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ASA Files Amicus Brief in Lee Case, Discussing FMV Concerns in ESOP Litigation

Responding to the appeal in the Lee case, the American Society of Appraisers recently filed an amicus brief supporting the dismissal of the case. The ASA draws attention to the fair market value (FMV) standard that applies in ESOP transactions and discusses the ESOP community’s longtime concern that the Department of Labor and some courts have all but abandoned FMV in scrutinizing ESOP transactions.

The Lee case arose out of the 2016 sale of shares in a construction company to an ESOP. The defendant trustee oversaw the transaction, and an experienced ESOP appraisal firm prepared the valuation underlying the transaction and subsequent annual valuations. The ESOP paid $198 million for an 80% ownership stake in the company. The transaction was financed with a loan from the company and the selling shareholders received warrants that would enable them to acquire additional voting stock. A 2016 year-end annual appraisal, which came 18 days later, valued the shares at $64.8 million.

The plaintiff’s complaint suggested that the two figures showed the trustee caused the ESOP to overpay for company stock. Last fall, a district court dismissed the case, finding the plaintiff had no standing as she failed to show she had suffered an injury. The plaintiff appealed the dismissal with the 4th Circuit Court of Appeals, and the Pension Rights Center (PRC), a nonprofit consumer organization, has filed an amicus brief supporting the appeal. The trustee has defended the dismissal of the case.

Not like a PE buyer: The ASA describes itself as the “largest multi-disciplinary organization devoted to the appraisal and valuation profession” whose members “regularly advise ESOP trustees on the FMV of employer stock for purposes of ESOP transactions, annual ESOP valuations, and other ERISA matters involving FMV appraisals.” Much of the ASA brief counters PRC’s argument that ESOP trustees should, but don’t, act like “real-world” buyers of companies, i.e., private-equity (PE) buyers. Some courts, too, “have been misled into error” on this issue, the ASA says. “Practices of PE buyers are incompatible with ERISA’s requirements and fundamental valuation principles,” the ASA brief contends.

No ERISA provision says a transaction is unlawful unless the ESOP trustee pursues the “lowest price possible for the ESOP” that a real-world (PE) buyer might pay, the ASA brief says. Rather, the valuation standard “specifically” required for ESOP transactions is the FMV. This is also the standard used for annual ESOP valuations, the brief notes. And it is the standard used in the Tax Code and regulations, in the Bankruptcy Code, and by a wide variety of statutes, the brief points out.

FMV is “not the lowest possible price a PE buyer might pay,” the ASA states. Instead, it is an “objective assessment of market forces, and it accounts for competing forces of sellers as well as buyers, both of whom seek to maximize gain.” PE buyers, the brief explains, don’t use the FMV standard for valuations. Rather, they look to “investment value,” a subjective estimate of what a specific buyer or group of investors might pay based on “subjective, personal parameters.” “PE valuations are guided by the rate of return an investor seeks,” the brief explains. In other words, a PE valuation does not consider the pressure “by a seller seeking the highest price.”

The ASA brief claims that, unlike a PE buyer, an “FMV appraiser adheres to valuation principles.” “The ESOP trustee’s statutory obligation to act in good faith does not require it to reject an FMV appraisal performed in accordance with valuation principles,” the brief says.

The ASA challenges a host of other claims about ESOPs that appear in the plaintiff’s and PRC’s briefs and “which are designed to color this Court’s views of ESOPs.” All of the claims are false, the ASA brief says. It notes that, in rejecting the plaintiff’s appeal, the 4th Circuit “has the opportunity to correct misimpressions that have been subjecting ESOPs to unjustified attacks.”

Stay tuned for further updates on this case.

A digest of the district court’s ruling in favor of the defendants in Lee v. Argent Trust Co., 2019 U.S. Dist. LEXIS 132066 (Aug. 7, 2019), and the court’s opinion are available to subscribers of BVLaw. Digests for Brundle v. Wilmington Trust N.A., 241 F. Supp. 3d 610 (E.D. Va. 2017); Brundle v. Wilmington Trust N.A., 258 F. Supp. 3d 647 (E.D. Va. 2017); and Brundle v. Wilmington Trust N.A., 919 F.3d 763 (4th Cir. 2019), and the courts’ opinions also are available at BVLaw.

Global BV News: Higher Multiples for Cross-Border vs. Domestic Buyouts Per New Study

An analysis of over 1,000 global private equity transactions reveals that cross-border buyouts are associated with significantly higher valuation multiples than domestic ones, says a new study. The authors attribute this finding to informational disadvantages of foreign acquirers.

