Is it an art or a science? Is it equal parts of art and science? Is one part weighted more than the other? Do the answers to these questions depend upon the purpose for which the appraisal is being sought? Do they depend upon who is asking the question?

Yes, no, maybe, sometimes.

Not very helpful, right? Yet, the results of an appraisal can have far-reaching economic consequences, especially where the object being valued is a decedent’s interest in a closely held business. For example, the appraisal can affect the taxable income from the operation of the business, or the gain realized on a subsequent sale of the business.

The valuation method and the factors considered can vary greatly depending upon, among other things, the nature of the business interest (a partnership interest or shares of stock in a corporation), the tax status of the business (C or S corporation, partnership or disregarded entity), the nature of the business (service- or capital-intensive), the nature of its assets (depreciable or amortizable), the identity of the other owners (family or unrelated persons), the life-stage of the business (in growth mode, or looking for a liquidity event).

It is often said that “where you stand depends upon where you sit.” This truth is often encountered upon the demise of an owner of a close business, as was reflected in a recent Tax Court (“TC”) decision. [Est. of Giustina v. Commr., T.C. Memo 2016-114]

The Partnership
Decedent owned a 41% limited-partner (“LP”) interest in Partnership, which owned timberland, and earned profits from growing trees, cutting them down, and selling the logs.

The Decedent’s estate and the IRS agreed that if Partnership sold off its timberlands, it would have received almost $143 million. If one included the value of its non-timberland assets, Partnership would have received over $150 million on a sale of its assets.

Through corporate structures, Partnership had two general partners (“GPs”): LG and JG. It had eight LPs, including Decedent.

The LPs were members of the same family (or trusts for the benefit of members of the family). The partnership agreement provided that an LP interest could be transferred only to another LP (or to a trust for the benefit of an LP), unless the transfer was approved by the GPs. A dissolution provision in the partnership agreement provided that if two-thirds of the LPs agreed (as measured by percentage interest), then Partnership would be dissolved, its assets sold, and the proceeds distributed to the partners.

The Decedent’s estate and the IRS disagreed over the value of the Decedent’s 41% LP interest. In particular, they assigned different weights to the probability that Partnership would sell its business or continue its operation.

Tax Court: Round One
The IRS’s expert gave greater weight to the sale value of Partnership’s assets than did the estate’s expert, and arrived at a fair market value (“FMV”) of $33.5 MM for the 41% LP interest. The TC declined to adopt the findings of either expert.

The TC took the view that the partnership asset values were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would sell its assets. The TC determined that there was only a 25% chance that Partnership would sell its assets after Decedent’s LP interest was transferred to a hypothetical third party. It reasoned that there was a 25% chance that the hypothetical buyer of the 41% LP interest could convince two-thirds of the partners to either: (1) vote to dissolve Partnership, resulting in the sale of Partnership’s assets and distribution of the proceeds to the partners, or (2) replace the two GPs (who had the authority to sell the assets and make distributions) to achieve the same result. The TC, therefore, gave a 25% weight to the value of the partnership assets rather than the greater weight used by the IRS’s expert.

The TC took the view that the cash-flows were relevant to the value of the 41% LP interest only to the extent of the probability that Partnership would continue its operations. It determined there was a 75% chance that Partnership would continue its operations.

In order to incorporate the cash-flows from continued operations into its valuation, the TC had to determine the present value of the cash-flows. It did this by adjusting the present value calculations of the estate’s expert. It also made certain assumptions about the annual increase in cash-flows and the rate for discounting the cash-flows to present value. This rate was the sum of: a risk-free rate of return equal to the rate of return on Treasury bonds, a risk premium for timber industry companies, a risk premium for small companies, and a risk premium for the unique risk of Partnership.

The TC accepted all of these components of the estate expert’s discount rate with the exception of the risk premium for the “unique risk” of Partnership’s timber business (as opposed to so-called “market risk”), which the TC reduced by 50%.

The TC explained that risk is not preferred by investors – they require a premium to bear it. However, some of the risk associated with an asset can be eliminated, the TC noted, through diversification if the owner of the asset also owns other assets, if the risks of the other assets are not associated with the asset in question, and if the other assets are great enough in value.

In evaluating a potential buyer’s ability to diversify the risks associated with Partnership, the TC assumed that the buyer could be an entity owned by multiple owners who could have diversified the unique risk associated with the 41% LP interest because the entity’s owners could hold other assets outside the entity.

Alternatively, the entity could diversify the risks of holding the 41% LP interest by holding other substantial assets that were unaffected by the Partnership-specific risk.

On the basis of its assumption that an entity with multiple owners could be the hypothetical buyer of the 41% limited-partner interest, the TC believed that a hypothetical buyer would not require a premium for all the Partnership-specific risk associated with owning the LP interest.

