before the transfer, any applicable restriction is disregarded in valuing the transferred interest. (Proposed (a)) Applicable restrictions are described in terms of their potential effects in the Proposed Changes. Consider the following: Applicable restrictions do include restrictions that are imposed under governing documents like partnership agreements or buy-sell agreements. However, proposed Section (a) states (as currently) that if an interest is transferred to or for the benefit of a member of the transferor s family, and the family controls the entity immediately prior to the transfer, any applicable restriction is disregarded in valuing the transferred interest. A restriction is an applicable restriction if it will lapse under its terms at any time after a transfer, or is capable of being removed by one or more family members acting individually or collectively. In other words, the attributed family control of an entity trumps any restrictions in the governing documents. What about disregarded restrictions? The term disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity that is described in one or more of paragraphs (b)(1)(i) through (v) of this section, if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor s family (subject to paragraph (b)(4) of this section, either alone or collectively. (Proposed (b)) Rather than quote extensively about the restrictions noted above, we summarize the discussion. 1. Disregard any provision that limits (or permits the limitation of) the ability of the holder of the interest to compel liquidation or redemption of the interest. There is a presumption, for valuation purposes, that the family can exercise the ability to liquidate all or a portion of a family partnership. 2. Disregard any provision that limits the amount to be received by the holder of the interest on liquidation or redemption to an amount not less than minimum value. Minimum value is defined, effectively, as the fair market value of the partnership s assets less relevant liabili Mercer Capital

142 ties, so net asset value (on a market value basis) and minimum value are equal to each other. For example, any provision that limits value to less than minimum value, like provisions in a buy-sell agreement that call for valuation at a discounted level (i.e., at the level of the interest) would be disregarded. 3. Disregard any provision that would defer the payment (to the holder) of the full liquidation or redemption amount for more than six months after the holder gives notice. The intent here seems to be to substantially eliminate the concept of an investment holding period in valuing minority interests in family partnerships. 4. Disregard any provision that would permit the payment of liquidation or redemption proceeds (to the holder) in any form other than cash or property (with property being valued at fair market value), so notes may not be issued (to the holder). There is a limited exception to the noted guidance for operating companies. This provision is attempting to assure there is no discounting based on the consideration to be received. There is no mention of hypothetical willing buyers or sellers in the Proposed Changes. The holder discussed above is presumably the hypothetical willing seller of a subject interest who then conveys the interest in a hypothetical transaction to the next holder, the hypothetical willing buyer. As we will see, the distinction between the hypothetical willing buyer and seller is critical to this analysis of the Proposed Changes, which obscure or attempt to eliminate the distinction between buyers and sellers. The Put Right of Proposed Section An assumed put right for holders of family partnerships is assumed in Proposed Section This is a central component of the Proposed Changes. Holders are assumed to have a right to put their interests to the relevant family entity. Any restriction that otherwise would constitute a disregarded restriction will not be considered a disregarded restriction if each holder of an interest in the entity has a put right as described in paragraph (b)(6) of this section. (Proposed Section (b)(5)(v)) The put is described as follows: The term put right means a right, enforceable under applicable local law, to receive from the entity or from one or more other holders, on liquidation or redemption of the holder s interest, within six months after the date the holder gives notice of the holder s intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption For purposes of this paragraph (b)(6), the term other property does not include a note or other obligation issued directly or indirectly by the entity, by one or more holders of interests in the entity, or by one or more persons related either to the entity or any holder of an interest in the entity (Proposed Section (b)(6)) The fictitious put right of the Proposed Changes assumes that every holder has a put right to receive proceeds at minimum value within six months of it being exercised. The put right is central 2016 Mercer Capital

143 to the intent of the Proposed Changes to eliminate (or virtually so) typical valuation discounts for family partnerships. Fair Market Determinations under the Proposed Changes With this background, we move to valuation instructions in the Proposed Changes to see how they appear to be looking at valuation. We have repetition of the theme of attributed control at the outset. For purposes of subtitle B, and not withstanding any provision of section , if an interest in a corporation or partnership (an entity), whether domestic or foreign, is transferred to or for the benefit of a member of the transferor s family, and the transferor and/or members of the transferor s family control the entity immediately before the transfer, any restriction described in paragraph (b) of this section is disregarded, and the transferred interest is valued as provided in paragraph (f) of this section. (Proposed (a)) We move directly to paragraph (f) to understand how the drafters of the Proposed Changes see the valuation process unfolding. Regarding restrictions that are disregarded, the proposal states: If a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise. (Proposed (f)) That is the extent of paragraph (f). Note the following: Appraisers are to use the standard of value known as fair market value. This is important, because appraisers have been making fair market value determinations for many years. The subject of the valuation upon transfer is the transferred interest. The distinction between the transferred interest and the entity in which it represents ownership is also important. Appraisers are to employ generally applicable valuation principles. This guidance apparently means that appraisers are to follow typical appraisal standards like Uniform Standards of Professional Appraisal Practice (USPAP) and the Principles of Appraisal Practice and Code of Ethics (PAPCE) of the American Society of Appraisers in their fair market value determinations, as well as generally accepted valuation methods and approaches. Finally, in determining fair market value, appraisers are to assume that all disregarded restrictions do not exist in the governing documents or anywhere. The instruction to disregard existing restrictions that are real and binding on the actual holders of interests in family partnerships forces appraisers to make hypothetical assumptions and render hypothetical appraisals. According to the PAPCE, we learn: A hypothetical appraisal is an appraisal based on assumed conditions which are contrary to fact or which are improbable of realization. The Society takes the position that there are legitimate uses for some hypothetical appraisals, but that it is improper and unethical 2016 Mercer Capital