They also find that, consistent with this idea, “the spread in valuation multiples becomes smaller when the target operates in a country with high accounting standards, when it was publicly listed prior to the buyout, and when information production is facilitated due to large firm size.” The study, “Cross-Border Buyout Pricing,” is available if you click here.

In a Crunch, Court Adopts Company’s DCF Model as Fair Value Indicator

In a statutory appraisal action prompted by the 2016 buyout of minority shareholders by the controller of a private company, the Delaware Court of Chancery recently found there was no meaningful market-based evidence of fair value and neither expert opinion, based on standard valuation methods, was “wholly reliable.” Forced to decide, the court adopted one expert’s discounted cash flow analysis.

‘Monumentally different valuations’: In 2012, McWane Inc. bought a controlling stake in Synapse Wireless (Synapse), an “internet of things” (IoT) company. IoT was seen as a growth industry, but Synapse never lived up to its promise. The company kept missing management’s projections by a wide margin and became reliant on ongoing funding from McWane to keep operating. The 2012 merger agreements gave McWane a right to buy newly issued Synapse shares at a per-share price based on the 2012 merger, as well as a right, beginning in 2018, to require the remaining minority shareholders to sell their stock to McWane.

In late 2013, McWane sued Synapse, alleging breaches and misrepresentations. The litigation settled in late 2015, with McWane winning a reduction in price of its call option to $0.42899 per share, reduced from the $4.997 per share it paid in 2012. McWane also secured a right to exercise the call option immediately and did so in early 2016. At that time, it acquired ownership of 99.346% of Synapse by offering shareholders $0.42899 per share. The petitioner rejected the offer and asked the Delaware Court of Chancery for a fair value determination under the state’s appraisal statute.

At trial, the parties offered expert testimony. Both experts used the same three valuation techniques (analyses of prior purchases of company stock, comparable transactions analyses, and discounted cash flow models). The experts even “materially agreed on several important inputs,” the court observed. However, “as has become standard fare for appraisal litigation, the experts reached monumentally different valuations,” the court said.

In a nutshell, the petitioner’s expert arrived at a fair value of $4.1876 per share. The company’s (respondent’s) expert declined to provide a single valuation, but his summary values ranged from $0.06 per share to $0.11 per share.

The court rejected the market-based evidence, including McWane’s acquisitions of Synapse stock preceding the 2016 merger. Neither the stock purchases following the 2012 merger nor the 2016 merger took place in a competitive market, the court said. As for the 2012 merger, the court said this transaction was “stale” and did not represent evidence of Synapse’s value at the time of the 2016 merger. Synapse, in 2016, faced different prospects than it did in 2012, the court noted.

‘Dicey valuation method’: The court also rejected the experts’ comparable transaction analyses, calling this approach “a dicey valuation method in the best of circumstances.” The experts’ DCF valuations also had “significant flaws,” the court said. It found particularly troubling both experts’ reliance on management projections, considering Synapse’s consistent failure to meet forecasts.

Normally, the court said, a fact-finder might determine neither party met its burden of proof and neither was entitled to a verdict. However, the statute required the court to provide a fair value appraisal. Therefore, the court decided to rely on the company expert’s DCF (with a slight adjustment), noting the expert “credibly made the best of less than perfect data to reach a proportionately reliable conclusion.”

The fair value of the company on the merger date was $0.228 per share, the court concluded—a notable drop from the $0.42899-per-share price McWane had offered to the dissenting shareholder in the context of the squeeze-out merger.

A digest of Kruse v. Synapse Wireless, Inc., 2020 Del. Ch. LEXIS 238 (July 14, 2020), and the court’s opinion will be available soon at BVLaw.

5th Circuit Upholds Tax Court’s Characterization of Interest and Discount Rulings

Estate of Streightoff v. Commissioner, 2020 U.S. App. LEXIS 10070 (March 31, 2020); Estate of Streightoff v. Commissioner, T.C. Memo 2018-178 (Oct. 24, 2018)

A valuation dispute in an estate tax case turned on how to characterize the transferred interest in the decedent’s limited partnership. The estate claimed it was an assignee interest, whereas the Internal Revenue Service argued it was a limited partner interest. Based on a controlling partnership agreement, an assignee had fewer rights. Consequently, the estate’s valuation experts argued a discount for lack of control was appropriate, while the IRS’ expert said it was inappropriate. Both parties agreed on applying a marketability discount but disagreed over the rate. The Tax Court adopted the IRS’ characterization and discounts. Recently, the 5th Circuit Court of Appeals affirmed the Tax Court’s interest characterization and valuation rulings.

