The following is extracted from a lengthy paper prepared by Linda Trugman of Trugman Valuation. She lays out in a logical fashion both the benefits of Family Limited Partnerships and the issues that must addressed in valuing them for tax purposes. As Linda lectures in valuation her presentation style is list-oriented which makes for relatively easy reading.
Family Limited Partnerships (FLPs) have grown in popularity
as an estate planning tool and a way to depress transfer tax values. Business
valuation experts should be aware of the issues involved in valuing FLP
interests and how to prepare a report that is less likely to be challenged by
the Internal Revenue Service (IRS) or, if challenged, will more likely be
resolved in favor of the taxpayer. Valuation analysts need to do more than
focus on what discounts they can use to reduce the value of a FLP
interest. The FLP agreement and other
partnership documents must be thoroughly analyzed before the valuation analyst
can begin to render an opinion of value.
The final report must at least contain certain information
about the assignment - the nature of the interest being valued, the terms of
the partnership agreement, and the financial condition of the entity. This
discussion is designed as an overview of the FLP valuation process and the
items to consider. It is designed to help you prepare valuation reports more
effectively and perhaps minimize the opportunity for the IRS to challenge your
opinion of value. This discussion also assumes that the reader has a basic
understanding about FLPs. Please note that FLP is being used as a generic term
in this paper. Many attorneys are currently using Limited Liability Companies
(LLC), rather than Limited Partnerships, but the overall structure of the
transaction and the valuation issues are the same.
WHAT IS A FLP? A FLP is a nontaxable entity that is created
and governed by statute and whose partners (both general and limited) and
assignees consist mainly of family
members. Many of the issues that arise in appraising FLPs become legal
interpretations of the partnership agreement, rather than A pure valuation
issues. Although as a valuation analyst, it is important that we know and
understand the issues, it is imperative that we leave the lawyering to the
lawyers. If there is any doubt in the valuation analysts mind regarding the
nature of the assignment or the terms of the partnership agreement, the clients
attorney should be the one to explain it to the valuation analyst, not the
other way around.
PENALTIES: Valuation analysts should be warned that applying
discounts too enthusiastically can backfire. Section 6701 of the IRC imposes
civil penalties on valuation analysts of $1,000 for aiding and abetting an
understatement of tax liability.
The IRS could also impose an administrative sanction barring
the valuation analyst from submitting probative evidence in future IRS
proceedings. For these reasons, the
report must be prepared judiciously and every statement be carefully documented
and presented in such a way that the valuation conclusion can be replicated and
understood by those for whom it is intended.
The valuation analyst should also be aware of the new
appraiser penalty rules that were described in the Pension Protection Act of
2006. Although these penalties specifically apply to valuations for charitable
contribution purposes, many believe that they will ultimately be extended to
appraisals of property for income and transfer tax purposes. The penalties fall
into two categories, a “gross valuation misstatement” and a “substantial
valuation misstatement.” For more information about the Pension Protection Act
and its affect on appraisers, see Pension Protection Act Changes Valuations for
Tax Purposes (http://aicpa.org/pubs/jofa/sep2007/crain.htm).
STARTING THE ASSIGNMENT: The valuation analyst should obtain
a retainer agreement (and a retainer) from the client which should spell out the precise nature of the
assignment the analyst is going to perform.
In order to prepare a thorough analysis and report, the valuation analyst
needs the following information:
1. The name of the client, i.e., the person who engaged the
valuation analyst. The client is
responsible for identifying the nature of the interest to be appraised.
2. The nature of the interest being appraised, e.g., general
partner interest, limited partner interest, limited liability company member
interest, assignee interest. It is important to note that what is being
appraised is not a percentage interest in any or all of the assets owned by the
FLP, but rather an interest in the FLP itself.
3 The size of the interest being valued. Size can be represented by a percentage
interest amount, number of units or shares, or even dollar amount.
4 The valuation date, and the purpose for which the
valuation is being performed, i.e., whether it isfor estate planning (gifting)
or estate valuation purposes.
5 The standard of value. The retainer agreement should
provide a definition of the standard of value that will be determined in the
appraisal. These are defined in the following tax regulations:
- Estate planning (gifting) -
Treasury Regulation 25.2512-1
- Estate valuation (after death) - Treasury Regulation
20.2031-1(b)
Both of these sections define the standard of fair market
value as follows:
The fair market value (of the property being valued) 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 sell and both
having reasonable knowledge of relevant facts.
