Valuation Questions and Answers

Valuation Questions and Answers

The Valuation Subcommittee of the Business Planning Committee has partnered with select valuation consultants to provide a forum for ACTEC Fellows to have their valuation questions answered by experts. To pose a question, submit it in email form to Members of the Valuation Subcommittee will submit your question to a rotating panel of valuation consultants, and will post the question and response below.


The questions that have been answered to date are to be considered NON-AUTHORITATIVE ANSWERS. They have been compiled by Scott Nammacher. As always, the facts and circumstances dictate how an appraiser handles issues.

Q: Is it appropriate to apply a key person discount when valuing an interest in a business for gift tax purposes? If so, how do you measure the discount?

A: The response below provides a summary of the feedback received.

The practitioners agreed that key person risk should be considered, to the extent that it exists, in developing a valuation conclusion. Specific examples of key person risk may include situations in which one person has significant customer or supplier relationships that are not institutionalized, has a unique skill set that is difficult to replace in the near term, or has multiple mission critical roles within the company. The most common example is a founder or shareholder who is widely perceived to be critical to the ongoing success of the business. Ultimately, the magnitude of a key person adjustment is a function of how that person’s absence might affect the riskiness and level of the company’s expected cash flows.

There are a number of ways one can take this into account. In general, the most common method employed for incorporating the impact of key person risk into the valuation conclusion is to make a subjective adjustment to the selected discount rate or valuation multiple employed to estimate the aggregate equity value. However, some risks can be discretely modelled, such as the risk of departure of a key relationship manager who is likely to take a material portion of the company’s business with him (her). One might use a scenario analysis with weighted outcomes to generate an “expected value.” Additionally, some appraisers may adjust the key person’s compensation upward, for their unique skills, assuming the compensation does not already reflect this (discussed in more detail below). Finally, there are also various studies sometimes used that focus on the impact on firm values (from publicly traded company data) of unexpected losses of top management teams or individuals, usually due to unexpected deaths in accidents. However, in many of these cases there is a deeper management base in place than a typical small, private company.

The appraiser will determine the best way to account for key person risk based on the information available and the facts and circumstances of the situation. Key person insurance, if properly constructed, may mitigate key person the impact of losing key personnel, reducing key person risk.

In an income tax construct, the concept of personal goodwill was recently “introduced” to the estate and gift tax community through two Tax Court cases. When personal goodwill exists, the value of a company can be materially reduced because its success is dependent upon the personal goodwill of a key employee. In Estate of Adell, the son had significant relationships that were critical to the company’s success. Given the significant risk, the expert for the petitioner applied a charge to earnings to reflect the personal goodwill of the son, materially reducing the value of the company. The discount rate employed by petitioner’s expert was reduced because the impact of the risk was specifically captured in the cash flows. The Tax Court favored this approach to the approach of the IRS, in which a specific cash flow adjustment was not applied and a higher discount rate was used.

In Bross Trucking, a gift tax case, the taxpayer retired from his trucking business effective December 31. On January 1, his sons established a competing company and captured almost all of the revenue of the taxpayer’s trucking business. The Tax Court ruled that there was no gift from Bross Trucking to the new company because the value of Bross Trucking resided in the father’s personal goodwill. This decision meant that there was no gift and no gift tax due.

The Tax Court’s decisions in Adell and Bross suggest that, in the absence of employment agreements, non-compete agreements or confidentiality agreements, goodwill (and value) that might otherwise be attributable to a company may belong to the key person instead. Such agreements may have the effect of transferring an employee’s personal goodwill to the company. These cases also raise questions as to whether or not key person risk is more narrowly defined to include issues related to retirement, health and mortality, and therefore separate from personal goodwill.

As with most valuation issues, the impact of key person risk on the valuation of a business can be subjective and is driven by the facts and circumstances of the situation. There is no “onesize fits all approach.”

Impact of a Controlling GP interest on an LP valuation

Q: Mom owns controlling interest in LLC and a limited partnership interest in Partnership. LLC is the general partner of Partnership. Partnership requires unanimity for major decisions, but otherwise GP controls day-to-day operations of Partnership. At mom’s death, the IRS asserts that there should be no lack of control discount on the partnership interest (as well as the GP interest) owned by Mom. What valuation positions are there to counteract the IRS’s position on the limited partnership interest in particular?

A: The consensus is that Mom’s interests need be aggregated since a rational investor looking to maximize return would bundle the two in any sale. However, since Mom did not have absolute control, some discounts, albeit of a more limited nature, should apply. This can be in the form of a discount for lack of control (DLOC) and/or a discount for lack of marketability (DLOM). Operating control materially reduces each of the applicable discounts.