Background. On Oct. 1, 2008, the decedent formed a limited partnership (LP) that was funded by the decedent’s assets. A partnership agreement said the purpose was to manage and preserve the assets and increase wealth. Over 60% of the assets were marketable equity securities, over 20% were fixed-income investments in municipal bonds, and about 13% were investments in mutual funds. The LP had a sole general partner (GP), which managed the partnership subject to limitations in the partnership agreement. The decedent’s daughter managed the GP. The LP was subject to Texas state law.

The decedent had an 88.99% limited partner interest in the partnership. The GP (management company) held a 1% ownership interest, and the decedent’s children held the remainder of the LP interests.

A partnership agreement (PA) gave limited partners some control. For example, it said that limited partners owning 75% or more of the partnership interests held by all limited partners could remove the general partner. If the partnership ended because of the removal of the GP, 75% of the limited partners could rebuild the partnership and elect a successor general partner. Also, 75% of the limited partners could approve the admission of additional limited partners. Further, 90% of the partnership interests could terminate the LP by written agreement.

Some transfer restrictions applied. A limited partner needed written approval from the general partner to sell or assign his or her interest in the LP. An “unadmitted assignee” (one who was never admitted as a substituted LP) was entitled to allocations and distributions but had no right to information or data related to the affairs of the partnership or to inspect the partnership’s books, or have the rights of a general partner or limited partner under the applicable Texas state statute.

Under the partnership agreement, an assignee could become a substituted limited partner if the assignee met three conditions: (1) there was consent by the general partner; (2) the interest transferred was a permitted transfer (as defined by the PA); and (3) the transferee executed the documents necessary to confirm the transferee was bound by the PA. A substituted limited partner had the same rights as an original limited partner.

Further, on Oct. 1, 2008, the decedent set up a revocable living trust and transferred his 88.99% LP interest to the trust. He was the sole beneficiary of the revocable trust and had power to change or terminate it during his life. The daughter who managed the company that held the GP interest served as trustee for the revocable trust.

The transfer occurred via an “Assignment of Interest” agreement that designated the decedent the “assignor” and the trust the “assignee.” Under this transfer agreement, the decedent transferred with the LP interest “all and singular the rights and appurtenances thereto in anywise belonging.” By signing the agreement, the revocable trust agreed to be bound by the partnership agreement. The decedent’s daughter signed the transfer agreement as holder of the decedent’s power of attorney, trustee of the revocable trust, and representing the management company that was the general partner.

The decedent died in May 2011. In August 2012, the estate filed an estate tax return in which it said the transferred interest was an assignee interest. The net asset value was about $7.3 million. It discounted that value by 37.2% to report a value of about $4.6 million. In a supplemental statement, the estate claimed discounts for lack of marketability, lack of control, and lack of liquidity.

In January 2015, the IRS issued a notice of deficiency of about $492,000. The service valued the transferred interest in the LP at about $6 million.

Tax court proceedings. The estate filed suit with the U.S. Tax Court, arguing procedural issues related to the IRS notice. The estate also challenged the valuation of the transferred interest.

Type of interest issue. The valuation depended on the type of interest the decedent transferred: assignee interest or limited partner interest.

The Tax Court noted that, under state law, a partnership interest was personal property and could be assigned unless a partnership agreement provided otherwise. Generally, an assignee has a right to allocations of income and distributions, but the assignee is not entitled “to become, or exercise rights or powers, of a partner.” An assignee may become a limited partner as the partnership agreement provides or if all partners consent.

Further, in federal estate and gift tax cases, the doctrine of substance over form applies. “In particular, we have indicated a willingness to look beyond the formalities of intrafamily partnership transfers to determine what, in substance, was transferred.”

The Tax Court found the transferred interest was a limited partner interest. For one, even though the transfer agreement labeled the transfer as an “assignment,” the agreement said the revocable trust was entitled to all rights flowing from ownership of the decedent’s limited partner interest. The court noted that the phrase all “rights and appurtenances” belonging to the decedent meant the right to vote as a limited partner and exercise the powers of LP holders under the partnership agreement.

Further, the court noted that the transaction met the conditions specified in the partnership agreement for admitting the transferred interest as a substituted limited partner. In signing on behalf of the general partner, the daughter consented to the transferee’s admission. The parties stipulated the transfer qualified as a permitted transfer. The trust agreed to be bound by the terms of the partnership agreement. The daughter signed the assignment agreement on behalf of the trust.