WHAT DOCUMENTS ARE NEEDED?
1 The FLP Agreement
(or other type of business agreement depending upon the form of the entity), as
well as a copy of the Certificate of Formation
that has been filed with the state where the entity has been
created. If the valuation analyst is not
familiar with the statutes of the state of formation (whether limited
partnership or limited liability company), it should be obtained. Most of them
are on line at the various Secretary of State’s websites.
2. A list of the assets that were initially contributed to
the partnership, as well as documentation of any assets that were contributed
after the formation of the FLP.
3. Valuations of real estate and other assets held by the
FLP as of the valuation date (for example, market values of marketable
securities). If the FLP owns interests in other closely held businesses or
partnerships, these interests must be separately appraised before the value of
the LP interest can be determined.
4.Financial statements and/or tax returns for the
partnership for a reasonable number of years, or since inception. If it is a
new partnership, these will not exist.
5.The general partner s anticipated policies regarding
distributions or a Section 754 election.
6. If the FLP is ongoing, a history of distributions, if
any, made to partners.
REVENUE RULING 59-60: Revenue Ruling 59-60 provides basic
guidelines for appraising shares of closely held corporations. It is also a valuable guide to appraising
FLPs. Every valuation report of a FLP
interest should closely follow Section 4 of Revenue Ruling 59-60, which
enumerates the factors the valuation analyst should consider in his or her
valuation.
CHAPTER 14: Chapter 14 of the IRC was enacted in October 1990, and outlines the
special valuation rules that must be adhered to when valuing interests in
closely held companies and partnerships. The basic premise behind this section
is that when valuing business interests that are to be transferred between
family members, the valuation analyst should ignore restrictions that would not
exist if the transaction was between unrelated third parties.
This Chapter consists of only four sections; three of which
actually relate to family limited partnerships.
If the partnership does not comply with the provisions of this Chapter,
the IRS may determine that the partnership does not exist for tax purposes and
value the underlying assets directly in calculating the applicable gift or
estate tax. The provisions of the Agreement should comply with the sections of
Chapter 14; however, it is up to the attorney to make sure that the Agreement
is legally binding, not the valuation analyst’s.
THINGS TO CONSIDER IN THE APPRAISAL PROCESS: The basic
characteristics of the transferred interest in the FLP, combined with specific
provisions in the FLP agreement and under state law, form the foundation for
the valuation adjustments used in arriving at the fair market value of the
transferred interest in the FLP. Some of
the factors to be considered in determining appropriate valuation adjustments
are:
- Provisions in
the Partnership Agreement
- A provision (term-of-years
provision) in the partnership agreement that the partnership shall continue to
exist for a definite term-of-years, unless it is dissolved or liquidated prior
to this date.
- No guarantee by the managing
general partner or general partners of the return of any partners capital contributions,
nor any allocations of profits or losses nor any distributions of distributable
cash (not even enough to cover the annual taxes of the partners).
- Approval rights of limited partners
required for certain major decisions, otherwise limited partners and assignees
are excluded from participation in management.
- How the election of new managing
general partners is accomplished.
- A provision that distances the
limited partners and assignees from the assets of the FLP.
- The managing general partner(s)/general
partner(s) right to determine distributable cash.
- Capital call provision obligating
partners and assignees.
- Limitations on the voluntary and
involuntary transferability of general partner, limited partner and assignee
interests.
- The presence of rights of first
refusal.
- A transferee or assignee of an
interest in the partnership will not become a substituted limited partner
unless approved by the consent of all partners.
- Whether the managing general
partners or general partners are required to make a IRC Section 754 Election.
- Limitations on the right of the
general partner, to withdraw from the partnership prior to the expiration of
its stated term and to provide that, should the general partner exercise his or
her power to withdraw early, his or her general partner interest shall become a
limited partner interest and he or she may also be subject to damages for
breach.
- Limitations on the right of a
limited partner and assignee to withdraw from the partnership prior to the
expiration of its stated term.
- Provisions for dissolution of the
partnership mirrors the provisions of state law.
Factors Not Found in the
Partnership Agreement
- The reputation, integrity and
perceived competence of the partnership management/general partner(s).
- The number of investors in the
partnership.
- The type of assets owned by the
partnership.
- Whether or not the assets of the
partnership are well diversified.
- The amount of financial leverage
inherent in the partnership s capital structure.
- The caliber of the information flow
from the partnership and the general partner(s).
- The current and historical amount
of cash actually distributed to partners and assignees.