144 to issue a hypothetical appraisal report unless (1) the value is clearly labeled as hypothetical (2) the legitimate purpose for which the appraisal was made is stated and (3) the conditions which were assumed contrary to fact are set forth. In USPAP, we have the concept of extraordinary assumptions and hypothetical conditions. The assumption about disregarded restrictions would not be an extraordinary assumption (in our opinion). However, it would be a hypothetical condition, which is defined as: Hypothetical Condition: a condition, directly related to a specific assignment, which is contrary to what is known by the appraiser to exist on the effective date of the assignment results, but is used for the purpose of analysis. Comment. Hypothetical conditions are contrary to known facts about physical, legal, or economic characteristics of the subject property; or about conditions external to the property, such as market conditions or trends; or about the integrity of data used in an analysis. Standard 10 of USPAP, Business Appraisal, Reporting, addresses hypothetical conditions: The content of an Appraisal Report must be consistent with the intended use of the appraisal and, at a minimum: clearly and conspicuously state all extraordinary assumptions and hypothetical conditions; and state that their use might have affected the assignment results; (Standards Rule 10-2(a)(x)) It would appear that under the Proposed Changes every appraisal rendered for gift and estate taxes purposes would have to be labeled as a hypothetical appraisal. Every appraisal rendered for gift and estate tax purposes under USPAP (as almost all are) would have to note the assumed hypothetical conditions. Ignoring applicable restrictions and disregarding restrictions that are otherwise in place and binding on the parties to family partnerships are clearly hypothetical conditions. This paper has not yet researched the standards of other organizations, but we are fairly confident they will have similar provisions noting hypothetical assumptions and requiring hypothetical appraisals. An Example to Focus on Relevant Valuation Issues With this background, we will look at one example of an instructional transfer found in paragraph (g) of the section immediately following the above quote. The example will be a vehicle to help examine what valuation under the Proposed Changes might be like. (g) Examples. The following examples illustrate the provisions of this section. (i) D and D s children, A and B, are partners in Limited Partnership X that was created on July 1, D owns a 98 percent limited partner interest, and A and B each own a 1 percent general partner interest. The partnership agreement provides that the partnership will dissolve and liquidate on June 30, 2066, or by the earlier agreement of all the partners, but otherwise prohibits the withdrawal of a limited partner. Under applicable local law, a limited partner may withdraw from a limited partnership at the time, or on the occurrence of events, specified in the partnership agreement. Under the partnership agreement, the approval of all partners is required to amend 2016 Mercer Capital

145 the agreement. None of these provisions is mandated by local law. D transfers a 33 percent limited partner interest to A and a 33 percent limited partner interest to B. (Proposed (g)) We have the example transfer. Nevertheless, D makes a gift of a 33% limited partnership interest to each of A and B. The question is, under the Proposed Changes we have been discussing, what is the fair market value of a 33% limited partnership interest? We focus on one gift for simplicity, as shown in the figure below. A 1% GP B 1% GP D 65% LP Limited Partnership X Gift of 33% Interest by D to A Before (and following) the gifts, A and B, as general partners, control Limited Partnership X. The example calls for two gifts, but the analysis will not change if we focus just on the gift of a 33% interest by D to A. D s interest is reduced to a 65% limited partnership interest. We assume that the restrictions on a limited partner s ability to liquidate are disregarded because the partners collectively could remove that restriction. Note that they don t, but through the power of family attribution, they are assumed to do so hypothetically. The comments above regarding appraisal standards bring this observation into focus. We look now at the results of the example in paragraph (g) before discussing valuation in more detail. (ii) By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on the ability of a partner to liquidate the partner s interest in the partnership that is not required to be imposed by law and that may be removed by the transferor and members of the transferor s family, acting collectively, by agreeing to amend the partnership agreement. Therefore, under section 2704(b) and paragraph (a) of this section, the restriction on a limited partner s ability to liquidate that partner s interest is disregarded in determining the value of each transferred interest. Accordingly, the amount of each transfer is the fair market value of the 33 percent limited partner interest determined under generally applicable valuation principles taking into account all relevant factors affecting value including the rights determined under the governing documents and local law and 2016 Mercer Capital

146 assuming that the disregarded restriction does not exist in the governing documents, local law, or otherwise. See paragraphs (b)(1)(i) and (f) of this section. (Proposed (g)) What guidance can we glean from this explanation of the first example? The partnership agreement has a requirement prohibiting any partner from withdrawing from the partnership. Partnerships have business purposes, and it generally is not conducive to their business purposes to allow for the withdrawal of any partner unless all partners agree. This restriction is not required by law. The transferor, D, and his family collectively could agree to amend the partnership agreement, so they are assumed to do so for purposes of the fair market value determination. This restriction is therefore disregarded in the valuation process. Appraisers are to determine the fair market value of a 33% interest under generally accepted valuation principles taking into account all factors affecting value from the viewpoints of hypothetical willing buyers and sellers, including the fact that disregarded restriction(s) do not exist for valuation purposes. Given the brevity of the example in the Proposed Changes, we make a few assumptions to focus on typical factors that appraisers must take into account in fair market value determinations. To make the example as simple as possible, assume that Limited Partnership X is a securities-only family partnership holding a diversified portfolio of large capitalization publicly-traded securities. The portfolio s current market value is $10 million. We make the following assumptions or observations: 1. Other than the disregarded restrictions, the partnership has normal terms and conditions that give rights to the general partner(s) to run the entity and that have an effect on limited partners. 2. The partnership will therefore be run by A and B who, as general partners, have operational control. The hypothetical willing buyer does not know what they will do with the management of the partnership, a fact that creates uncertainty. A and B can change their minds regarding investment policy and there is nothing the expected buyer can do about that. The hypothetical buyer can infer expectations about the future from past performance, but uncertainty remains. 3. A s and B s (and D s) self-interests might run counter to the interests of the hypothetical willing buyer, a fact that creates additional uncertainty. 4. The expected return on the $10 million securities portfolio is 8.0%. 5. Interviews with A and B indicate that, like in the past, the partnership is expected to pay a quarterly distribution at an annual rate of 2.5%. 6. Expected appreciation of the portfolio is therefore 5.5% (8.0% - 2.5%). 7. A 33% interest in a partnership with marketable securities is being acquired, and its pro rata share of net asset value is $3.3 million (minimum value). Whether the price is net asset value 2016 Mercer Capital

147 of $3.3 million or a discounted price, the ultimate price requires investors of substantial net worth. No rational hypothetical or real investor would tie up $2.0 million or $3.3 million in such an investment without having substantial assets such that this asset would be a small part of a diversified portfolio of assets. The size of the interest limits the potential market to wealthy individuals or institutions who we can assume have sophistication to analyze the economics of this investment. The bottom line is that the market for the 33% interest in Limited Partnership X is quite limited and sophisticated. 8. There is one exception to the normal terms above. The hypothetical willing buyer would have a hypothetical put to the partnership calling for liquidation of the interest at minimum value, or net asset value. The economic effect of this put (for cash or property within six months) is intended to effectively eliminate minority interest and marketability discounts. What is Fair Market Value? The definition of fair market value (from Revenue Ruling 59-60) is partially quoted in discussing the value of notes issued by operating companies in the Proposed Changes, and not when valuing partnership interests. The definition of fair market value in the ASA Business Valuation Standards follows: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Fair market value presumes that there are hypothetical willing buyers and hypothetical willing sellers. They are able, or have the financial capacity, to engage in hypothetical transactions. They are equally knowledgeable about the risks and benefits of a proposed investment, i.e., about the relevant facts. The market they are acting in is open and unrestricted, even if private. Neither the hypothetical willing buyer nor the hypothetical willing seller is acting under any compulsion. Limited Partnership X Gift of 33% Interest by D to A Hypothetical Willing Buyers FMV Hypothetical Willing Sellers 2016 Mercer Capital