The form of the agreement supported the conclusion that the transferred interest was a limited partner interest, as did the economic realities underlying the transfer, the Tax Court found. Only the general partner had the right to direct the partnership’s business; neither limited partners nor assignees had managerial rights. Even if an assignee had no right to books and records of the partnership or inspection of documents, in reality this made no difference here as the daughter was in control of the general partner and also was the trustee of the revocable trust, the Tax Court said.

Moreover, the court noted that the partnership agreement’s provision that the assignee did not have the right to vote as a limited partner had no practical significance regardless of whether the interest was a limited partner interest or assignee interest. The reason was that the limited partners never voted on anything after execution of the agreement. Further, during his life, the decedent could revoke the transfer to the revocable trust. Had he done so, he would have held all the rights of a limited partner, including the right to vote on business matters.

The Tax Court characterized the transferred interest as a limited partner interest.

Valuation issues. The next issue concerned the implications of that characterization for the fair market value determination of the transferred interest. Did discounts apply, and, if so, which ones, and at which rate?

Both parties presented valuation expert testimony. All experts (one for the IRS and two for the estate) considered the LP an asset holding entity. The parties stipulated to the NAV of the LP on an alternative valuation date.

“Fair market value,” under estate tax regulations and Tax Court case law, has been defined as “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.” “The hypothetical willing buyer and the hypothetical willing seller are presumed to be dedicated to achieving the maximum economic advantage.”

DLOC. The IRS’ expert proceeded from the assumption that the contested interest was a limited partner interest. The expert found that, under the partnership agreement, the decedent’s 88.99% interest held considerable influence and control over the management of the LP. She noted the provision that limited partners with a 75% interest had the power to remove general partners. Further, the partnership terminated if the general partner was removed. The expert said a buyer of the decedent’s interest would pay more for the degree of control flowing from that interest. She concluded it was inappropriate to apply a discount for lack of control (DLOC).

In contrast, the estate’s experts prepared a valuation based on the assumption that the transferred interest was an assignee interest. As such, they found that none of the control-related benefits available to limited partners under the partnership agreement were available to the assignee interest. The experts found a 13.4% discount for lack of control was appropriate.

The court quickly resolved the issue, noting, since it found this was a limited partner interest, the interest did not lack control and there was no case for use of a discount for lack of control.

DLOM. Both parties’ experts used the Mandelbaum factors in determining the discount for lack of marketability.

The Mandelbaum case requires an analysis of several factors, including: (1) the entity’s financial condition; (2) the entity’s capacity to pay and history of paying distributions; (3) the nature of the entity and its economic outlook; (4) the management of the entity; (5) the amount of control held by the interest; (6) restrictions on the transferability of the interest; (7) the required holding period for the interest; (8) the entity’s redemption policy; and (9) the costs associated with making a public offering. See Mandelbaum v. Commissioner, T.C. Memo. 1995-255, aff’d, 91 F.3d 124 (3d Cir. 1996) (available at BVLaw).

The IRS’ expert agreed that it was appropriate to apply a DLOM because there was no ready market for interests in privately held entities. The discount could “entice prospective buyers.” She relied on data from restricted stock studies that showed a trend toward a decreasing DLOM rate in more recent years. The trend coincided with amendments to SEC regulations shortening the holding periods for purchasers of restricted stock to resell their interests.

The expert also noted that the LP’s financial condition was strong, and the entity was capable of making distributions each year. Diversification and high liquidity of the assets made the contested interest very attractive to a hypothetical buyer. Further, the decedent’s interest had a significant amount of control, which also favored lowering the discount rate. In addition, the partnership agreement provided for right of first refusal to family members, the partnership, and the general partner, which also weighed in favor of a lower discount. The IRS’ expert proposed an 18% DLOM rate.

In contrast, the estate’s experts relied on older restricted stock studies from a period when SEC regulations prescribed the longest holding periods for restricted stocks. Assuming this was an assignee interest, the estate’s experts found the interest holder would not be able to force liquidation. They found a higher rate relative to the rates in the restricted stock studies was appropriate.

The estate’s experts acknowledged the risk factors for the partnership favored a lower discount. As for distributions, the experts relied on statements from the entity’s representatives that there would be no distributions in excess of the partners’ tax liability in the foreseeable future. This policy, the experts argued, favored a higher discount rate. They concluded that a 27.5% DLOM rate was appropriate.