- Underlying cash flow coverage of
yearly distributions made to partners and assignees.
- The size of the interest.
- The universe of interest buyers.
- The default rules under state law.
WHAT ABOUT METHODOLOGY? What is the best approach to use to
value a FLP interest? Which methods can
and should be used? Section 5 of Revenue
Ruling 59-60 states in part:
- (a) ... in general,
the valuation analyst will accord primary consideration to earnings when
valuing stocks of companies which sell products or services to the public,
conversely, in the investment or holding type of company, the valuation analyst
may accord the greatest weight to the assets underlying the security to be
valued.
- (b) The value of the
stock of a closely held investment or real estate holding company, whether or
not family owned, is closely related to the value of the assets underlying the
stock. For companies of this type the valuation analyst should determine the
fair market values of the assets of the company. Operating expenses of such a company and the
cost of liquidating it, if any, merit consideration when appraising the
relative values of the stock and the underlying assets. The market values of the underlying assets
give due weight to potential earnings and dividends of the particular items of
property underlying the stock, capitalized at rates deemed proper by the investing
public at the date of appraisal. A
current appraisal by the investing public should be superior to the
retrospective opinion of an individual.
For these reasons, adjusted net worth should be accorded greater weight
in valuing the stock of a closely held investment or real estate holding
company, whether or not family owned, than any of the other customary
yardsticks of appraisal, such as earnings and dividend paying capacity. This
would seem to imply that some type of asset-based approach would be the most
appropriate if, indeed, the only approach to appraising a FLP interest. Whereas an asset-based approach might be a
frequently used approach to valuing such an interest, it is by no means the
only one. Often an income approach may
be used as well. The approach to be used
may be determined by the underlying assets of the FLP or whether or not there
is a history of distributions to the partners and how extensive and consistent
the distributions were. Depending on the assets held by the partnership, a
market approach could also be utilized. Depending on the circumstances of the
case, more than one method may be appropriate.
- In Estate of Etta H. Weinberg, et al. V. Commissioner (TC
Memo 2000-51), the Court accepted both an income approach and an asset-based
approach to determine the value of decedent s minority interest in a limited partnership
that owned and operated an apartment complex.
The Court found that the taxpayers use of the net asset value method
under the asset-based approach was warranted since the property would retain
most of its inherent value regardless of rental income production. Furthermore,
The Court found that the capitalization of the three-year average of
distributions under the income approach was also appropriate. The findings of
The Court illustrate that the reliance on one approach (particularly the
asset-based approach) for the valuation of FLPs is not always sufficient or
relevant.
- In deciding on the methodology to apply to the valuation of
partnership interests, When valuation consultants use an asset based approach
to value a FLP interest, the restrictions in the partnership agreement are
often the sole justification for the amount of the discounts. In these cases,
the IRS attempts to disregard the restrictions for valuation purposes by
demonstrating that the terms of the partnership agreement are onerous and not
comparable to arm s-length transactions. If the restrictions are disregarded,
the IRS then argues to invalidate the partnership agreement for valuation
purposes, resulting in a significant increase in the value of the limited
partnership interest. While this rationale has not been proven in tax court,
the IRS has used it to successfully negotiate with taxpayers for an increase in
the amount of gift and estate taxes that would have otherwise been paid. If the
valuation is determined using the income and market approaches and does not
rely solely on the restrictions in the partnership agreement, it is more
difficult for the IRS to dispute the valuation.
Asset Based Approach:
Obtain fair market value of all assets and liabilities on the balance sheet and
apply appropriate discounts (for lack of control and marketability).
Income
Approach: Determine cash flow available to partners, and capitalize
or discount as appropriate. Apply discount for lack of marketability (no
discount for lack of control necessary as cash flow capitalized or discounted
is the amount available to the minority owner, and therefore, the result is a
minority value).
Because of what Section 5 of Revenue Ruling 59-60 says, many
analysts do not think that an income approach is appropriate when valuing an
interest in a FLP. However, a minority owner cannot force the sale of the underlying
assets of a business, and although the valuation analyst applies a discount for
lack of control to account for this (among other factors), does the discount
truly account for the inability of the minority owner to obtain the value of
the underlying assets? Valuation theory
discusses this issue and textbooks state that the asset based approach is generally
inappropriate when valuing a minority interest unless the holder has the right to
liquidate the entity or sell off the assets and distribute the proceeds.