148 In the context of the example of Limited Partnership X, appraisers are to determine the fair market value, as defined above, of the 33% limited partnership interest. Fair market value occurs at the intersection of hypothetical negotiations between hypothetical willing buyers and hypothetical willing sellers, as seen conceptually in the figure at the bottom of page 10. Keep the definition of fair market value and the explanatory comments in mind as we look at an example provided in the Proposed Changes and as amended for this discussion. Fair Market Value Method 1 We include the assumptions above as among the factors influencing fair market value, all of which will be considered by hypothetical willing buyers and sellers in their hypothetical negotiations. Consider two ways to examine valuation in accordance with the Proposed Changes. Some readers of the Proposed Changes, and likely the drafters, think that fair market value would be determined in two straightforward steps. 1. Determine the minimum value of Limited Partnership X. Minimum value of the partnership is determined by taking the fair market values of all of the securities in its portfolio, which we assume to be $10 million. Subtract liabilities, and there are none, so minimum value, or net asset value, is $10 million. The actual wording of the definition of minimum value suggests that, under the Proposed Changes, contingent but real liabilities like embedded capital gains liabilities in C corporations are excluded from minimum value calculations. 2. Determine the fair market value of the 33% interest. Under this method, the put right assumed to be transferred to the hypothetical willing buyer is thought to eliminate any discount for lack of control (the interest controls liquidation) and any marketability discount (since the partnership is the presumed market at minimum value). The fair market value is determined to be $3.3 million ($10 million x 33%). The problem is, this method does not determine the fair market value of the 33% interest, because it did not consider all the factors outlined above. This first method effectively assumes that the family partnership (.e., Limited Partnership X in this instance) does not exist for valuation purposes. It also assumes, as do the Proposed Changes, that the business purpose of the partnership is irrelevant. How can the business purpose have relevance if any partner can demand liquidation of his or her interest at any time? The hypothetical willing buyer of fair market value did not show up for the hypothetical negotiation with the hypothetical willing seller. The hypothetical seller is pleased with the conclusion of $3.3 million because in the hypothetical transaction he or she gets $3.3 million in cash or property quickly. However, as we will see below, no rational hypothetical willing buyer would pay $3.3 million for the 33% interest, even with a put. The overriding purpose of the Proposed Changes is to eliminate valuation discounts. It is therefore interesting that the Proposed Changes document includes neither of the terms minority interest discount or marketability discount (or any variations of these names). In addition, the only mention 2016 Mercer Capital

149 of hypothetical buyers and sellers is found in the partial quote of the definition of fair market value in connection with the discussion of the valuation of notes that might be issued by operating businesses in certain circumstances. Fair Market Value Method 2 We now turn to a second method to determine fair market value. It is actually the method called for by the guidance above from Proposed (g). In this method, appraisers apply generally accepted valuation principles and consider all factors that are important regarding the asset from the perspective of hypothetical willing buyers and sellers. We provided a general list of factors for Limited Partnership X above. We incorporate them and then provide a fairly typical analysis of them and other typical investment factors below. What are some of the considerations or questions that hypothetical willing buyers might think important in negotiating to purchase the 33% interest in Limited Partnership X from a hypothetical willing seller? 1. In acquiring the 33% interest, the hypothetical willing buyer would have to desire or be satisfied with the exact portfolio as configured by A and B as general partners. If the hypothetical buyer wanted this portfolio, he could reconstruct it on his own and have control over the assets. He will not have control over the assets once he acquires the 33% interest in Limited Partnership X. The hypothetical seller would have to make some concession for this fact. 2. Would the hypothetical willing buyer be satisfied with the management abilities and decisions of A and B and their expected distribution policy? At the very least, their control of the partnership creates uncertainty for a new 33% limited partner, which requires compensation. 3. The hypothetical willing buyer would recognize that NAV (minimum value) does not include costs of liquidating the partnership or portions of it. He might have concerns over future pushback from the partnership as a result. This would be particularly true in the event of a total liquidation, where if he received minimum value, other partners would have to receive less than minimum value. 4. The hypothetical buyer would recognize that, even if an effective put existed for his interest after the hypothetical purchase, the value of the 33% interest is at risk. One thing this author knows from nearly 40 years in business is that surprises in liquidation are almost always negative. The hypothetical buyer would demand some compensation for this risk. 5. The hypothetical willing buyer would also know that the 33% interest represents a significant investment in the context of his overall portfolio. The hypothetical buyer would be a quite wealthy individual or an institution of some kind perhaps, although the interest is not really of institutional quality. 6. Minimum value (net asset value) is $3.3 million. There would be no reason to invest in the partnership and tie up valuable resources without some incremental return expectation, even with a put, which, as we see, has some uncertainty attached to it. That increment in return would come from an increase in the required holding period return above the 8.0% expected return of Limited Partnership X Mercer Capital

150 7. The hypothetical buyer would recognize that if he exercised his put, it would be in the best interests of remaining partners to wait to pay for the full six months provided by the hypothetical put. He would demand some compensation for the wait, as well as for the risks assumed as result of the wait. The put does not solve all problems. 8. The hypothetical willing buyer would not pay net asset value for the 33% interest of Limited Partnership X, even with a put right at minimum value. It is not economic to assume that he would pay minimum value, immediately put the interest, and hope to get his money back in six months. 9. The hypothetical willing buyer would consider all these things and determine how much of a valuation discount would be required to induce him to purchase the interest. 10. The hypothetical willing seller, who is rational, capable and knowledgeable, would recognize the value-reducing impact of the factors we have focused on above and negotiate for the best price possible, which we know is not minimum value. The appraiser s job is to simulate the hypothetical negotiations outlined above and to estimate or quantify the extent of the required valuation discount. Note that we have not mentioned minority interest discounts or marketability discounts. Reference to control premium or other studies regarding minority interest discounts are irrelevant in this world of the Proposed Changes. Reference to restricted stock studies is also irrelevant. No buyers in the transactions analyzed in the restricted stock studies have a put at minimum value or at any value. In the world of the Proposed Changes, appraisers will have to analyze the economics of each particular family partnership and the economics of each interest. They will have to analyze the extent that the assumed put at minimum value might impact value. And they will have to make assumptions about the specific economics (risks and cash flows) of each interest being valued. Based on our initial review, this analysis will best be done quantitatively, at least in part. Of course there will qualitative considerations, as well. Additional Considerations Regarding Fair Market Value of Family Partnerships It should be clear from the analysis of Fair Market Value Method 2 that the conclusion of Method 1 does not represent fair market value. The conclusion of Method 1 (minimum value) provides unwarranted enrichment for the hypothetical willing seller and uncompensated expected risks for the hypothetical. That result does not satisfy the requirements of the definition of fair market value because it not a price at which buyers and sellers would agree. All of the factors noted above exist for Limited Partnership X, which is a securities-only family partnership. It should be clear that when we consider all these factors, a fair market value determination of the 33% interest described above would require some discount, and perhaps a significant discount, to induce a rational hypothetical or real purchaser to make the investment Mercer Capital

