Defang the IRS’ Large Block Interest
Position in an Audit
Perhaps naive, but like many clients, I assumed those rendering an opinion of value for equity or investor concessions for impairments commonly referred to as “discounts” would defend them.
A surprising number of firms do not and will not offer support for challenges to their work product. This begs the question of what is the benefit of a rendered opinion without robust empirical support and ability to defend it. Dozens of white papers and 150+ failed opponent challenges later, the below is a user-friendly presentation that eviscerates the common practice of challenging significant adjustments.
The facts are simple. Properties held in a partnership for a long-period have appreciated; however, in the past half-decade, the market took back much of the gain. The issue of contention is whether more taxes are due. The Service selects tax court cases that provide for little or no “discounts”. Real world issues are ignored, such as a March 2009 date of value– where the stock market lost 40% of its value.
The following excerpt reflects how we commonly defang the Service’s assault by asking: Does a unit holder possessing a majority interest equate to the ability to optimize the return on investment by liquidating the company as of a discrete date?
“If the interest was not meeting investor expectations, the process in which to effectuate change within the company is either by forcing a management change through unanimous vote, the sale of most if not all of the interests held and/or the underlying asset(s) - all of which would be time and resource consuming as well as in accordance with the LLC’s operating agreement. In other words, holding a majority interest does not possess the attributes of ready liquidity.
Further, the assumption that holding the interest attaches with it the ability to know the optimal time to sell a business, interest and/or asset, the optimal price to place on the business, interest and/or asset, and the optimal period to expose and market the business, interest and/or asset in order to achieve the highest possible price is faulty. In other words, holding the interest does not equate to the shares being liquid or readily marketable or to achieve the highest price.
(Anecdotally, it is instructive to witness that the Harvard and Yale endowments’ institutional fund advisors who had much more diversified portfolios, control and superior knowledge lost an average of 27% - 35% of portfolio values at or near the market collapse by March 9, 2009 and the NASDAQ lost 42% of its value due to some of these same issues.)
The Estate of Andrews (79 T.C. 938, 953 (1982), examined the private placement market and flotation costs and allowed a combined discount of 65%. The court affirmed the appropriateness of the DLOM applicable to even a controlling interest in Estates of Dunn (79 TCM 1337); Maggos (79 TCM 1861); Jameson (99 TCM 1383) and Dougherty (59 TCM 772).
In Estate of Bennett v. Commissioner (65 TCM 1816 – 1992), Judge Parker recognized a 24.8% discount for lack of marketability even though Mr. Bennett held 100% of Fairlawn Development Inc., as there was an absence of a public market for the closely held business’ shares. No sales of its stock had ever taken place. It had never been listed on any exchange or been on the OTC market.
The Court relied on the rationale used in the Estate of Dougherty 59 TCM 698-1990, where Judge Hamblen allowed a 10% discount for management costs and a 25% discount for lack of marketability. This was despite valuing a 100% interest in a company’s stock holding a diverse asset portfolio.
In the Estate of Morkill (November 26, 1997), the Court allowed a 30% discount for a 100% GP Interest that held 80% marketable securities and a residential interest. This decision appears consistent with a 91% GP interest in private company stock holding real property (farm) in the Estate of Anderson (June 11, 1999), where the Court allowed a 33.33% discount as well as Judge Shield’s decision in Simpson v. Commissioner TCM (P-H) 94,207 (USTC, May 11, 1994).
In the Estate of Hendrickson, the Court allowed a 30% DLOM citing few growth opportunities, earnings subject to significant interest rate risk, no history of share repurchase or sale and no readily available market. The Court recognized that any avenue to sell, transfer or liquidate could take considerable time and expense of paid advisors. A discount for lack of marketability might be considered even when valuing a controlling interest or one that holds fairly liquid assets, to account for the greater difficulty of selling a private company versus a public one.
The IRS Valuation Training Text for Appeals Officers (1998) specifically references the Court decision in Andrews quoting: “… even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer stock.”
Now from the perspective of an “investor” under the Fair Market Value standard. Examine the LLC’s operating agreement. At best, the 99% may have voting rights, but as drafted is unlikely to have control held by the Manager. That assumes the hypothetical investor would be an approved substitute Member, which will require the Manager’s approval. At worst, the interest upon death may be assumed to be assignee, which has no voting rights, as there is no guarantee the “outside” investor would be approved.
The support for and level of discounts have several considerations. Are there put and call options/ obligations in the LLLC agreement? Can the noncontrolling 99% effectuate the sale of the underlying assets? Did the asset have greater value in the past? Did the controlling interest sell it then at an optimal time and amount, as the Service’s faulty logic assumes occurs at the time of death. Does this reflect a serious impairment to the 99% economic interest? What are the notional investor’s options to pursue more freely traded, 100% direct investment options? (1) Wait for an indeterminate period (serious opportunity costs) until the control interest elects to either liquidate the LLC or sell the underlying asset(s) and assume after doing such (not guaranteed), that s/he would distribute the net proceeds, OR (2) Sell the interest to a third party requiring a significant concession based upon LLC provision restrictions and poor performance of the underlying assets. This is the impairment that an investor examines and will seek a “discount” to achieve better total return results in similar alternative investments. Clearly, real property assets are illiquid, which compounds the problem.”
Since my golf game is mediocre and no contest will be won by boyish charm and good looks, it comes down to genuinely understanding why an investor seeks concessions, not simply citing tax court cases.