There is generally no plan to sell the assets before an FLP
before termination, which is generally at least 20 to 30 years from the date of
inception. Therefore, it seems that if an FLP generates income, this reflects
and actual return to the minority owner, and should be considered in the
valuation process. However, if the FLP
is not distributing the income, the minority owner may be faced with a similar
situation as under an asset based approach – there is income, but the minority
owner does not receive the benefit of it.
Another issue in applying an income approach is the amount
of income earned. Very often, the
investment earnings or net rental income is very low, but the growth in the
assets is large. Unless there is a plan to sell the assets at a definitive time
in the future, the return to the minority owner is a low level of income that
does not truly reflect the value of the assets.
However, the appraiser should still remember that the minority owner cannot
force the sale of the assets, and therefore, the assets do not have as much
value to a minority owner.
Another potential problem that exists is the selection of a
discount or capitalization rate, especially if the holdings are marketable
securities. Although market-derived rates of return are available, they are
usually derived from ownership of the
underlying assets However, the valuation assignment is to value an interest in
a holding company, and therefore, adjustments must be made to the
market-derived rates to adjust for risk.
Market Approach:
Determine valuation multiples by looking for comparable publicly traded
interests, The appropriate multiple could be price to NAV (net asset value),
adjusted for the risks associated with your specific valuation assignment. From
a practical standpoint, this is generally the same as the asset-based approach.
VALUATION
ADJUSTMENTS: Valuation adjustments are supposed to reflect the lack of
control inherent in limited partnership interests and the lack of marketability
any type of closely-held partnership interest endures. These are two separate
issues that usually result in two separate adjustments or discounts. The Courts recognize the necessity for these
discounts, but often disagree with how much of a discount may be allowed. Fair
market value is determined by the nature of the interest transferred. Unless the partners agree to admit the
transferred interest as a partner, it is an assignee interest. Therefore, the hypothetical willing buyer would consider as
significant whether or not the other partners would admit him or her as a
partner with all the rights that go with being a partner.
Sources of rates of return include The Wall Street Journal,
Ibbotson Associates, National Association of Real Estate Investment Trusts
(NAREIT).
Sources for comparable (guideline) data are Closed End
Mutual Funds (The Wall Street Journal, Morningstar) and Partnership Spectrum
published by Partnership Profiles, Inc.).
An assignee interest has only an economic interest in the
partnership. That is, he or she has a
right to receive distributions, if any, and to distributions on
liquidation. An assignee interest has fewer
rights than a limited partner.
A limited partner, like a minority shareholder, does not
have the ability to get at the partnership assets, either to manage them or
dispose of them. A limited partner may
have little or no say in partnership management issues. And, like a minority shareholder, a limited
partner does not control distributions.
These are all prerogatives of management or, in the case of the limited
partnership, the general partner, or the general partner who has been
designated as the managing partner.
The hypothetical willing buyer most likely would not pay
liquidation price (pro rata of the underlying assets) for a limited partner or
assignee interest in a limited partnership.
What a willing buyer would pay would be something less than liquidation
value in order to receive a return on his or her investment. This is the basis for valuation adjustments
or discounts.
The analyst must read the partnership agreement carefully to
determine what the rights and duties of both types of partners are. The voting rights of the limited partners
should be determined. These are the
types of things that will contribute to the size of the discount for lack of
control.
Discount for Lack of
Control: The types of assets owned by the partnership must be considered
when finding a starting point for this discount.
Although a FLP could hold almost any type of asset, most
FLPs own either marketable securities, real estate, or some combination of
both. Marketable securities: A logical reference point when valuing such a FLP
is a closed-end investment company.
It is best to use closed-end investment companies (mutual
funds) that hold publicly traded securities that are similar to the securities
held by the FLP, such as domestic stocks, foreign stocks, speciality funds,
corporate bonds, municipal bonds, or government bonds. There are many other types of funds.
Typically, these funds trade at discounts to their net asset
values (NAVs). Statistical efforts to
determine a definitive explanation for these discounts have failed to reveal a
reason for the discounts. In any event,
the discounts (and premiums) observed in the marketplace serve as a proxy for
the lack of control discount. The reason
that they serve as a proxy is that holders of closed end funds have the same
lack of control over the underlying assets that a limited partner in a FLP has.
It is presumed that these discounts represent the market s decrease in value
for not having access to the assets, and not having any control over them.
Whether the valuation analyst adjusts these discounts before
applying them to his or her FLP interest is a question of specific facts and
circumstances of your particular valuation. If you believe that the interest
you are appraising has less control, then you might increase the discount, and
vice versa.