151 The issues are exacerbated when we move from securities-only to less liquid or illiquid assets in family partnerships. A few initial thoughts include considerations for these asset classes: Income-producing property. Assume the sole asset in a family partnership is an apartment building with a market value of $10 million. All other facts remain the same as with Limited Partnership X. The hypothetical willing buyer is given a put for cash at minimum value ($3.3 million). What will he think about the value of the put when the only way he can exercise it is for the general partners to sell the entire building. They are precluded from providing a note, which might be possible given the lack of leverage. How long would it take to sell the apartment building in the ordinary course of business to achieve market value? Whatever the ultimate discount negotiated for the 33% limited partner interest in Limited Partnership X, it would be higher than for a partnership holding a $10 million income-producing property. If the exercise of the put by the hypothetical buyer forces a sale of the property, the net proceeds of the sale will be less than minimum value, which we assume for simplicity is $10 million, and minimum value for the 33% put exercise is $3.3 million. Assume expenses of sale are 5%, or $0.5 million. Net proceeds are therefore only $9.5 million. If the partner exercising the put receives $3.3 million, remaining proceeds are only $6.2 million to be shared by the remaining partners, or less than their pro rata share of minimum value, or $6.7 million. In real life, partners would never agree to such a put that provides an incentive to exercise in spite of the long-term business objective of owning the income producing property. Raw land well outside a city border. This partnership was created to hold raw land and to wait for the growth of the city to overtake it in a few years. It has not happened yet, and if things go well, it will take a number of years for development to begin to reach the property. The property s market value is $10 million. Value is assumed to be growing at about 8% per year, but there is, of course, no expected distribution. Hypothetical buyers would ignore the six month expectation of cash and would hardly appreciate payment in the form of a portion of the property. The hypothetical buyer would think that if he ever exercised the put, it could take a quite long time for the partnership to sell the land and provide minimum value. Consider that we have replicated our comments regarding expenses of sale here. The hypothetical buyer would require a premium in return, and therefore, a lower value than minimum value of $10 million. An operating business. The business is a profitable distribution company earning $2.0 million per year. It is valued at five times earnings, or $10 million. Growth and distribution yield characteristics are similar to Limited Partnership X. Again, the put option would not have material value in the eyes of hypothetical buyers. The company might or might not be able to issue a note for the put exercise, depending on its leverage and performance at the time. If it could issue a note, that would not represent the form of investment that the investor is seeking. And cash in six months is problematic when it comes to selling operating businesses. It can take 1-2 years or more to sell on relatively favorable terms, and often longer. There is no provision in the put right for expense sharing on sale. Further, there is an argument that, because the operating company is subject to a put by all partners, the overall financial risk of the company itself is increased. If so, the put right would have a negative impact on minimum value (appraised value) and the put right would have a negative impact on value. The hypothetical willing buyer would require a premium in return, and therefore a lower value than the minimum value of $10 million Mercer Capital

152 In each of the above examples, minimum value of $10 million would not be indicative of fair market value when applied to a 33% interest. The partnerships do exist and do have business purposes. Conclusions The Proposed Changes to Section 2704 appear to be designed to eliminate the use of minority interest and marketability discounts in fair market value determinations of illiquid, minority interests in family limited partnerships (and C corporations and S corporations and limited liability companies). They do so by assuming that there is a presumed (hypothetical) liquidation of limited partnership interests being transferred, with the presumed liquidation being at minimum value, or net asset value. All family member partners are presumed to vote in favor of eliminating restrictions on transfer, and to clear a path towards hypothetical liquidations. The problem with the Proposed Changes is that they fail to realize that even with no restrictions on transfer, and if all applicable restrictions are ignored and we consider all of the named disregarded restrictions, appraisers are left with illiquid minority interests in family partnerships that have investment characteristics that still require analysis to determine fair market value. This paper made certain fairly typical assumptions so that we could dig into the valuation dynamics implied by the example of Limited Partnership X and three other partnerships. We disregarded what we were instructed to disregard and still developed, under the named assumptions, a discount by whatever name is appropriate. Appraisers will have to determine what that is based on their fair market value determinations and their consideration of all relevant factors pertaining to subject interests. About the Author Z. Christopher Mercer, FASA, CFA, ABAR is the founder and chief executive officer of Mercer Capital. With nearly 40 years of business valuation experience, he has prepared, overseen, or contributed to hundreds of valuations for purposes related to tax, ESOPs, buy-sell agreements, and litigation, among others. mercerc@mercercapital.com Mercer Capital

153 Mercer Capital Mercer Capital s ability to understand and determine the value of a company has been the cornerstone of the firm s services and its core expertise since its founding. Mercer Capital is a national business valuation and financial advisory firm founded in We offer a broad range of valuation services, including corporate valuation, gift, estate, and income tax valuation, buy-sell agreement valuation, financial reporting valuation, ESOP and ERISA valuation services, and litigation and expert testimony consulting. In addition, Mercer Capital assists with transaction-related needs, including M&A advisory, fairness opinions, solvency opinions, and strategic alternatives assessment. We have provided thousands of valuation opinions for corporations of all sizes across virtually every industry vertical. Our valuation opinions are well-reasoned and thoroughly documented, providing critical support for any potential engagement. Our work has been reviewed and accepted by the major agencies of the federal government charged with regulating business transactions, as well as the largest accounting and law firms in the nation on behalf of their clients. Contact a Mercer Capital professional to discuss your needs in confidence. Contact Us Z. Christopher Mercer, FASA, CFA, ABAR mercerc@mercercapital.com Timothy R. Lee, ASA leet@mercercapital.com Bryce Erickson, ASA, MRICS ericksonb@mercercapital.com Nicholas J. Heinz, ASA heinzn@mercercapital.com Travis W. Harms, CFA, CPA/ABV harmst@mercercapital.com Matthew R. Crow, CFA, ASA crowm@mercercapital.com MERCER CAPITAL Memphis 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee Dallas Merit Drive, Suite 480 Dallas, Texas Nashville 102 Woodmont Blvd., Suite 231 Nashville, Tennessee Copyright 2016 Mercer Capital Management, Inc. All rights reserved. It is illegal under Federal law to reproduce this publication or any portion of its contents without the publisher s permission. Media quotations with source attribution are encouraged. Reporters requesting additional information or editorial comment should contact Barbara Walters Price at This article does not constitute legal or financial consulting advice. It is offered as an information service to our clients and friends. Those interested in specific guidance for legal or accounting matters should seek competent professional advice. Inquiries to discuss specific valuation matters are welcomed. To learn more about Mercer Capital, visit our web site at

