Don’t let Holman Strangi Your Client

We’re in unchartered waters with the uncertainty of the financial markets and future political and tax landscape. There are two primary ways to make lemonade with the lemons Wall Street has foisted on our most affluent clients. (1) Transfer/gift greater interests due to the reduced value of the underlying assets & (2) Look to reallocation of portfolio assets to include more municipal bonds with recapitalization of interests to enhance dividend pay out while preserving principal. What remains the same is to ensure the operating agreement provisions reflect a myriad of legitimate business purposes that are adhered to by the interest holders to avoid piercing the veil by the service.

For other than estate attorneys, we find a decline in market conditions produces an increase in the level of partner disputes (business and marital). We urge advising clients to focus on due diligence from ensuring buy-sell agreements are completed, adhered to and funded. Tighter funds will likely produce high costs of capital and lower multiples, but stronger clients may be able to take this opportunity to improve operating performance and acquire market share from poorer performing competitors.

The following article should be instructive for estate/tax practitioners as well as business and family law attorneys and advisors.  The underlying premise of recent attacks by the IRS after emboldened by the tax court decision in Holman (May 2008) is that a corporate entity holding investments that are deemed liquid (readily converted into cash) necessitates ignoring the closely-held interest subject to valuation and applicable discounts.  This fundamentally ignores the myriad of legitimate business purposes for creating an enterprise. 

It is incumbent upon professional advisors to savagely attack such a position.  The sample letter below provides some legal and economic arguments.

Dear Mr. Smith:

In response to your request, I have reviewed the Service’s position of an aggregate 21.2% downward adjustment made to the pro rata value held by the decedent of $3,392,000.  There are both material and theoretical issues that necessitate a response.

There is a fundamental error in the reading of our own findings.  Our report has applied the Income Approach, which appears to have been overlooked.  In consideration of the Tax Courts’ findings in  Andrews, Katz, Watts, Ward et al, use of this approach tends to be preferred in developing the impairment for lack of control (See RR59-60), as it more closely examines the economic benefit associated with the investor’s expected return (yield and capital appreciation).

Estate of Andrews v. Commissioner 79 T.C. 938, 942, 1982
Estate of Katz v. Commissioner 27 TCM 825-1968
Estate of Watts v. Commissioner 823 F 2d 483 (11 Cir. 1987)
Estate of Ward (87 TC 78 – 1986)

Our Income Approach analysis provided a 35.9% lack of control discount.  Yet, the Market Approach solely relied upon by the Service provided a 10% discount result, which relied upon closed-end funds.  Our Market Approach was given the principal weight of 75% and provided a weighted DLOC of 16.5%; therefore, there was no error in our calculation.  This weight was selected based upon unique factors of the LP interest and not a “one discount fits all methodology”.

Hence, the Service wishes to argue the fact pattern of Holman in giving weight of 10% to the impairment for lack of control versus a higher level without any empirical support.  It appears clear the impairments of noncontrol are considerably greater than in Holman given the LP’s  minority stake in 39 separate funds.  Also note the LP agreement’s provisions that significantly impairs the equity held by the decedent.  “A decedent GP/LP interest becomes a “special limited partnership” interest which will not be eligible for operating distributions and will only receive capital distributions upon the winding up of the LP.”  This factor severely impacts the economic value of the interest when considering the Discount for Lack of Marketability (“DLOM”).

Estate of Holman v. Commissioner TCM 13012, May 27, 2008

The second issue for the Service is the size of the DLOM, where they opined 12.5%.  What is measured in the DLOM is the degree of liquidity impairment associated with the uncertainty (of investment performance compared to alternatives) with often an unknown holding period and a limited pool of potential investors for a sizeable non-controlling LP interest.  (Not the underlying assets held.)  In the operating agreement, the type of investor is accredited, which constitutes fewer than 3% of the American population suggesting a small pool of potential buyers.  In addition, to the aforementioned liquidation provision, 10% of the LP value is deferred for six months after liquidation of the interest is permitted. 