Another issue relates to the similarities of the portfolios. The
valuation analyst might believe that his or her portfolio would trade at a
higher or lower discount. Whatever position the valuation analyst takes, the
discussion should include all the reasoning behind the adjustments.
This discount only pertains to the issue of lack of
control. It has nothing to do with
marketability factors. The perceived
riskiness of any individual security in the FLP s portfolio will be reflected
in the market value of that security.
Any adjustments the analyst might be tempted to make because the
partnership interest is not as easily traded as a share in a closed-end mutual
fund should be avoided. That is a
different discount.
The analyst might not need a discount for lack of control if
he or she utilizes an income approach and the benefit stream is already on a
minority basis.
There are several factors that might be considered in making
adjustments to the starting point for the discount for lack of control.
Remember that adjustments should be reasonable and reflect the facts of the
particular FLP interests.
- Professional management: Many FLPs
do not have professional management, while closed-end funds do. This would
drive the discount higher.
- Regulation: Closed-end funds are
regulated by the SEC; the FLP investor enjoys no such protection.
- Diversification and size: The FLP
portfolio may not have the same level of diversification as a closed-end fund. One can look at specialized funds which
invest in one industry as a comparison.
FLPs are often very tiny compared to closed-end funds. This might increase the discount.
- Investment objective: A FLP
portfolio may reflect no defined investment policy or objectives. This may be a lack of professional
management.
- Quality: Speculative versus
investment grade. Recall, however, that
the security s market price should reflect the market s opinion as to its
overall quality. Avoid double counting
in the discount.
- Performance: If the FLP has been in
existence for a while, its total return might be compared with that of various
similar closed-end funds.
- Average maturity: For fixed income
portfolios, average maturity of the bonds will affect their market values. Again,
this factor should be addressed in the price of the security. However, recent
court cases have frowned on adjustments to the lack of control discount because
they cannot be supported. Recent decisions have used an average or median
discount of the selected funds. Valuation analysts often use the median
discount because it eliminates outliers from the data. However, if you have already
eliminated the outliers, you may be overcompensating by using the median of a
smaller group of funds. Therefore, be consistent with the data that is used.
- Real Estate: Very often, a FLP will
hold one or more pieces of real property.
These might range from the family home to vacation property, vacant
land, a farm, or some income producing real property, such as apartments, retail,
or office space. The analyst should
review these assets carefully in order to determine the nature of each, as this
will affect the selection of discounts.
A starting point for determining lack of control discounts
for FLPs owning real estate would be real estate limited partnerships
(RELPs). These partnerships have been in
existence for a number of years and a body of data has been accumulated on many
aspects of them. A fairly liquid
secondary market for RELPs exists. It is
nowhere near as liquid as a stock exchange, but enough transactions take place,
that there is good data on the discounts at which these securities trade to
their NAVs. Recently they have begun extensive reporting on a secondary market
for non-publicly traded real estate investment trusts (REITs).
Data on this market has been gathered by Partnership
Profiles, Inc. since 1990. Partnership
Profiles issues a bi-monthly publication entitled Direct Investment Spectrum
which offers general commentary about the secondary market for RELPs and
REITs. Operating data for five years are
provided where available, including information on cost of properties owned,
percentage leverage, gross revenues, net income, cash flow, working capital,
and a history of distributions to partners.
This data can be accessed through their Minority Interest
database at www.partnershipprofiles.com. An annual subscription can be
purchased for unlimited searching of their data.
The following factors can influence the price of a RELP in
the secondary market.
- The type of real estate assets
owned by the partnership.
- The amount of financial leverage
inherent in the partnerships capital structure.
- Underlying cash flow coverage of
yearly distributions made to partners.
- The caliber of the information flow
from the partnership and the general partner.
- Whether or not the assets of the
partnership are well diversified.
- The reputation, integrity, and
perceived competence of the management/general partner.
- Liquidity factors such as: how
often a partnership interest trades, the number of investors in the partnership,
the time period until liquidation, the universe of interest buyers, whether the
partnership is publicly or privately syndicated, and the presence of rights of
first refusal.
- Whether or not a FLP has a history
of making distributions is an important consideration in determining the discount. Generally, partnerships which make
distributions trade at smaller discounts to their NAVs, all other things being
equal. The amount of debt is important
as well. If the appraisal FLP has no
debt, it should be compared to partnerships that have little or no debt as
well.