154 Proposed Changes to Regulations Under IRS Code Section 2704 Issued August 2, 2016 Regarding the Proposed Changes from Business and Valuation Perspectives Z. Christopher Mercer, FASA, CFA, ABAR Mercer Capital mercercapital.com ChrisMercer.net Handout materials to accompany Valuation in Tax: Key Discounts Every Valuation Professional Should Know - Session 60 Housekeeping Details CPE Code This webinar qualifies for 1 hour of CPE credit A CPE Code will be announced twice during the webinar. To receive credit: Enter the CPE Code on the post-webinar survey. The survey will pop up when you end the webinar CPE Certificates will be ed to you within 2-3 days Questions To ask a question, use the Question window in the control panel Because of time constraints, I may not have time to answer all questions during the webinar Any questions not answered during the webinar will be answered off-line after the webinar Handouts Download this presentation deck as well as our recent whitepaper from the Download section of GoToWebinar Link to Proposed Changes: Technical Difficulties and Other Problems Report any problems via the Chat window in the control panel Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

155 Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 3 Caveats at the Outset I speak as an individual business appraiser from business and valuation perspectives Our views on the Proposed Changes are evolving There are many uncertainties and unknowns in the Proposed Changes. We reserve the right to change any views expressed today based on evolving interpretations and new information Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

156 The Proposed Changes Represent an outright attack on family operating businesses in spite of what I call the so-called operating business exception Represent a not-so-subtle attack on the business purposes of family asset-holding entities Create a hypothetical world and hypothetical conditions that are not consistent with fair market value concepts Create a world in which families are assumed to work and interact together unlike any family of size I have ever seen Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 5 A Bit of Irony The purposes of the Proposed Changes include the prevention of undervaluation of transferred interests in family entities Current valuation concepts for illiquid minority interests include consideration of minority interest and marketability discounts (DLOMs) The terms minority interest discount and marketability discount are not mentioned in the Proposed Changes The drafters of the Proposed Changes have these familiar and useful discounts in their cross-hairs Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

157 So What are Clients to Do? Advice of Numerous Estate Planning Attorneys 1. Engage in transactions now where there is an existing intent to transfer interests 2. No one will know for probably three years whether the Proposed Changes pass judicial muster (assuming they are implemented as drafted) 3. Lock in the existing rules as much as possible 4. Better the devil you know than the one you don t know Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 7 Overview 1. Begin with a concept of control ( could this be complete control?) 2. Define a class of entity applicable restrictions that are not applicable given presumption #1 3. Describe a class of disregarded restrictions that are to be disregarded if they limit the ability of a holder to redeem or liquidate an interest (given presumption #1) so any holder can liquidate at any time 4. Provide for an impossible, commercially unreasonable put right to every interest holder 5. Require business appraisers to determine the fair market value of interests under assumptions that are known to be untrue and even commercially unviable 6. Create a hypothetical valuation environment that is not consistent with the standard of value known as fair market value and that requires business appraisers to assume hypothetical conditions and to render hypothetical appraisals Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

158 Control Defined For purposes of section 2701, a controlled entity is a corporation, partnership, or any other entity or arrangement that is a business entity within the meaning of section (a) of this chapter, immediately before a transfer, by the transferor, applicable family members, and/or any lineal descendants of the parents of the transferor or the transferor s spouse. (Proposed (i)) Other business entities. In the case of any entity or arrangement that is not a corporation, partnership, or limited partnership, control means the holding of at least 50 percent of either the capital interests or the profits interests in the entity or arrangement. In addition, control means the holding of any equity interest with the ability to cause the liquidation of the entity or arrangement in whole or in part. (Proposed (iv)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 9 Control in Words Complete Control A controlled entity is one where control is held by a family comprised of the any lineal descendants the parents of a transferor or a transferor s spouse very broad Control consists of at least 50% of the voting power within the broadly defined family (or has voting power to liquidate) Controlling families are assumed to vote collectively to eliminate applicable restrictions and also any disregarded restrictions Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

159 One Potential Anomaly Bank Holding Company 100% Bank 50% 50% Dad 1 Child 1 Child 2 Dad 2 Child 3 Child 4 Complete Control Complete Control Dad 1 and Dad 2 are Unrelated Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 11 Applicable Restrictions (b) Applicable restriction defined (1) In general. The term applicable restriction means a limitation on the ability to liquidate the entity, in whole or in part (as opposed to a particular holder's interest in the entity), if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor's estate, and/or any member of the transferor's family, either alone or collectively (Proposed (b)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

160 Applicable Restrictions Not Applicable if Family has Control (a) In general. For purposes of subtitle B (relating to estate, gift, and generation-skipping transfer taxes), if an interest in a corporation or a partnership (an entity), whether domestic or foreign, is transferred to or for the benefit of a member of the transferor's family, and the transferor and/or members of the transferor's family control the entity immediately before the transfer, any applicable restriction is disregarded in valuing the transferred interest. (Proposed (a)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 13 What are Applicable Restrictions? Do include restrictions that are imposed under governing documents Buy-sell agreements Rights of first refusal Restrictions on transfer Restrictions on right to liquidate interests or entities Put rights at less than minimum value Other Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

161 Disregarded Restrictions (b) Disregarded restrictions defined (1) In general. The term disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity that is described in any one or more of paragraphs (b)(1)(i) through (iv) of this section, if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor's family (subject to paragraph (b)(4) of this section), either alone or collectively. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 15 Disregard Any Provision That: 1. Limits (or permits the limitation of) the ability of the holder of the interest to compel liquidation Not realistic or commercially reasonable Such limitations are placed in operating agreements to facilitate the operation of entities to achieve their business purposes 2. Limits the amount to be received by the holder of the interest on liquidation or redemption to an amount less than minimum value Are family businesses money machines that provide instant cash on demand? Don t you wish that you could be guaranteed minimum value on every investment you make? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

162 Disregard Any Provision That: 3. Would defer payment (to the holder) if the full liquidation or redemption amount for more than six months after the holder gives notice What happens with entities owning illiquid assets that are not divisible? Would permit the payment of liquidation or redemption proceeds in any form other than cash or property Cannot issue note to liquidating owner but must pay cash (or distribute property) Not commercially reasonable 4. Authorizes or permits the payment of any portion of the full amount of the liquidation or redemption proceeds in any manner other than in cash or property Promissory notes are not acceptable payment Cash only, which would force the liquidation of most partnerships to redeem any significant interests Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 17 What are the implications of disregarded restrictions for family members? 1. Creates a presumption that any holder (in the family?) can demand liquidation of his/her interest(s) at any time at minimum value and receive cash or property pro rata to the interest 2. Makes an implicit assumption (in the Proposed Changes) that there is no place or purpose for family asset holding entities 3. Would place all family operating companies at significant risk Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