If one examines the seven tax court cases selected and cited by the Service, the DLOM range is from 12.5% to 25% with a median of 22%.  Our 35% discount was not arbitrarily selected, but empirically supported; yet, the Service has arbitrarily selected 12.5% without any empirical support testing whether their opined impairment measure is too high or low.  Our report examines the traditional restricted stock studies, but goes on to also look at more than 18 factors that would likely increase the impairment well above the cited 22% median; especially given the LP provisions after the death of the interest holder. 

Instead, the Service has cited a study by one IRS experienced valuation expert, Mr. Burns, who refers to the gradually lower discounts associated with Rule 144 (restricted) stock (one year holding period reflecting a median discount of 22%).  What is understood by most valuation experts is the clear evidence that the longer the holding period and the lower the dividends received, the greater the discount and that to isolate the factors related to market size is only part of the DLOM considerations.  The Service’s position is that since the closely held entity holds a portfolio of marketable securities (which the LP does not), then it would be much less risky. This, in turn, would reduce the level of downward adjustment.   

The fact is the decedent’s estate would have had to wait almost a year to liquidate according to LP provisions and his date of passing.  This factor is coupled with LP interest experiencing underperforming market returns (non-optimal) despite being a fund of funds (30+ year return for mixed large and small cap index was 12%).  In addition, there is an embedded gain tax liability* and a 2% liquidation fee.  If the Holman Court would had allowed for 12.5% discount assuming immediate liquidity of Dell stock, but for the 2703 issue, then what would the discount have been a full year later for a non-controlling interest in the LP?  Clearly, it’s much greater than 12.5%.

*Given the dollar for dollar embedded gain liability discount in the tax court decision in Jelke (40% reduction), also where holding marketable securities was the principal asset, the 12.5% opined DLOM discount appears quite modest.  In fact, the weakness of Jelke was the court relied upon Judge Laro’s Mandelbaum decision which benchmarks at 35%.  This produced a discount that was 1500 basis points (15%) lower.

Jelke v. Commissioner, TCM 3512-03, November 15, 2007

The taxpayer’s analyst’s position seems to be well supported by other tax court cases where the business entities held primarily a portfolio of more liquid marketable securities, certificates of deposit and/or cash (versus various LP interests of funds of funds).

                                                                                                TTL ASSETS                             DLOC                             DLOM

Kelly v. Commissioner TCM 2005-235                                  $ 1,226,421                                12%                                 20%

Jelke v. Commissioner, TCM 3512-03                                   $ 4,588,155                                 10%                                15%

Peracchio V. Commissioner, TCM 2003-280                      $ 2,008,370                               6%                                  25%

Dailey v. Commissioner, TCM, 2001-263                             $ 1,267,619                                 [40% aggregate]

The direct ownership in optimal alternative investments would have had a return expectation of 12%+/- total return (pre-tax) as of the date of value.  However, the decedent’s ownership is a non-controlling LP interest which held interests in a multitude of LPs - not more liquid underlying stock with a combined return below this 12% benchmark.  This is why there was a long lag time prior to liquidation being authorized.   

Finally, the chart below reflects the various alternative investments and average long-term rates of return since 1960, as reported by Ibbotson Associates, Inc. and clearly suggests a buy-hold investor expectation that should be above that obtained by directly held portfolio of publicly traded small company stocks of 17.2%.

                                                                                                                             Avg. Ret.                                                 Std. Dev. (Risk)

Venture Capital                                                                                                     45.0%                                                      115.6% 

Small Company Stocks                                                                                         17.2%                                                       25.0% 

International Stocks                                                                                              15.2%                                                       21.6%

Large Company Stocks                                                                                         13.3%                                                       15.7%

Long-term Gov’t. Bonds                                                                                         7.6%                                                       11.4%

Treasury Bills                                                                                                            6.0%                                                       2.7% 

Therefore, the opined 17.6% return after our aggregate discount of 44.7% appears to be well supported.  Further detail, as to how the DLOM of 35% was determined was addressed in our September 20, 2006 report.

Respectfully submitted,

Business Valuations Ltd.                                                                               

While time fame, performance, legal structure, restrictions and many other issues may impact an argument, one must be prepared to defend legitimate adjustments based upon sound economic principles.  This article provides one suggestion on how to do so.