- Consider as many comparable
partnerships from this study as possible.
Courts have maintained that more comparables are better than fewer, and
certainly better than only one.
Discount for Lack of
Marketability: An additional adjustment is often made to account for the
fact that there is no secondary market for FLP interests, nor is one ever
likely to develop. These interests lack
marketability; that is, they cannot be liquidated or converted to cash
quickly. If one owns shares of a
publicly traded corporation, one may call a broker, sell the shares and have
the cash proceeds within a few business days.
Not so with FLP interests, and this is the basis for the
discount for lack of marketability or DLOM.
In addition to the lack of a secondary market for FLP
interests, certain provisions are often written into FLP agreements restricting
the transfer of interests, especially to individuals or entities outside the
family circle.
These restrictions create an additional lack of
marketability factor. Some of them are:.
- With some exceptions, a general
partner, limited partner or an assignee may not transfer all or any part of his
or her interest without the prior written consent of the general partners, which
consent may be given or withheld at the discretion of the general partners.
- A transferee of an interest in a
FLP shall only be entitled to the rights of an assignee unless the consent of all
general partners and a majority in interest of the limited partners is given to
make the transferee a substitute limited partner.
- No partner or assignee shall have
the right to withdraw from the FLP prior to its dissolution and liquidation..
- No partner or assignee may withdraw
or reduce his or her capital contribution or capital account without the consent
of the general partner.
Other Provisions Affecting
Marketability
In addition to provisions in the Agreement which restrict
transfer, a history of little or no dividends or distributions from the FLP to
the partners is a factor that affects marketability. A willing buyer might be more inclined to
ignore restrictions on transfer of his or her interest in exchange for a stream
of cash benefits. However, little or no distribution history is common with
FLPs, which often retain income and gains in order to fulfill the long-term
investment goals of the partnership.
Another factor that might affect the marketability of a FLP
interest is the 754 Election. This is an election that the partnership might
make under IRC Section 754, which provides that the partnership may elect to
adjust the inside basis of the partnerships underlying assets. In other words,
the partnership can adjust its internal books to show that a new partner paid a
higher price for assets that are worth more at the time of the purchase (transfer).
This election would not affect the existing partners, but it would have
positive tax consequences for a new partner.
If there is nothing in the Agreement that addresses the 754
election, it does not mean that the partnership cannot make the election. It still can.
However, a willing buyer might wish to have assurance that such an election
will be made. This is especially
critical if the appraised fair market value of the underlying assets of the partnership
have increased in value over their original basis. Since there is considerable record keeping involved
once this election is made, a FLP may be reluctant to make the election.
However, the courts seem to believe that a buyer would never purchase without
making sure that a 754 election is in place, so although many smaller
partnership do not and will not make a 754 election, the courts will not
necessarily accept this as a legitimate reason for increasing the discount.
When valuing a general partner interest, some consideration
may be given to an additional marketability factor reflecting the liability
exposure assumed by the general partner and that under many states partnership statutes,
a majority of the limited partners may remove a general partner that assigns
all of the general partners interest in a FLP to a third party. Here, the analyst must read the Partnership
Agreement carefully to determine under what circumstances a general partnership
may be transferred or whether, after withdrawal of a general partner, that
general partner interest becomes a limited partner interest. In this case, the DLOM might be increased.
A FLP can require additional capital from the partners in
order to meet operating expenses and have extra capital for partnership requirements. This type of provision is not included in
every FLP Agreement, but its presence may warrant an additional lack of
marketability factor. Capital calls
might require that an interest holder remain liquid in order to meet them,
rather than place funds in a higher yielding but less liquid investment. A willing buyer would give this additional
liability exposure and potential loss of a more favorable investment rate of
interest consideration in determining value and so does the business valuation
analyst when valuing the interest in the FLP.
Sources of
Marketability Discounts: The sources for discounts for lack of
marketability for FLP assignments are the same as for all valuation
assignments, restricted stock studies and pre-IPO transactions. The valuation analyst
starts with these studies and then needs to address the facts and circumstances
of the specific valuation assignment to determine the adjustments to the benchmark
discount that will be utilized in the assignment at hand. However, the analyst
can also use the Quantitative Marketability Discount Model (QMDM) to quantify
the methodology. Others use the Mandelbaum factors Mandelbaum v. Commissioner,
T.C. Memo 1995-255 (Affd. 91F.3d 124, 3 rd Circuit, 1996) which include the
following:.
