Just like Strangi saga: Holman – Bad Fact Pattern

I have paraphrased the case summary with my own two cents involving an industry trend of lowering discounts due to weak appraisals, weak advocating or weak judicial mettle.  Last week the Tax Court issued Holman v. Commissioner (May 27, 2008), a decision packed with issues relevant to gifts of family limited partnership interests, including 1) whether the transfer of assets (shares of Dell stock) constituted a direct or indirect gift; 2) whether the limited partnership should be treated (and valued) analogous to a trust; and 3) what discounts for lack of control and marketability apply to the gifts. 

Of particular interest to appraisers and attorneys: Holman is a fully reviewed opinion, binding on the entire Tax Court bench coming on the heels of Astleford v. Commissioner (T.C. Memo. 2008-128; No. 4342-06 (5 May 2008)) where a better work product allowed for a combined 85% discount to net asset value.  (The Tax Court decided valuation issues in the context of a family limited partnership (FLP) with the end result of the decision, which reviewed appraised values related to transfers of agriculture (1,187 acres of farmland), a 50% general partnership (GP) interest along with three 30% limited partnership (LP) interests.  Per the Tax Court, the total combined discounts equaled nearly 85%.  First, the court permitted an effective discount of over 20% for market absorption on the real estate; then a 30% discount on the 50% GP interest; and then a more than 35% combined discounts on the LP gifts. (I’d argue that there was double discounting for illiquidity, which would have lowered the overall discount.)) 

In its consideration of direct/indirect gifts, Holman resurrects Chapter 14 (§§ 2703, 2704 I.R.C.).  Before we review, remember by creating an asset holding company, such as an LLC or LP, the voting and/or economic rights are associated with interests held by the investor – not direct ownership of the underlying asset.  The valuation issues saw both experts starting with the net asset values, and both used closed-end funds to determine minority discounts for the noncontrolling interests.  While the taxpayer’s expert included specialized equity funds, the IRS expert relied solely on general equity funds—which the court found the more “thoughtful” approach.  As for determining the discount for lack of marketability (DLOM), both experts began with the restricted stock studies (certainly not the only methodology or necessarily the best). 

But in what promises to be the most controversial aspect of the opinion, the IRS broke down the data by market access (liquidity) and holding periods, concluding that in this case, limited market access supported a 12.5% DLOM.  The IRS expert made no adjustment for a holding period, because the partnership’s redemption provisions allowed it to repurchase the shares at fair market value, thus succeeding to the benefits of any discounts.  The court agreed with this approach, finding the holding period of “little influence” in this case (however, fails to recognize whether a noncontrolling interest holder could force such an action).

Clearly, the holding period does have a critical impact on the ability to liquidate [the partnership and the LP interest(s)] and on the investor’s expected return.

Not the least influences are likely opportunity costs especially when there is no guarantee that liquidation will occur during an optimal period (highest return) where the GP may decide to sell. The uncertainty of the process gives rise to some level of discounts, which must be greater than the benefits of direct ownership for impairments associated with lack of control and marketability of the LP interests.   The “metric of marketability” assumes there is a market in place to begin, but for many of these interests (especially non-controlling ones in a private company), there is no ability to access underlying assets to sell or influence cash flows for distribution. 

The holding period in the restricted stock studies clearly demonstrate the longer the period before a liquidation event, the greater the downward adjustment expected by the investor due to factors such as opportunity costs and market volatility/uncertainty.  This, in turn, increases the return to adequate motivate the investor (i.e., $100 share with 10% total return might be inadequate for a minority interest in a private company, but by lowering (discounting) the share price by, say, 40%, the return increases to $10/$60 or 16.7%, which is more comparable to long-term public small cap company returns.  More over, there are better and more reliable quantitative measures that can be applied to substantiate the illiquidity discount.  Frankly, I’m disappointed they were not applied and the analysts for the IRS or the taxpayer did not properly weight the Income Approach as permitted in Watts (Commissioner 823 F 2d 483 (11 Cir. 1987).

Further, the Court’s acceptance of the IRS’s proposed restructuring liquidation also “seems to depart from the fair market value ‘hypothetical [investor] of a willing buyer/willing seller.’  Yet, the court noted that such a transaction “is perhaps inconsistent with the stated purpose of the partnership.”  Marketability is not an on and off switch, it’s a continuum.  The issue is one of varying degrees of liquidity and the economic benefit [yield/distributable income and capital appreciation/growth] to the investor during the holding return.  Rule 144A did not create a market for restricted stock…it merely increases the number of likely buyers, thus potentially increasing [but not guaranteeing] the liquidity of restricted stock.   Moreover, after a relatively brief holding period (now 6 months for 144A), restricted stock can be sold in the public marketplace at no discount—but there is no such option available for these LP interests. The restricted stock of a public company is more liquid than private stock.  It always is and always will be.  Surprisingly, the Holman Court found otherwise.  Further, a simple examination of stock options received by company executives reflects that on many, if not most, occasions, simply because an option can be exercised doesn’t mean it will, which extends its holding period sometimes for years.

In the end, it’s troubling the Tax Court found one appraiser less helpful than the other—and then assigned the latter’s work greater credibility.  Legal practitioners and their clients must work with appraisers to make certain the valuation evidence, data used and conclusions reached are most appropriate and reasonable.  Thus, choose your expert wisely.  Even with its unsupported claims…the IRS won because it simply had the better expert.