One of the estate’s experts testified that his analysis would have been different valuing the contested interest as a limited partner interest, considering the rights under the partnership agreement.

The Tax Court said it agreed with all experts that it was appropriate to use a DLOM. Since the court had concluded the interest was a limited partner interest, the estate experts’ rate, based on the assumption of an assignee interest, was too high, the court said. It adopted the 18% DLOM rate the IRS’ expert proposed.

Appeals court proceedings. The estate appealed the Tax Court decision with the 5th Circuit Court of Appeals, challenging the characterization of the transferred interest (as well as the validity of the deficiency notice).

The 5th Circuit noted that, even though the transfer document labeled the transaction an assignment, “the unambiguous language of the Assignment purports to convey more than an assignment interest.” The court pointed to the language “all and singular the rights and appurtenances thereto in anywise belonging.” There was no limiting or restrictive language, the court said. Therefore, it was “difficult to reconcile the Estate’s characterization of the Assignment given the document’s language.” Further, the daughter’s signature represented that the LP recognized this permitted transfer conveyed “all and singular … [the LP’s] rights and appurtenances” of the decedent. This encompassed the 88.99% limited partnership interest.”

The 5th Circuit also said it agreed with the Tax Court’s substance-over-form rationale. The assignment lacked economic substance outside of tax avoidance, the court said. Although the entities’ limited partners in theory held certain managerial and oversight powers that assignees did not have, “there were no practical differences after the Assignment was executed.” Besides the daughter, no other limited partners seemed to exercise their rights or responsibilities. There was no attempt to remove the general partner, and the partnership did not hold meetings or votes. “Without genuine nontax circumstances present, the Assignment is the functional equivalent of a transfer of limited partnership interest,” the court said.

In a footnote, the 5th Circuit said how the interest was classified “is significant in terms of the degree of control” of the LP. Holding an 88.99% unadmitted assignee interest provided no right to an accounting of the affairs of the partnership. On the other hand, under the PA, the holder of an 88.99% LP interest needed only one additional limited partner’s agreement to terminate the partnership. Of course, the PA also specified rights applicable to a limited partner owning 75% of the LP or more.

In another footnote, the 5th Circuit said the estate also challenged the Tax Court’s valuation by failing to recognize the assignee interest in the limited partnership. Rather than a disagreement with the Tax Court’s value determination, the dispute turned on the interest characterization, the 5th Circuit said. In affirming the Tax Court’s classification of the contested interest as a limited partnership interest, the 5th Circuit said it also affirmed the Tax Court’s estate valuation.

Calculations of Value Are Admissible in Divorce, Alabama Appeals Court Confirms

Horne-Ballard v. Ballard, 2020 Ala. Civ. App. LEXIS 50 (May 1, 2020)

About two years ago, in Rohling v. Rohling, an Alabama appeals court upheld a trial court’s decision to admit into evidence a qualified expert’s estimate about the value of the owner spouse’s business based on a calculation engagement. Recently, the admissibility of calculations of value became an issue in another divorce case, presenting the appeals court with an opportunity to overturn Rohling. The court declined.

Whether calculations of value have any role to play in business valuation, and particularly in the litigation context, has been a contentious topic among appraisers (as BVWire readers know), and courts have not been uniform in their positions. In Alabama, however, the issue seems now settled.

Weight, not admissibility: In the instant case, the flashpoint was the value of the wife’s medical practice. The trial court awarded the wife sole ownership of the practice and the husband $550,000 in alimony in gross. The trial court did not make a specific finding of value. But, based on the alimony amount, the wife assumed the trial court used the value estimate of the husband’s expert.

This expert, an experienced CPA and valuator, used a calculation of value, which, she explained, was different from an opinion of value. She said her approach eliminated some calculations that she did not believe were appropriate in this case and (as reported in the appeals court opinion) said “that a calculation of value requires less speculation than does an opinion of value.”

The wife at various points in the proceeding objected that a calculation of value was not as thorough as an opinion of value and was not admissible under the state’s Rule of Evidence 702, governing admissibility of expert testimony.

The trial court found the expert qualified and the testimony admissible. It said any objections to the methodology went toward weight and the expert’s credibility. The husband’s expert proposed a value of $2.5 million for the practice. In contrast, the wife’s expert, also an experienced CPA and valuator, provided an opinion of value that put the value of the practice at $241,000. He explained the additional factors and calculations that were involved in preparing the more thorough opinion of value.