IRS focus would likely be on Mom’s ability to do a partial liquidation of underlying assets, thereby distributing assets without the unanimous vote. IRS may well argue from several directions: 1) Section 2704(b)(ii) could arguably apply where if restriction (unanimous vote required) is greater than state law (majority or 2/3rds in some states), then state law may apply, making this restriction an “applicable restriction” to be ignored…defaulting to state law for valuation; 2) IRS may argue Section 2703(a) as well as economic “arbitrage” arguments as to what the LPs would pay (in terms of discount dollars) the 1% GP to sell assets.

On the other side there are real economic and case law arguments for discounts. Owning partial control vs. full control has been shown to make a difference in public company premiums. Control premiums in acquisitions of 50.1% to 80% (not full control) vs. 80% to 100% (full control) appear to show differences (although likely difficult to prove specifically how much). The argument that one would not pay as much for partial control as for full control is a highly defensible one to start with.

Court cases have allowed discounts for larger ownership interests that have some control but lack full control. These include:

One highlighted outcome, based on pre-trial negotiations, was a DLOC in the low 20%s rather than a DLOM as reflected in the cases.

a. Estate of Oman: 20% DLOM for 75.6% interest

b. Estate of Dunn: 22% DLOM for 62.96% interest

c. Estate of Bennett: 15% DLOM for 100% interest in a real estate holding C- corp.

d. Estate of Maxcy: 15% DLOM for a 94.25% interest

e. Von Hagke v. U.S.: 8% DLOM for 83.08% interest

S Corp Valuations

Q: What is the proper approach to valuing an S Corp these days with regard to the pass through nature and how that compares to the regular corporations that are often used as guideline companies?

A: Depending on the interest being valued, this can vary.

A controlling (100%) interest in a Tax Pass-Through Entity (TPTE) is typically not adjusted for the tax savings, since the buyer of a 100% in a C-corp. could convert the company to a TPTE relatively simply, so the pricing should already reflect this benefit in market multiples of transactions. This implies that transaction multiples derived from control interest acquisitions of public and private companies already reflect pass-through benefits.

In a minority interest (shareholder level) situation, there is typically agreement that a buyer may pay more for an interest in a TPTE than he would for an identical interest in a C-corp. An analysis needs to be done to quantify the benefits and add them to value. The benefits include (1) that there is a single level of income tax for a TPTE shareholder and (2) that retained earnings get stepped up and can accumulate over time in a TPTE and get better capital gains treatment relative to a C-corp. upon a sale of assets or liquidation of company.

The members responding to this question believe there is a two-step approach to valuing these kinds of entities. The first is to come to a value as if it is a C-corp., since most of the data available for valuation is from the public marketplace which is dominated by C-corps (multiples, rates of returns, transaction data, etc.). This involves tax affecting the income at a C-corp. rate in an income approach.

The second step is to estimate/quantify a premium for the benefits of the TPTE. There are several different models in the marketplace to try to quantify these benefits. There is no industry agreement on models (with some appraisers not even doing step two) but the models try to quantify the following, typically:

These factors, and others, can be incorporated into an analysis of the benefit from the pass through structure to a minority interest level shareholder. The inputs and issues need to be discussed and quantified in the report in some detail. Some firms use one of various models in the marketplace while others use other approaches.

  • The difference between C-corp. tax rates and pass-through personal tax rates levied on the taxable earnings of the entity. Also, any differences in the treatment of what is considered allowable taxable income and expense items.
  • The level of distributions of the entity, especially distributions beyond those necessary to pay the taxes on pass-through taxable income arising from the operations of the entity. The obligation to pay the taxes on the entity’s income cannot be de-coupled from the ownership interest in the entity, so both the benefits of ownership (distributions and eventual sale for return of capital) and the liabilities of ownership (mandatory tax burden) must be combined in any analysis of value. In this sense, tax impacts are the same as any other governmental regulatory impact on a company and its owners.
  • The inside build-up of the owner’s interest’s cost basis for any earnings retained in the pass-through entity and any differences on the treatment of capital gains taxes on sale (or dissolution) of a C-corp. interest versus a pass-through interest.
  • Restrictions on marketability between C-corp. interests and TPTE interests, particularly with respect to S-corp. interests:
    • The types and number of parties who can qualify to own S corp interests is limited.
    • The trading markets for C-corps versus pass-through entities (particularly qualification for public trading).
    • The universe of hypothetical willing buyers for the subject TPTE interest. This is particularly necessary to consider in the case of 100% ownership interests, since elements of control include the ability to change capitalization and legal form of ownership structure.
  • Risks related to the shortening or elimination of the TPTE benefit, such as a C-corp. buyout of the entity in the near term, volatility of earnings, tax law changes reducing the relative benefits (C-corp. taxes reduced, personal taxes raised, etc.), changes in distribution policies, the risk of losing the TPTE benefit (particularly relevant for S-corps., or inside assets invested in using retained earnings (cap gain producing or not) can all impact the positive impacts of above.