The TC concluded that the FMV of the 41% LP interest was $27.5 MM.

Court of Appeals
The estate appealed the TC’s decision, and the Ninth Circuit (the “Circuit”) held that the TC had erred by finding that there was a 25% chance that Partnership would sell its business and dissolve.

The Circuit held that a buyer who intended to dissolve Partnership would not be allowed to become an LP by the GPs, who favored the continued operation of Partnership. The Circuit also found it implausible that the buyer would seek the removal of the GPs who had just granted the buyer admission to Partnership.

Finally, the Circuit found it implausible that enough of the other partners would go along with a plan to dissolve Partnership.

Consequently, the Circuit directed the TC, on remand, to “recalculate the value of the Estate based on the partnership’s value as a going concern.”

The Circuit also held that the TC erred “by failing to adequately explain its basis for cutting in half the Estate’s expert’s proffered company-specific risk premium.”

The Standard
The FMV of an item of property includible in a decedent’s gross estate is its FMV at the time of the decedent’s death. The FMV 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 to sell, and both having reasonable knowledge of relevant facts.

In the case of shares of stock of a closely held corporation, the FMV is determined by taking into consideration the company’s net worth, prospective earning power and dividend-paying capacity. Other relevant factors to be considered include the good will of the business; the economic outlook in the particular industry; the company’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange.

The weight to be accorded such comparisons, or any other evidentiary factors considered in the determination of a value, depends upon the facts of each case. In addition to the relevant factors described above, consideration must also be given to non-operating assets, to the extent such non-operating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.

Tax Court: Round Two
In response to the Circuit’s direction , the TC based its adjusted valuation of the 41% LP interest entirely on Partnership’s value as a “going concern.” In the TC’s view, the going-concern value was the present value of the cash-flows Partnership would receive if it were to continue its operations.

However, the Circuit opinion, in discussing the possibility that a hypothetical buyer could force the sale of Partnership’s assets, held that the hypothetical buyer must be a buyer to whom a transfer of an LP interest was permitted under the partnership agreement. By the same token, in evaluating the hypothetical buyer’s ability to diversify risk, the TC considered only a buyer whose ownership of an LP interest was permitted by the partnership agreement.

Under the partnership agreement, an LP interest could be transferred only to another LP (or a trust for the benefit of another LP) or a person receiving the approval of the two GPs. Other than Decedent, there were seven LPs. All seven were individuals and trusts. The record did not support the notion that any of the LPs had enough assets to diversify the risks of owning an additional 41% LP interest. The LPs appeared to be family members (or trusts for the benefit of family members) who probably had most of their wealth tied up in the family business in the form of their partner interests in Partnership.

Under the partnership agreement, an LP interest could be transferred to a person other than an LP (or a trust for the benefit of an LP) only if that person was approved by the two GPs. The two GPs were LG and JG (through corporate structures). For 25 years, they had run Partnership as an operating business. The record suggested that these two partners would refuse to permit someone who was not interested in having Partnership continue its business to become an LP. Thus, the TC determined that they would not permit a multiple-owner investment entity to become an LP.

Such an entity would seek to increase the returns on its investments. If such an entity owned the 41% LP interest, it would attempt to have Partnership discontinue its operations and dissolve. More generally, the TC found that no buyer that LG and JG would permit to become an LP would be able to diversify the Partnership-specific risk.

As a result of these findings, the TC determined that a hypothetical buyer of the 41% LP interest would be unable to diversify the unique risks associated with Partnership. Without diversification, the buyer would demand the full risk premium assigned to the interest by the estate’s expert.

Thus, after eliminating any weight attributed to the value of Partnership’s assets, and applying the Partnership-specific risk premium, the TC valued the LP interest at $13.95 million.

In applying the hypothetical willing buyer-willing seller standard, the courts have routinely stated that one must not speculate about who might buy a decedent’s stock, how a buyer might desire to work themselves into a major role in the company, what combinations they might form with the decedent’s family members, and whether the buyer would be able to buy more shares from members of the decedent’s family. According to the courts, speculation about what imaginary buyers might do should be ignored because, by engaging in such speculation, one departs from the willing buyer-willing seller test.

On the other hand, courts have recognized that it is appropriate, in applying the hypothetical willing buyer-willing seller test, to consider who owns the remaining shares in the company. In general, and without more (such as litigation among the members of the family), courts have concluded that it is unlikely that a member of the taxpayer’s family would join with an outsider to control the actions of the company, noting that family members have a distinct advantage in forming coalitions, especially where they have a history of dealing with one another.

As was demonstrated by the decision discussed above, the recognition of a family connection among the surviving owners goes not only to the size of the discount that may be applied in valuing a decedent’s minority interest in a business entity, but also to the methodology that that must be applied in determining the value of the business as a whole.