In challenging the trial court’s divorce judgment with the state Court of Civil Appeals, the wife claimed the trial court had erred in admitting into evidence the testimony of the husband’s expert. The expert used an unreliable methodology that produced an estimate that was speculation and, therefore, was inadmissible. The wife said an opinion of value, as prepared by her expert, was “much more exacting” than the opposing expert’s calculation of value. The wife asked the appeals court to overrule Rohling v. Rohling.

The reviewing court rejected the request and declined to “make a determination as to which methodology is best in valuing assets in the context of a divorce action.” As it did in Rohling, the appeals court said it would not substitute its judgment as to the weight to be given to an expert’s testimony for that of the trial court. The trial court’s judgment stood.

Court Says Reduced Minority Discount Appropriate Where Minority Interest Has Elements of Control

Nelson v. Commissioner, T.C. Memo 2020-81 (June 10, 2020)

Two issues dominated this gift tax case in which the donor transferred limited partner interests into a trust. The taxpayers, by way of the limited liability company, held a stake in a successful family business that owned several operating subsidiaries. One issue concerned the nature of the taxpayers’ transferred interests based on the language in the transfer documents. The other issue related to the appropriateness of discounting for lack of control in determining the fair market value of certain subsidiaries. The taxpayers’ expert found a discount for lack of control was justified because she valued all subsidiaries on a controlling interest basis. The Internal Revenue Service’s trial expert argued that each subsidiary was already valued on a noncontrolling basis, making it unnecessary and inappropriate to adjust for a lack of control. The Tax Court adopted a third way.

Transfer of LP interests. The taxpayers (husband and wife) owned stock in a very successful business the wife’s father had built. The company, Warren Equipment Co. (WEC), was a holding company that owned 100% of each of its seven subsidiaries.

Two subsidiaries stood out. The largest, accounting for 51% of WEC’s value, was Warren Cat, which operated as the exclusive dealer for Caterpillar engines and earthmoving equipment in a prescribed territory. Warren Cat was subject to Caterpillar’s sales and service agreements, including restrictions on selling the rights to the Caterpillar dealership.

Another subsidiary, Compressor Systems Inc. (CSI), made up 45% of WEC’s value. CSI’s main business was selling and renting gas compression equipment to the oil and gas industry as well as providing financing and maintenance for the equipment.

The other five subsidiaries made up the remaining percentage.

The wife and her siblings held most of the WEC common stock. A shareholder agreement imposed stock transfer restrictions. The wife held her interest in WEC stock indirectly through a company called Longspar that was set up in 2008 as a limited partnership as part of a tax planning strategy. The goal was to protect assets, make gifts without fractionalizing interests, and ensure the wife’s family would keep control of WEC. Longspar owned about 27% of WEC common stock.

The wife and her husband were Longspar’s sole general partners, together holding a 1% general partner interest in the LP. Under Longspar’s partnership agreement, only the general partners had full control over the expenditures, incurring debts, use of partnership assets, distributions, and hiring advisors. Limited partners had no control over the company’s management, excepting the power to veto certain activities. The partnership agreement also included transfer restrictions related to the general and limited partners’ interests in Longspar.

As part of a succession plan, on Dec. 31, 2008 (valuation date), the wife made two transfers of LP interests in Longspar to a trust. One transfer involved a gift. The language in the transfer instrument said the wife desired to make a gift “having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of December 31, 2008) …, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.”

In a second transaction a few days later, the wife sold her interest in Longspar. The memorandum of sale noted the transfer of an interest “having a fair market value of TWENTY MILLION AND NO/100THS DOLLARS ($20,000,000.00) as of January 2, 2009 …, as determined by a qualified appraiser within one hundred and eighty (180) days of the effective date of this Assignment.”

In connection with the transfers, an appraiser found the FMV of a 1% limited partner interest in Longspar was $341,000. This appraisal was based on a valuation of WEC common stock by an Ernst & Young (E&Y) valuation analyst.

The appraisal of the Longspar interests concluded that the limited partner interests transferred amounted to 6.14% and 58.65% of Longspar to the trust.

Ultimately, the IRS determined the wife and husband (petitioners) had undervalued the Dec. 31, 2008, gift as well as the Jan. 2, 2009, transfer. The taxpayers challenged the IRS’ findings with the U.S. Tax Court. The petitioners contended the first transfer of a limited partnership interest in Longspar (Dec. 31, 2008) was a gift and the second transfer (Jan. 2, 2009) was a sale.

