|
As the transfer of wealth between generations accelerates, an increasing number of estate tax returns are being filed. The methods and techniques used to arrive at a "fair market value" are becoming increasingly sophisticated and complex. Application of discounts from the value of the assets being gifted for lack of control and marketability are becoming increasingly creative. As a result, the Internal Revenue Service (IRS) has become more aggressive in examining and challenging the adjusted "fair market value", resulting in increased litigation in the Tax Court. In the process many errors in reports have been observed. We now find the Tax Court itself becoming "valuation experts."
Evolution of the Valuation Profession
A landmark case in business valuation is the Estate of Edgar A. Berg v.
Commissioner (T. C. Memo 1991-279). The court criticized the experts for the estate as not being qualified to perform valuations and failing to provide analysis of the appropriate discount. The court observed the estate's appraisal (valuation) consultants, both CPAs, made only general references to a prior court decision to justify their opinion of value. Additionally, the court observed they were not in the business appraisal profession, did not have any formal education in business appraisals and were not members of any professional appraisal associations. In rejecting the Estate's experts, it accepted the IRS's expert because he had the background and training desired by the court, and developed discounts by referring to specific studies of comparable properties and demonstrated how they applied to the asset being examined. This marked the beginning of the Tax Court leaning toward the side with the most comprehensive and logical appraisal. Previously, the Court had a tendency to "split the difference." The Berg case, in my opinion, launched the profession of Business Valuation.
Since the Berg case, the valuation profession has grown in numbers and the body of knowledge continues to expand and proliferate principally due to new tax laws and the IRS's emphasis upon gift and estate tax returns. We shall also see later in this article that CPAs are not the only professionals committing errors.
Many articles have been published recently in professional journals suggesting that the discounted cash flow method and/or the guideline company methods are the acceptable methods to value a closely held entity. Capitalization of historical earnings has been criticized as an acceptable valuation method.
The use of the Capital Asset Pricing Method and Weighted Average Cost of Capital,
rather than the build up method are being touted as the better methods of developing capitalization/discount rates in spite of the need to refer to public market data for betas.
Recently, Chris Mercer, ASA, CFA introduced Quantifying Marketability Discounts in
late 1997. (See Discounts and Family Limited Partnerships Holding Only Marketable Securities CPA/LSC May issue).
These methodologies, while excellent when they can be utilized, are complex. In the opinion of the author, these "sophistications" have led to more errors in reports by both boutique and large valuation firms. They are not only committed by beginners and CPAs, as some in the appraisal society would lead you to believe, but by seasoned professionals accredited by one or more of the four appraisal and valuation accrediting organizations. (AICPA, ASA, IBA, NACVA)
For example, I recently reviewed an ESOP valuation of a machine job shop with
revenues of $1.7 million and adjusted net income of $75 thousand in the year of the valuation. Revenues over the past five years were erratic. The prior year revenues were $560 thousand with a loss of $600 thousand, yet the year before exceeded the current year. The Subject Company currently had a few small aerospace related jobs with the remainder being custom props for the entertainment industry.
The valuation was prepared by an ASA employed by a Los Angeles valuation firm. The discounted future earnings and guideline company methods were used to arrive at a fair market value. The earnings projection for discounting was prepared with little input from the client. The guideline companies selected were principally precision aerospace machine shops with revenues from $30.0 Million to $120.0 million. The fair market value was determined to be $650 thousand, a multiple of 8.7 times current year adjusted net income! If you were the ESOP Trustee, would you rely upon the reported value for redeeming ESOP shares?
Common Errors in Valuation Reports
In the September and August issues of CPA/LSC, Robin Taylor wrote a two-part article entitled Seven Deadly Sins of Business Valuators. Shannon Pratt, in the Third Edition of Valuing Small Businesses & Professional Practices (McGraw-Hill 1998), devotes an entire chapter (29) to Common Errors. At the AICPA National Business Valuation Conference in November of 1996, Butch Williams presented "Common Mistakes Made by CPAs in Preparing and Reporting Business Values". The Author included a similar list in a course written for NACVA in 1995, which has been incorporated into a Power Point presentation that has been presented to attorneys and CPAs throughout the United States.
A list of typical errors paraphrased from these sources is shown below:
Failure to:
- State the date of the valuation and the date prepared
- Define the purpose of the valuation
- Define the standard of value (e.g. Fair Market)
- Conduct a site visit
- Include assumptions and limiting conditions
- Discuss:
- Company background
- Industry in which the company participates
- Market in which the company competes
- Competition
- Economic environment in which the company competes
- Prepare a comparative financial analysis with industry performance
- Examine and discuss all common valuation methods
- Adequately define "earnings"
- Disclose assumptions and source of cash flow projections
- Define formulas - CAPM, WACC, Fama-French, Gordon Growth Model
- Apply the proper discount/capitalization rate to "earnings" as defined
- Adequately discuss and analyze guideline companies selected
- Discuss empirical data sources for premiums and discounts applied
- Reconcile values indicated by each valuation method examined
- Select one value
- Disclose sources of information contained in the report
The IRS and Tax Court's Current Views
Since the Berg case, the IRS and the Tax Courts have become increasingly
sophisticated in the matters of valuation approaches and theory. The Court no longer accepts simply using "bald assertions" in valuation reports and testimony.