Valuation Impact of Merger of two Partnerships with Differing Ownership Interests

Q: Two partnerships are merging. Their governing provisions are identical, but for names. Ownership interests in the first are 49/49/1 two LP partners and a corporate GP. Ownership interests in the second include the three partners of the first entity (1% GP and 10% each for the individuals), but also other family members (40% cumulatively) and trusts for yet other family members (39% cumulatively). The assets of Pship 1 and Pship 2 are substantially similar but not identical (primarily ranch land and oil and gas interests in the same geographic area (as to each other), and a limited amount of cash and securities). Income tax counsel says in order to complete the merger without indirect gifts when determining the resulting ownership interests, we need appraisals not only of the underlying assets of both pships, but also of:

Partner 1’s 49.5% LP interest in Pship 1;

Partner 2’s 49.5% LP interest in Pship 1;

Partner 3’s 1% GP interest in Pship 1;

Partner 1’s 10% interest in Pship 2;

Partner 2’s 10% interest in Pship 2;

Partner 3’s 1% GP interest in Pship 2;

Family members’ 10% interests (each) in Pship 2; and

Trusts’ 13% interests (each) in Pship 2.

If the valuation date is the same, and the governing documents are identical but for identity of partners, could we have the interests in Partnership 1 appraised and extrapolate (or ask the appraiser to give a short‐form extrapolation) as to the value of the interests in Partnership 2 using the same valuation methods, discounts, and conclusions?

A: Since it is a merger of two 100% entities, we generally don’t see the need to value the specific ownership interests given the documents are identical except for ownership. That does not mean the IRS might not argue gifts, but it would seem the risk is low, especially since Partner #3 retains GP control.

As for the assets owned, while “similar” in nature, you indicate they are not the same. Someone could obviously extrapolate/apply the valuation methods used in valuing the assets of partnership #1 to those of #2, but we question whether the results would meet the requirement of the intended use (i.e., adequate disclosure). Extrapolating means no real valuation has occurred on Partnership #2’s assets. It may be that such an exercise, from an appraiser’s perspective, would not even qualify as a “Calculation” type report if they have done no work looking into the assets. It could raise your risk profile on audit (with the IRS) or if a shareholder from either partnership later believes the assets (in Partnership #2) were under or overvalued, without an appraisal of them specifically.

Effect of Filing a Tax Return that Reports a Gift of a Fractional Interest, but only Filing an Appraisal of the Whole Entity (but still taking a discount for the fractional interest)

Q: I am wondering what the thoughts might be of filing a gift tax return with appraisals which do not identify lack of marketability or fractional interest discounts, but still having the tax preparer take a discount to the interests which are gifted. The clients obtained appraisals for the entire asset owned, but the appraisals do not reflect any discounts. The clients only asked the appraisers to come up with a value of the whole, not of only an interest under it, or what discounts might be appropriate, and they are unable to get further/more extensive appraisals done before the October 15th extension date for their return (and in one instance, the appraiser just passed away).

They only want to make a gift of a fractional interest of approximately 25% of a real estate limited liability company (which controlling agreement has transfer restrictions) holding pieces of commercial property and about 25% of a closely held company with some marketable securities (less than 10% of the entire value) holding mostly copyrights in musical compositions and artworks. The family would like to take a reasonable discount given the minority interest passing and the difficulty in selling it by the recipient. They feel that a 30% discount is very fair. I have warned them that doing so without the supporting appraisal could be a red flag for an audit, but they are thinking that if they get audited, they can get an appraiser to support the 30% discount after the fact given it’s conservative nature.

Any thoughts you might have on this approach would be greatly appreciated.

A: Clients can always choose the discount they use when filing gift tax returns. Filing without any appraisal would likely run afoul of the adequate disclosure requirements and likely preclude the start of thestatute of limitations. However, while we are not lawyers, it may be possible (but is unclear) that filing an appraisal (of only underlying assets) without the discount aspects incorporated (but still claiming a discount independently) would may start the statute running since there is no formal requirement the discount be determined by a qualified appraiser. But, since it is unclear, it could expose the family to risk if picked up on a gift audit, or worse yet, an estate audit years later, when the transfer may be “re‐opened.” Since the assets are mostly intangible (copyrights and artwork) there could be more risk in these types of valuations than if the assets were just straight marketable investments.

While time was short and no appraisal could be completed before filing, it sounds like these risks can’t be helped, unless amended returns are filed later, with the discount appraisal. Doing it the right way, even a bit late, can help make sure this set of potential problems don’t crop up.

As an aside, if a discount has to be decided on without an appraiser’s involvement, best the client decide the levels and not the attorney. No appraiser, much less an attorney, could tell if the 30% level is “reasonable,” “fair” or “conservative,” without doing the needed work. If audited later, the attorney would not want to be exposed to a claim by the client that they determined something they were not trained to determine.


Contributions to the above answers came from (in no particular order):
FMV Opinions, Management Planning Inc., Empire Valuation Consultants,
Stout Risius, Ross and Willamette Management Associates.