Applicable legal principles. The court first stated the law regarding the transfer of property by gift.

Where property is transferred for less than “adequate and full consideration,” the amount by which the value of the property exceeds the value of consideration is considered a gift. For federal tax purposes, gift tax does not apply to a transfer for full and adequate consideration. A transaction between family members is “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.” See Frazee v. Commissioner, 98 T.C. 554 (1992), aff’d without published opinion, 786 F.2d 1174 (9th Cir. 1986).

As for the law related to valuation, if a gift involves the transfer of property, “the value thereof at the date of the gift shall be considered the amount of the gift.” The applicable standard of value is the fair market value. The fair market value of the gifted property is defined as “the price at which it would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Willing buyer and willing seller in this context are “purely hypothetical” figures. Determination of FMV in a closely held entity depends on consideration of all relevant facts and circumstances, which include discounts for lack of control and lack of marketability.

Dollar amount or percentage interests? The court first decided whether the transfer of the LP interests involved the specific dollar amounts stated in the transfer instruments—$2.096 million and $20 million—or whether the instruments indicated a transfer of percentages in Longspar (i.e., 6.14% and 58.65%).

The court said it would look to the transfer documents rather than subsequent events to decide the amount of property the taxpayer gifted. It noted the language of the transfer provisions required transfer of an interest having a specified fair market value as determined by an appraiser within a specified period of time. In other words, fair market value here was qualified by the clauses “qualified appraiser” and the fixed time period. Therefore, the court, agreeing with the IRS, concluded the transfer involved fixed percentages, not dollar amounts, of limited partner interests in Longspar.

Valuing holding company. The Tax Court was presented with valuations from three experts. Two experts testified on behalf of the petitioners: the Ernst & Young appraiser who valued the WEC common stock as well as the second appraiser who valued the transferred limited partner interests in Longspar. The court found both of these experts were eminently qualified.

The IRS offered testimony from an equally experienced appraiser and expert witness. The court said it “recognized all three as valuation experts.”

The experts agreed that a valuation of the transferred Longspar limited partner interests necessitated a valuation of WEC common stock. Both parties relied on the valuations by the E&Y valuator. In essence, this expert valued each subsidiary. She did this by grouping the subsidiaries and applying what she considered to be the most appropriate valuation method for each group. She then combined the values of the subsidiaries, subtracted WEC’s debt and preferred stock, and arrived at a total FMV for WEC on a controlling interest basis, she said. The E&Y expert applied a 20% minority discount and a 30% discount for lack of marketability.

The IRS’ expert agreed in principle with the opposing expert’s value determination before discounts, and he accepted the E&Y expert’s use of a 30% discount for lack of marketability (DLOM). At the same time, the IRS’ expert found the valuations resulted in a noncontrolling valuation; therefore, it was inappropriate to apply a 20% minority discount. He critiqued aspects of the various valuations.

For example, to value Warren Cat, the largest subsidiary of WEC, as well as two smaller subsidiaries dealing in heavy equipment, the Ernst & Young valuator used the net asset value method. She reasoned the various service and sales agreements that were binding on each subsidiary did not allow for the use of the income approach. Also, in actual market transactions, the value of these dealers was based on their net asset values, the expert explained.

The IRS’ expert, referencing Shannon Pratt’s treatise, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (4th ed., 2000), argued that the E&Y appraiser had only valued Warren Cat’s tangible assets. Because she failed to value the company’s intangible assets, which were present, she generated a valuation on a noncontrolling interest basis, which in turn precluded application of a minority discount, the IRS’ expert said.

The court disagreed with the IRS expert’s reasoning, finding that, in other cases dealing with valuations of dealerships, the Tax Court had disregarded intangible assets such as goodwill. Further, the court said, here, the E&Y expert did consider Warren Cat’s intangible assets; specifically, she considered the restrictions in the service and sales agreements, which she found represented a large part of the company’s intangible assets. The restrictive terms in the agreements applicable to each of three subsidiaries “may eliminate the value of the subsidiary’s intangible assets to a hypothetical buyer,” the court said. It concluded the E&Y expert had determined fair market value on a controlling interest basis.

The E&Y expert valued three other subsidiaries, including the relatively large CSI (representing 45% of WEC’s holdings), under the income approach, specifically using a discounted cash flow analysis. She used cash-flow projections based in part on discussions with management. To determine the applicable discount rate for the projections, she considered comparable guideline companies. To determine whether minority discounts were appropriate, she considered factors such as operating margins, excess assets, and excess salaries for management. She reasoned that elements of control would not accrue to minority shareholders of a publicly traded company and concluded minority discounts were necessary for the instant valuations.