- ·
Financial statement analysis
- ·
Company’s dividend policy
- ·
Nature of the company, its history, its position
in the industry and its economic outlook
- ·
Company’s management
- ·
Amount of control in transferred shares
- ·
Restrictions on transferability of stock
- ·
Holding period for stock
- ·
Company’s redemption policy
- ·
Costs associated with going public
There are several other lists lists of factors to consider
that have been published. The first comes from Guide to Business Valuations (p.
14-34):
Some of the factors that would cause an interest to trade at
a low marketability discount include
- ·
Minimal volatility in the value of the
underlying assets..
- ·
Above average expectations for future yield..
- ·
A proven and stabilized history of income.
- ·
Certainty of distributions or expectation of capital
appreciation.
- ·
Limited time period on restriction of ability to
sell the interest.
- ·
Favorable outlook for future growth of the
entity.
- ·
Factors that would cause an interest to trade at
a higher discount include
- ·
High degree of volatility in the value of the
underlying assets.
- ·
Questionable ability to generate a satisfactory
return on assets.
- ·
Inability to generate sufficient earnings for
distributions or to support future growth in
- ·
operations.
- ·
Small size in relation to other investments and
lack of diversification.
- ·
Involvement in industries or activities viewed
unfavorably by the investing public.
The second comes from an article
published by Robert E. Moroney entitled
Why 25% Discount for Nonmarketability in One Valuation, 100%
in Another?
In Moroneys article, he points out 11 different factors that
should be considered in the application of a DLOM. Some of the are very similar
to the Mandelbaum factors. They are as follows:.
- ·
High dividend yield: Companies that pay
dividends tend to be more marketable than companies that do not.
- ·
Bright growth prospects: Companies that have
bright growth prospects are easier to sell than companies that do not. This makes them more marketable..
- ·
Swing value: If a block of stock has swing
value, it may be more marketable than the typical small block of stock. This swing value could include a
premium. This can be emphasized where a
2 percent interest exists with two 49 percent interests. The 2 percent interest can be worth quite a bit
to either 49 percent interest if it will give that interest control of the
company.
- ·
Restrictions on transfer: Restrictions on
transfer make the stock less marketable due to the difficulty in selling them.
- ·
Buy-sell agreements: Buy-sell agreements can go
either way. The agreement can create a market
for the stock, making it more marketable, or the agreement can restrict the
sale making it less marketable.
- ·
Stocks quality grade: The better the quality of
the stock, the more marketable it will be.
This can be evidenced by comparing the subject company to others for
supporting strengths and weaknesses.
- ·
Controlling shareholders honesty: The integrity
of the controlling shareholder can make a big difference regarding the ability
to sell a partial interest in a company.
If the controlling shareholder tends to deal with the other shareholders
honestly, the other interests in that company tend to be more marketable.
- ·
Controlling shareholders friendliness: Similar
to the shareholders honesty, the manner in which he or she deals with others
can make the stock more marketable.
- ·
Prospects for the corporation: If a corporation
has good prospects for the future, it will generally be more marketable.
- ·
Prospects for the industry: A company that is in
an industry with good prospects will also generally be more marketable.
- ·
Mood of the investing public: When the investing
public is bullish, they are more readily willing to make an investment. This can increase the marketability.
However use of any of these “lists,” is a benchmarking
technique which the courts have been frowning on. They want the valuation
analyst to explain why the studies are relevant to the particular valuation subject.
One additional source of data are two databases that include
specific restricted stock and pre-IPO transactions. Resold by Business
Valuation Resources and located at www.bvmarketdata.com, they are available by
subscription. They are:
a. FMV Restricted Stock Study: This database currently
contains 475 total transactions; including 205 transactions in Manufacturing,
138 transactions in Business Services, 45 transactions in Finance, Insurance
and Real Estate, and 25 transactions in Transportation,Communications,
Electric, Gas and Sanitary services
b. Valuation Advisors Lack of Marketability Discount Study
(pre-IPO): As of July 2007, this database contained 3,547 transactions and over
1,470 companies dating from 1995 to 2006. No breakdown of data by SIC Code was
provided.
Other Potential
Adjustments: There are several other adjustments that may be included in
determining a final value. Some of these adjustments may apply to the value of
the underlying assets, rather than to the value of a FLP interest. In some
cases, these are factors that are considered in the quantification of DLOM,
rather than being included as a separate discount.
