December 2008

Discounts for Lack of Control, Marketability

A recent Tax Court ruling strengthens the IRS’s scrutiny of transfer restrictions in family limited partnerships

The IRS has aggressively – and for the most part effectively – challenged the efficacy of family limited partnerships (FLPs) as tax avoidance devices, particularly through the application of Internal Revenue Code (IRC) § 2036(a). Now, with the Tax Court’s binding opinion in Holman v. Commissioner, the IRS has resurrected IRC § 2703, regarding transfer restrictions, in its scrutiny of FLPs. Moreover, the court addresses discounts for lack of control and lack of marketability, including an interpretation of the holding period component in these determinations.

Limited partnership

This decision involves the Holman Limited Partnership (HLP), which was created by Mr. & Mrs. Holman on November 2, 1999, and funded with $2.8 million of Dell Computer stock. Six days later, the Holmans gifted limited partner (LP) interests to each of their four children. The Holmans made smaller gifts of Dell stock to HLP in 2000 and 2001, each time causing reconfiguration of the partnership so that by 2001 they owned just over 12% as general and limited partners, while the remaining LPs owned nearly 88%.

Given the overriding reasons for forming the HLP – asset protection and educating the children on wealth management – the partnership agreement included substantial restrictions on the transfer of LP shares, including a buy-back provision in the event of a non-permitted transfer.

On their gift tax returns for each of the three transfers, the Holmans relied on an independent appraisal, which applied an overall 49.25% discount to the value of the LP transfers. The IRS challenged the transfers, claiming that:

• the first (made in 1999) was an indirect gift;

• § 2703 voided the transfer restrictions; and

• all the discounts were excessive.

This article addresses only the issue of valuation discounts and how they were addressed by the court. Valuation discounts are necessary to account for levels of risk associated with the ownership interest subject to valuation. There are no “prescribed” levels of valuation discounts, i.e., they cannot be determined by relying on a few set formulas applied in the same manner to every set of facts and circumstances. The facts and circumstances will require careful analysis so that any valuation discounts selected are rationally supportable, specific to the valuation being performed, and appropriate given the unique facts and circumstances of the engagement.

Experts clash on discounts

One of the most important variables affecting value is the degree of control rights (if any) inherent in the interest being valued. The ability to influence decisions concerning the entity has an intrinsic value, and investors will, accordingly, be willing to pay more for this control. In determining the applicable discount for lack of control, both experts relied on data from closed-end investment funds, and each used three samples – one for each gift – of similar size. (In fact, they used many of the same samples.) Although the IRS relied solely on general equity funds, finding them most comparable to the HLP, the Holmans’ expert used seven specialized funds. The IRS calculated median, mean, and interquartile mean discounts for each of his samples; the Holmans’ expert computed only the median, adjusting them an additional 10% upward to account for the HLP’s qualitative factors (e.g., lack of diversification). Their conclusions for the discount for lack of control appear in the table at left.

At trial, the Holmans’ expert admitted that the specialized funds resembled HLP only in their singular focus, and he agreed there was no correlation between the funds’ quantitative factors and the discounts at which they traded. He further admitted that his report failed to explain why he included the specialized funds in his samples.

The court calculated the median discounts from this subset of specialized samples (17.1% and 17.8%) and compared them to the medians from the full sample (12% and 13%). It found the differences sufficiently significant to disregard the data and adopt the more reliable general equity fund data. It constructed samples from the data common to both experts, resolving outliers by following the lead of the IRS expert and using the interquartile mean. Overall, the court applied minority interest discounts of 11.32%, 14.34%, and 4.63% to the three respective gifts.

Holding period

Both experts used restricted stock studies to calculate the discount for lack of marketability (DLOM). From his samples, the Holmans’ expert calculated median and mean discounts of 24.8% and 27.4%, respectively. Because the LP units had “virtually no ready market” and a willing buyer would have “no real prospects” of publicly selling those interests for full value, he concluded that the DLOM should be “at least” 35%.

The IRS expert examined restricted stock studies for three distinct periods and calculated the average discounts for each:

• Before the SEC adopted Rule 144A (pre-1990), when there was no resale market for restricted stock, the average discounts were 34%.

• The seven years after 144A, which permitted limited access to a resale market, the average discounts were 22%.

• The two years following the 1997 amendment of 144A, which reduced the required holding period from two to one year, the average discounts were 13%.

Based on this evolution, the IRS expert isolated two components that influenced investors in restricted stocks: (1) limited liquidity and (2) the holding period. In particular, he concluded that the 12% decline in discounts between pre- and post-144A was due to the opening of a limited resale market, and it represented the “charge” or incremental level of discounts that investors demanded before 1990, when the market became more liquid. The other 22% (of the 34%) was attributable to holding period restrictions and other factors. For private holding companies such as the HLP, which are not subject to legally imposed holding periods or the risks attendant to restricted stock, he contended that the discount for lack of marketability was closer to 12%.

Adopting this baseline, the IRS expert analyzed HLP’s specific factors: its failure to make distributions and diversify from Dell stock, and its transfer restrictions. Those factors increased marketability, he contended, specifically because Dell is freely tradable, and the buy-back provision permitted the partnership to dissolve and redistribute the assets to the remaining partners. The withdrawing LP would benefit because, in the event of an impermissible assignment, given the minority and marketability discounts that would apply to the proportional share of NAV, it would be in the LP’s economic interest (as well as the partnership’s) to negotiate some price between the discounted value of the units and the dollar value of the units’ proportional NAV share.

A reasonable buyer would request (and likely receive) a discount ranging from 10% to 15%, the IRS expert concluded. Given his baseline of 12%, he applied an overall DLOM of 12.5% for the LP interests. He made little, if any, adjustment for the holding period, noting that, in this case, it had “little, if any, influence.”

More credible expert

Once again, the court lacked confidence in the Holmans’ expert and found the IRS expert’s approach more persuasive. Observing that, if the LP units lacked any available market, the resulting DLOM could conceivably reach 100%, and the gifts would then have zero value. At any rate, the Holmans’ expert failed to persuade the court that his “stopping point” at 35% was “anything but a guess.”

The court also believed that the IRS expert correctly considered the partnership buy-back scenario; even if it ran counter to the HLP’s stated purpose – to preserve family assets – the purpose might well yield to the partners’ economic self-interest. Finally, the court agreed that, in this case, the holding period carried little weight, and it adopted the 12.5% as the appropriate marketability discount. ■

POSTSCRIPT

As in some previous issues of Valuation Perspectives, this month’s article provides a synopsis of a recent case that has direct relevance to many current valuation issues. It underscores the importance of applying a thorough and supportable valuation analysis, presented in a report that adequately documents all material assumptions.

It has become clear that a simple utilization of the average discounts from various studies will not stand up to IRS scrutiny. Rather, the most probative evidence for quantifying the relevant discount for lack of marketability or lack of control is found in transactions involving companies with characteristics as similar to the subject entity as possible. Accordingly, a more rigorous use of the relevant databases to select transactions in companies having characteristics as close as possible to the subject entity would be a more relevant approach in estimating the appropriate discount for lack of marketability and lack of control. — Lynton Kotzin