163 Lapse or Removal of Limitation (3) Lapse or removal of limitation. A restriction is an applicable restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or the restriction may be removed after the transfer by any one or more members, either alone or collectively, of the group consisting of the transferor, the transferor's estate, and members of the transferor's family. (Proposed (b)(3)) (3) Lapse or removal of limitation. A restriction is a disregarded restriction only to the extent that the restriction either will lapse by its terms at any time after the transfer or may be removed after the transfer by any one or more members, either alone or collectively, of the group consisting of the transferor, the transferor's estate, and members of the transferor's family. (Proposed (b)(3) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 19 Lapse or Removal of Limitation (1) For purposes of subtitle B, the lapse of a voting right in a corporation or a partnership (an entity), whether domestic or foreign, is a transfer by the individual directly or indirectly holding the right immediately prior to its lapse (the holder) to the extent provided in paragraphs (b) and (c) of this section. (Proposed (a)(1) The value of a lapse (of control or liquidation right) is the fair market value of the interest before the lapse (minimum value) minus the fair market value of the interest after the lapse (presumably a discounted value) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

164 Assignee Interests A transfer that results in the restriction or elimination of the transferee s ability to exercise the voting or liquidation rights that were associated with the interest while held by the transferor is a lapse of those rights. For example, the transfer of a partnership interest to an assignee that neither has nor may exercise the voting or liquidation rights of a partner is a lapse of the voting and liquidation rights associated with the transferred interest. (Proposed (a)(5)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 21 CPE Code Please record this number. To qualify for CPE, record this code on the exit survey which will pop up after you exit the webinar. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

165 What is a Put Right? A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of a security at a specified price within a specified time (Investopedia) A put provides a potential avenue to liquidity if a business has the financial wherewithal to honor it Put rights are considered to provide some downside protection for investors Why would you put if the future looks bright? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 23 The New Put Right (iv) Put right of each holder. Any restriction that otherwise would constitute an applicable restriction under this section will not be considered an applicable restriction if each holder of an interest in the entity has a put right as described in (b)(6). (Proposed2704-2(b)(4)(iv)) (v) Right to put interest to entity. Any restriction that otherwise would constitute a disregarded restriction under this section will not be considered a disregarded restriction if each holder of an interest in the entity has a put right as described in paragraph (b)(6) of this section. (Proposed (5)(v)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

166 Breaking the Put Right Down Restrictions are not considered disregarded applicable restrictions or disregarded restrictions if each holder of an interest in an entity has a put right The put right apparently trumps other provisions in the IRS valuation book It is not commercially reasonable to assume that each member of a family entity or any entity would have unlimited put rights to the entity No so subtle attack on the business purposes of family entities Going concern status of an entity where each holder has a put right to the entity? Race to put first? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 25 Pricing of the Put Right (6) Put right. The term put right means a right, enforceable under applicable local law, to receive from the entity or from one or more other holders, on liquidation or redemption of the holder's interest, within six months after the date the holder gives notice of the holder's intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption. (Proposed (6)) The DOT/IRS seem to believe this put right is no issue at all, since families would simply vote to liquidate to honor a put if necessary, even if it destroyed their business Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

167 (ii) The provision limits or permits the limitation of the amount that may be received by the holder of the interest on liquidation or redemption of the interest to an amount that is less than a minimum value Minimum Value The term minimum value means the interest s share of the net value of the entity determined on the date of liquidation or redemption. Essentially, minimum value is the net asset value of an entity on a market value basis (on the date of liquidation or redemption and not on the valuation date) Language attempts to exclude real liabilities like embedded capital gains in C corporations For asset holding entities, minimum value is really maximum value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 27 Put Right Questions for Family Entities The fictitious put right is apparently enforceable under local law How? It doesn t exist What do the words on the page say as to how the put operates? They don t. Appraisers will have to define? Right to receive from the entity or from one or more holders How are the other holders involved? (One big happy family?) Within six months after holder gives notice of intent to withdraw How can appraisers assume payment within six months if assets are illiquid? A securities-only entity might be able to honor a put by liquidating securities What about the business purpose of the family entity? Cash or other property equal to minimum value No promissory notes Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

168 What If the Asset is an Apartment Building? What good is a so-called six month put when it may take a year or more to liquidate the underlying asset? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 29 What If the Asset is Urban Dirt? What good is a so-called six month put when it may take a year or two or more to liquidate the underlying asset? Concept of fractional interest discount part of fair market value of the interest? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

169 What If the Asset is Farmland? What good is a so-called six month put when it may years to liquidate the underlying asset? Concept of fractional interest discount part of fair market value of the interest? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 31 More Put Right Questions for Family Entities Does the put right flow to hypothetical willing buyers, who, in turn, would be able to put the interest at minimum value at any time? Would hypothetical willing buyers believe this, or is this a hypothetical condition that must be assumed by appraisers? Would hypothetical willing buyers even show up to negotiate? What kind of investment is it when value is created by a hypothetical put rather than by the economics of an investment over a reasonable expected holding period? Determined as of the date of the hypothetical liquidation or redemption What about risks between the put and the hypothetical liquidation? Securities only? Apartment building? Urban dirt? Rural land? What about liquidation costs? The put is at minimum value, but the proceeds will be less than minimum value? Are liquidation costs to be shared or is the first to put a winner? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

170 Summary Thoughts Regarding the Hypothetical Put Right From Business and Valuation Perspectives Non-economic Would never be negotiated between arm s length parties (or families) Would be subject to definition by appraisers If deemed real, could have positive impact on value of interests in family asset holding entities In the alternative, the riskiness of any operating entity where all holders have a put right is increased, so overall entity value could be diminished Certainly does not fix value at so-called minimum value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 33 The Operating Company Exception The Company A company with an active trade or business representing 60% or more of its value can issue a note The Note The note (or other consideration) must: Be adequately secured Provide for periodic payments of principal and interest with no deferral provision Provide a market rate of interest Have a fair market value equal to the liquidation proceeds Interesting that the Proposed Changes recognize the risks inherent in a note issued by a family operating business, including illiquidity, but they do not recognize the same impediments to liquidity for operating business interests Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

171 The Operating Company Exception The Company Not really an exception at all Passive (or non-operating) assets cannot be used to honor a put Existence of hypothetical put rights increases risk and cost of capital, and depresses entity value? Ability to liquidate or redeem for all interests creates instability for operating companies The Note Not feasible to secure a note if the company is already borrowing and pledging operating assets What is a market rate of interest? Leverage may increase the company s debt costs What happens if the company cannot issue a note? Should appraisers increase cost of capital to reflect this risk and lower operating company value? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 35 Talk About Fair Market Value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

172 Both are able and willing to trade Both fully (reasonably) informed Both have financial capacity Hypothetical willing buyers Engage in a (hypothetical) transaction for the interest for money or money s worth (cash equivalent) Neither acting under compulsion On the valuation date Hypothetical willing sellers Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 37 When is FMV Determined? The Death Bed Transfer Solution Valuation Date NAV $10,000 Interest 33% Pro Rata NAV $3,300 Valuation Adj. x (1-25%) Year 1 Year 2 Year 3 D Dies in Accident What Happens? When is FMV Determined? An unforeseeable subsequent event redetermines FMV 2.5 years after the Valuation Date? HWB Pays $2,475 Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