1 Fractional interest
adjustment: The fair market value of
an undivided ownership interest in real property is worth something less than
the percentage of ownership multiplied by the fair market value of the real property
as a whole. Fractional interest adjustments
should not be limited to undivided interests in real property, but should be
considered any time a fractional interest is held in any type of property.
2 Portfolio Adjustment:
The basis for a portfolio adjustment is a FLP with a non-diversified portfolio
of marketable securities.
3.Restricted
Securities Adjustment: Restricted securities are those that are acquired
from an issuer in a transaction exempt from registration requirements of
federal and state securities laws (known as A private placements).
There are also restrictions imposed by the SEC. on resales
of these restricted securities. Several Court cases have upheld additional
discounts to account for restricted securities, but if the price of the
security already reflects such a discount, it should not be taken twice.
4.Blockage Adjustment:
This adjustment accounts for the depressive effect of suddenly placing a large
block of stock or real estate on the market.
5.Adjustment for
Built-In Capital Gains Tax: Under the willing buyer-willing seller test,
adjustment may be made for the fact that the underlying assets may now have a
market value greater than book value and that there may be a built-in capital
gain with respect to those assets. If
so, a willing buyer might become responsible for capital gains tax when the
assets were sold. A hypothetical willing
buyer would take this into consideration when evaluating a FLP interest. This issue is also related to the Section 754
election.
THE REPORT: One useful way to present a report is to set it
following the eight factors of Revenue Ruling 59- 60. Remember, the ultimate user
of your report is the Internal Revenue Service. By laying out your report in the
order of the eight factors, you are showing the service that you are
considering each of the factors that they have laid out in their ruling. In
addition, you should include sections relating to capitalization and discount
rates, if appropriate, as well as discounts and premiums.
The AICPA’s Statement on Standards for Valuation Services
states the following:
- The detailed report is structured to provide sufficient
information to permit intended users to understand the data, reasoning, and
analyses underlying the valuation analysts conclusion of value. A detailed
report should include, as applicable, the following sections titled using wording
similar in content to that shown:
- ·
Letter of transmittal
- ·
Table of contents
- ·
Introduction
- ·
Sources of information
- ·
Analysis of the subject entity and related
nonfinancial information
- ·
Financial statement/information analysis
- ·
Valuation approaches and methods considered
- ·
Valuation approaches and methods use
- ·
Valuation adjustments
- ·
Nonoperating assets, nonoperating liabilities,
and excess or deficient operating assets (if any)
- ·
Representation of the valuation analyst
- ·
Reconciliation of estimates and conclusion of
value
- ·
Qualifications of the valuation analyst
- ·
Appendices and exhibits
The valuation analyst should also consider following the
Internal Revenue Services Adequate Disclosure
Rules as laid out in Regulation Section 301.6501.
Essentially, the Internal Revenue Service is telling the valuation analyst that
to pass muster, we must present a fully supported and documented report. This
is not substantially different from the AICPAs Standard, or USPAP....do your
work and report it.
Do not have the reader of the report have to guess about
your methodology, discounts, or
conclusions. For example, you do not want to state...the studies indicate 25 to
45 percent, therefore, we selected 35 percent. This is not supported. There are
numerous court cases which disallow discounts, strictly because the valuation analyst
did something similar to this. You should select a benchmark discount and then
adjust it based on specific items that you discussed in detail in your report.
CONCLUSION: In
conclusion, I would like to emphasize the importance of our role as
valuators. We believe it is important
that the valuation analyst not cross the line from being an independent
valuation analyst to being an advocate of bigger and bigger discounts. This can happen, especially if a client
requests that we review a partnership document with an eye to adding
restrictions and provisions that might increase the discounts.
Although advising an attorney on the provisions of the
agreement is really outside of the scope of the valuation analyst’s assignment,
this does not excuse valuation analysts from being aware of the law, especially
state laws regarding limited partnerships, and limited liability
companies. Key questions to review with
the partnerships attorney might include:
1.What restrictions in the partnership documents are more
restrictive than state law?
2. What is the state law?
Get a copy of the stats limited partnership act and read it thoroughly.
3. Does a limited partner have a right of withdrawal from
the partnership and on what basis?
These issues can impact the valuation opinion. It is
important for the analyst to remember that his or her assignment is the
determination of fair market value. This means the consideration of both a hypothetical
willing buyer, as well as a hypothetical willing seller. Your final opinion of
value must be reasonable.
Remember, the buyer might buy for that low a price, but as
an independent analyst, you must also ask yourself the question, if I was the seller,
would I sell that low?