The IRS, as a result of the discounts being taken in valuations for estate and gift tax purposes, has been giving valuation reports increasing scrutiny. Karen Lewallen Sumler, IRS director of estate and gift-tax administration, in a 1998 interview with The Wall Street Journal stated... "Growing use of estate-planning techniques that can slash the valuation of gifts is prompting the IRS to boost resources in the gift-tax area". She goes on to say... "Valuation is the real frontier in estate taxes. A major IRS concern is the family limited partnership, which allows taxpayers to discount (steeply) gifts of partnership shares to family members. Some have claimed discounts of 50% or more". "...Last year's tax law put a time limit on the IRS's ability to challenge the value of gifts, requiring the IRS to act within three years of filing a proper gift tax return." (See Adequate Disclosure of Gifts, Discounts and Positions by Steve Kaplan in the May issue of CPA/LSC regarding the latest proposal regarding Gift & Estate Tax Returns). In Bernard Mandelbaum v. Commissioner (T.C. Memo1995-255, June 12, 1995) Tax Court Judge Davis Laro created significant discussion within the valuation community by raising key issues regarding marketability discounts and setting forth ten factors to be considered in determining an appropriate discount for lack of marketability. These are:
- Private vs. public sales of stock
- Financial statement analysis
- The Company's dividend policy
- Nature of the Company, its history, position in the industry and its economic
outlook
- Strength of Company management
- Amount of control transferred
- Restrictions on transferability of stock
- Holding period required in the stock
- The Company's redemption policy
- Costs associated with making a public offering
The Court considered each of the above ten factors and determined subjectively that a 30% marketability discount was appropriate.
The Estate of William J. Desmond v. Commissioner (T.C. Memo 1999-76) (See
Brief Case, April 1999) provides a thorough discussion of valuation methods, application of premiums and discounts and appraisal reports by the Court including criticism of the expert reports and subsequent analysis and conclusion.
Briefly, the court stated that each of the expert's reports were subject to criticism.
Because of the limitations imposed by the IRS on their expert the Court rejected their report. The Court further stated that the fair market value reached by the taxpayers expert better represented the fair market value of the decedent's stock in a paint manufacturer, but only adopted in part the expert's report.
The Court rejected the expert's asset approach as vague and generally unhelpful
implying the expert may have improperly applied the method without further elaboration. The Court also modified the computation and application of the control premium and discount for lack of marketability resulting in an increase of 10.7% over the value reported in the estate tax return.
In The Estate of Jameson v. Commissioner (T.C. Memo 1999-43), the Court takes a position on several valuation issues which differ from the direct testimony of the
valuation experts. The Tax Court concludes the estate tax value to be $ 5.8 million v. $4.2 million determined by the estate and $6.2 million by the IRS (See Brief Case, May 1999, for a discussion of the Court's approach to built-in gains). This case will be discussed in more detail in future issues.
The Court unfortunately is not always on point. (Are any of us?) In Simplot v.
Commissioner (112 T.C. No. 13 1999), March 22, 1999, the tax court demonstrated a lack of common sense. After agreeing with the Estate's expert on three of four issues, it applied a premium for control to a minority interest. In any valuation the last step is to ask, "would I buy this stock? Clearly the Court did not apply the "sanity check" in this case. Christopher Mercer reviews this case in detail at http://www.bizval.com. As demonstrated by the cases discussed above, the Court is taking the application of valuation theory to another level. Although all of the above case references refer to Tax Court cases, these principles apply to all valuation matters subject to litigation. An excellent article for your library is "Preparing Valuation Reports to Withstand Judicial Challenge" written by Robert T.Willis, Jr. CPA, CFA in the December 1998 issue of Estate Planning (RIA GROUP, Boston, MA). In that article, Mr. Willis discusses significant court cases published from 1975-1997 relating to the Court's views on valuation and commentary regarding deficiencies in valuations and the expert's testimony.
Any professional involved in litigation support where valuation is at issue is urged to keep current on the evolution of valuation developments in the Courts.
This article is being reprinted from the CPA Litigation Service Counselor with permission from Harcourt Professional Publishing Division, 525 B Street, Suite 1900, San Diego, CA 92101.
|