173 Point to Paragraph (f) For purposes of subtitle B, and not withstanding any provision of section , if an interest in a corporation or partnership (an entity), whether domestic or foreign, is transferred to or for the benefit of a member of the transferor s family, and the transferor and/or members of the transferor s family control the entity immediately before the transfer, any restriction described in paragraph (b) of this section is disregarded, and the transferred interest is valued as provided in paragraph (f) of this section. (Proposed (a)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 39 Fair Market Value Instructions per Paragraph (f) If a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise. (Proposed (f)) Remember disregarded restrictions? Essentially anything that would prevent liquidity for cash within six months Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

174 Normal Valuation for Family Asset-Holding Entity Operating Agreement Restrictions on transfer Right of first refusal Buy-sell agreement Restrictions on liquidation Put right at less than minimum value Normal operating provisions Entity/Interest Economics Net asset value Expected distribution yield Expected growth in value Expected holding period for investment Risks of the expected holding period General illiquidity Asset composition Expected management policies Limited market for interests Restrictions on transfer Acquisition and monitoring costs Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 41 Section 2704 Valuation Operating Agreement Restrictions on transfer Right of first refusal Buy-sell agreement Restrictions on liquidation Put right at less than minimum value Normal operating provisions Put right to all owners at minimum value Entity/Interest Economics Net asset value Expected distribution yield Expected growth in value Expected holding period for investment Risks of the expected holding period General illiquidity Asset composition Expected management policies Limited market for interests Restrictions on transfer Acquisition and monitoring costs Put right at minimum value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

175 Immediate Implications of Proposed Guidance Appraisers are to use the standard of value known as fair market value The subject of the valuation upon transfer is the transferred interest The valuation date is the date of transfer The distinction between the transferred interest and the entity in which it represents ownership is also important Appraisers are to employ generally applicable valuation principles USPAP ASA Business Valuation Standards and Principles of Appraisal Practice and Code of Ethics of the American Society of Appraisers Other relevant standards from other organizations Now, appraisers are to assume that all disregarded restrictions or applicable restrictions do not exist in the governing documents or anywhere In disregarding actual restrictions, must appraisers assume hypothetical conditions and render hypothetical appraisals? Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 43 Hypothetical Appraisal (PAPCE) A hypothetical appraisal is an appraisal based on assumed conditions which are contrary to fact or which are improbable of realization. The Society [the ASA] takes the position that there are legitimate uses for some hypothetical appraisals, but that it is improper and unethical to issue a hypothetical appraisal report unless (1) the value is clearly labeled as hypothetical (2) the legitimate purpose for which the appraisal was made is stated and (3) the conditions which were assumed contrary to fact are set forth. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

176 Hypothetical Condition under USPAP Hypothetical Condition a condition, directly related to a specific assignment, which is contrary to what is known by the appraiser to exist on the effective date of the assignment results, but is used for the purpose of analysis Comment: Hypothetical conditions are contrary to known facts about physical, legal, or economic characteristics of the subject property; or about conditions external to the property Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 45 Reporting Implications under USPAP The content of an Appraisal Report must be consistent with the intended use of the appraisal and, at a minimum: clearly and conspicuously state all extraordinary assumptions and hypothetical conditions; and state that their use might have affected the assignment results; (Standards Rule 10-2(a)(x)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

177 Fair Market Value Defined (ASA Business Valuation Standards) The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 47 Fair Market Value Defined (Revenue Ruling Section 2.02).02 Section (b) of the Estate Tax Regulations (section of the Estate Tax Regulations 105) and section of the Gift Tax Regulations (section of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

178 Sec. 4. Factors to consider. All Relevant Factors of RR It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all-inclusive are fundamental and require careful analysis in each case Question: Are the economics of an illiquid minority interest that is transferred among the relevant factors that should be considered? The Proposed Changes as written suggest, perhaps not Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 49 CPE Code Please record this number. To qualify for CPE, record this code on the exit survey which will pop up after you exit the webinar. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

179 An Example from the Proposed Changes D and D s children, A and B, are partners in Limited Partnership X that was created on July 1, 2016 D owns a 98 percent limited partner interest, and A and B each own a 1 percent general partner interest The partnership agreement provides that the partnership will dissolve and liquidate on June 30, 2066, or by the earlier agreement of all the partners, but otherwise prohibits the withdrawal of a limited partner Under applicable local law, a limited partner may withdraw from a limited partnership at the time, or on the occurrence of events, specified in the partnership agreement Under the partnership agreement, the approval of all partners is required to amend the agreement None of these provisions is mandated by local law D transfers a 33 percent limited partner interest to A (omit transfer to B for example). (Proposed (g)) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 51 Limited Partnership X The example is silent regarding the assets held by Limited Partnership X or how or when it came into being Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

180 Limited Partnership X After Transfer But as a business appraisers, we have to value the 33% interest Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 53 Fair Market Value of the 33% Interest Recall the definitions of Fair Market Value They apply to the 33% interest of Limited Partnership X Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

181 Partnership Assumptions Regarding Limited Partnership X 1. Partnership agreement contains normal provisions providing for the right of general partners to manage the affairs of the partnership 2. Partnership will dissolve in 2066 or by earlier agreement of the partners 3. Otherwise, withdrawal by a partner is prohibited 4. Under local law, an LP may withdraw from a partnership as specified in the partnership agreement; however, approval of all of the partners is required to amend the partnership agreement 5. None of these provisions is mandated by local law 6. Likely there are certain restrictions on transfer to non-family investors and a right of first refusal provision in the event someone desires to obtain liquidity 7. Business purpose is to maintain, preserve and grow family wealth Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 55 Economic Assumptions Regarding Limited Partnership X 1. Plain vanilla large capitalization, securities only 2. Market values of securities total $10.0 million as of the date of transfer 3. No liabilities 4. Net asset value ( minimum value ) is $10.0 million 5. Expected annual return on the portfolio is 8.0% 6. Expected distribution is 2.5% of beginning asset value 7. Expected annual appreciation in value is 5.5% (8.0% - 2.5%) 8. D has life expectancy of 8 years and A and B plan to liquidate upon his death Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

182 Possible Valuation Methods Under the Proposed Changes Method 1. Pro Rata Net Asset Value (Minimum Value) Hypothetical Method 2. Pro Rata Net Asset Value less a valuation adjustment pertaining to uncertainties regarding the ability of the entity to honor the put on a timely basis Hypothetical Method 3. DCF Value based on expected cash flows, expected growth and expected risks associated with receipt of the cash flows ( Normal DCF method as hedge) Not Hypothetical Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 57 Method 1 Pro Rata Net Asset Value Step 1 Determine market values of all assets of Limited Partnership X and subtract liabilities That s $10.0 million for Limited Partnership X (Minimum Value) Step 2 Fair market value of the 33% interest in Limited Partnership X is therefore $3.3 million ($10.0 million x 33%) - Hypothetical Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

183 Method 1 NAV / Minimum Value Does not represent fair market value Hypothetical willing buyer was not present for the hypothetical negotiations No HWB would pay minimum value for the interest when there is immediate downside risk and lack of control following a put (if the HWB, who is not a family member, gets the put) Many interpret this Method 1 as the goal of the DOT/IRS A number of attorneys have said this is not the right interpretation of the IRS goal based on conversations with IRS personnel However, many make this interpretation, so we show it, even though it ignores Proposed (f) Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 59 Method 2 NAV Less Uncertainties Regarding Liquidation Examine hypothetical family entities holding four distinctly different asset classes Securities only Income producing property (an apartment building) Vacant urban dirt with little immediate potential Rural land with little immediate potential Make simplifying assumptions re basic economics of the partnerships Make simplifying assumptions re the estimated time to liquidate the underlying assets of the partnerships Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

184 This Levels of Value Chart Will Likely Not Work Under Proposed Changes Controlling Interest Basis Control Premium Marketable Minority Value Minority Interest Discount Marketability Discount Nonmarketable Minority Value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 61 Levels of Value Under Section 2704? Net Asset Value (Minimum Value) Valuation Adjustment (If warranted by the economics of the investment) Illiquid Minority Value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

185 Method 2 NAV Less Uncertainties Regarding Liquidation Hypothetical Buyers Question the Expected Time to Liquidation of Assets All are Hypothetical Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 63 Method 3 No Put ( Normal ) A Hedge Valuation Relevant Factors Pertaining to the 33% Interest for Methods 2a and 2b 1. Limited Partnership X has a specific portfolio that HWBs could replicate and maintain complete control Additional Risk 2. HWB subject to future management decisions of A and B and their expected distribution policy Additional Risk 3. HWB has information acquisition costs that can only be recouped in initial pricing - Additional Risk 4. HWB has ongoing investment monitoring costs that can only be recouped in initial pricing Additional Risk 5. HWB has uncertainties of the expected holding period which is of unknown duration, even though assumed Additional Risk 6. HWB would recognize that $3.3 million pro rata NAV (or a discounted value from there) represents a significant investment that limits the market for the interest Advantage Buyer Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

186 Method 3 No Put ( Normal ) Relevant Factors Pertaining to the 33% Interest for Methods 2a and 2b 7. HWB understands that, with no right to put or withdraw, that there is no market for the interest and it is quite illiquid Additional Risk 8. All of above suggests that HWB accepts additional risk that requires compensation over the basic expected 8.0% return of the Partnership, which implies a valuation discount (of whatever name) from minimum value 9. The HWS, who is rational, capable and knowledgeable, would recognize the valuereducing impact of the factors above and negotiate for the best possible price from his viewpoint, which he knows is not minimum value Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 65 Method 3 No Put ( Normal ) Develop a Required Return for the 33% Interest Remember the Economics of the 33% Interest Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

187 Method 3 No Put ( Normal ) DCF Valuation Assumptions Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 67 Method 3 No Put ( Normal ) Calculate Range of Expected Valuation Discounts Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

188 Method 3 No Put ( Normal ) Examine the Implied Expected Returns for the Investment Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 69 H.R A BILL To nullify certain proposed regulations relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes. Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, SECTION 1. NULLIFICATION OF CERTAIN PROPOSED REGULATIONS RELATING TO RESTRICTIONS ON LIQUIDATION OF AN INTEREST WITH RE SPECT TO ESTATE, GIFT, AND GENERATION SKIPPING TRANSFER TAXES. Regulations proposed for purposes of section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016 (81 Fed. Reg ), and any substantially similar regulations hereafter promulgated, shall have no force or effect. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

189 Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 71 Z. Christopher Mercer, FASA, CFA, ABAR Mercer Capital mercercapital.com ChrisMercer.net Follow Up Questions: Any questions that I was unable to address during the webinar will be handled off-line. CPE Credit: After exiting this webinar, a survey will pop up. Please record the CPE Code as instructed. CPE Certificates will be ed within 2 3 days Other: If you would like to further discuss the Proposed Changes to Section 2704, please contact any of us here at Mercer Capital. Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital

190 Z. Christopher Mercer, FASA, CFA, ABAR Chris Mercer is the founder and CEO of Mercer Capital, a national business valuation and financial advisory firm. Chris began his business valuation career in the 1970s and has been involved with hundreds of valuations for purposes related to mergers & acquisitions, litigation, and estate and gift tax planning, among others. Chris has extensive experience in litigation engagements including statutory fair value cases, business damages, and lost profits. He is also an expert in buy-sell agreement disputes. Chris is a prior chair of the Standards Sub-Committee for the Business Valuation Committee of the American Society of Appraisers and a former member of the International Valuation Professional Board of the International Valuation Standards Committee (IVSC). Z. Christopher Mercer, FASA, CFA, ASA CEO, Mercer Capital mercerc@mercercapital.com Linkedin.com/in/zchristophermercer Designations held include Fellow Accredited Senior Appraiser (FASA) from the American Society of Appraisers, Chartered Financial Analyst (CFA) from the CFA Institute, and Accredited in Business Appraisal Review (ABAR) from the Institute of Business Appraisers. Chris has written widely on business valuation-related topics and is a frequent speaker on business valuation issues for national professional associations, other business and professional groups, and business owners. Recent books authored by Chris include Unlocking Private Company Wealth (Peabody Publishing, LP 2014), Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing, LP 2010) and Business Valuation: An Integrated Theory, 2nd Edition, with Travis W. Harms (John Wiley and Sons 2008). For a complete list of the books authored by Chris, as well as further information on his valuation-related experience, view his complete CV at Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital 73 About Mercer Capital Mercer Capital is a national business valuation and financial advisory firm We offer a broad range of services, including corporate valuation, financial institution valuation, financial reporting valuation, gift and estate tax valuation, M&A advisory, fairness opinions, ESOP and ERISA valuation services, and litigation and expert testimony consulting We have provided thousands of valuation opinions for corporations of all sizes in a wide variety of industries. Our valuation opinions are well-reasoned and thoroughly documented, providing critical support for any potential engagement Our work has been reviewed and accepted by the major agencies of the federal government charged with regulating business transactions, as well as the largest accounting and law firms in the nation in connection with engagements involving their clients For over thirty years, Mercer Capital has been bringing uncommon professionalism, intellectual rigor, technical expertise, and superior client service to a broad range of public and private companies and financial institutions located throughout the world. Feel confident in our experience and expertise Mercer Capital Proposed Changes to Regulations Under IRS Code Section 2704 // 2016 Mercer Capital