For two companies, she also prepared valuations based on the market approach, finding there were enough comparable publicly traded companies. In addition, she conducted an analysis of similar transactions for which she created a specialized transaction multiple based on discussions with management.

The IRS’ expert contended the income approach resulted in fair market valuations of noncontrolling interests. The projections underlying the E&Y’s expert’s valuations did not include specific assumptions as to a shareholder’s ability to get more for a controlling interest than a noncontrolling interest. Also, the IRS’ expert said, the opposing expert’s DCF analysis failed to consider the effect of other factors, including increased profits or changes in capital structure that typically differentiate a controlling interest from a noncontrolling interest. The IRS’ expert also found the E&Y expert’s market analysis flawed, particularly the expert’s decision to decrease the multiples for the subject companies to reflect differences with the guideline companies and then to apply control premiums to offset the decrease. The IRS’ expert said the multiples for the guideline companies the E&Y expert used in her analysis already represented minority marketable multiples. A downward adjustment of the multiples still resulted in values for noncontrolling interests. Applying a minority discount to those values was improper, the IRS’ expert said.

The court agreed with the IRS’ expert that, under the income approach, the Ernst & Young appraiser had failed to consider factors that distinguished a controlling interest from a noncontrolling interest. But, the court noted, Pratt’s treatise on valuation also stated that “[e]ven minority shares can have some elements of control. These elements of control may reduce, but rarely eliminate, the discount for lack of control.” Based on Pratt’s treatise, the court, in earlier decisions, had found that a discount for lack of control did not apply under three scenarios: blockage power, swing vote, and takeover protection.

The Tax Court found here these types of control were not present. “WEC’s interests involve minority shares with elements of control for which a discount for lack of control should be reduced but not eliminated,” the court concluded.

On the other hand, the court found the valuations resulting from the market approach were on a noncontrolling interest basis. It noted that the E&Y expert’s decision to reduce the multiples undermined her analysis as this move suggested that her guideline companies were not sufficiently similar to the subject companies. Moreover, the court said the expert failed to find comparable transactions for her specific transaction multiple, causing the court to reject this valuation method.

Size of minority discount. In valuing WEC’s common stock, the court was presented with a 20% minority discount the petitioners’ expert proposed and no minority discount at all based on the IRS expert’s proposition that all valuations were on a noncontrolling interest basis.

The court, looking at prior decisions related to valuations of minority interests in holding companies, found a 15% minority discount was appropriate. The court also adopted the E&Y expert’s 30% DLOM.

Valuing transferred LP interests. The next step in the valuation process was valuing the limited partner interests in Longspar. All experts agreed to value Longspar as a holding company and used the E&Y appraiser’s valuation of WEC as a starting point where WEC common stock made up about 99% of the value of Longspar’s assets.

The petitioners’ second appraiser used a net asset valuation. He started with the E&Y expert’s fair market value determination of WEC common stock (applying both a DLOM and minority discount) from which he deducted Longspar’s liabilities to arrive at a controlling, marketable value of the company. He removed the 1% general partner interests and applied a 15% minority discount and a 30% DLOM to arrive at the value of the transferred limited partner interests. From this value, he determined the value of a 1%, 6.14%, and 58.65% LP interest in Longspar.

This appraiser explained a minority discount was justified because a hypothetical buyer of a limited partner interest in the company would not have control over management of Longspar; another consideration was that one family, rather than a group of investors, controlled 100% of Longspar interests. For the minority discount, the appraiser considered 43 closed-end funds but ultimately found only three funds were comparable to Longspar.

The IRS’ expert used a similar method but removed the minority discount in the E&Y expert’s valuation of WEC common stock. He considered 30 closed-end funds. His analysis found that none of the funds were comparable to Longspar. He concluded there would be almost no lack of control disadvantage to a minority owner in Longspar except “under certain circumstances, the precise nature of which cannot be exactly determined with reference to empirical/market data.” He calculated a 5% minority discount by making two reductions to the average discounts for his sample funds.

The court, based on its earlier conclusion that a 15% minority discount was appropriate to value the WEC common stock, noted that both experts’ starting valuations required adjustments.

In valuing the LP Longspar interests, the court rejected both experts’ analysis and discounts. A discount to reflect the possibility of a lack of control disadvantage to a minority owner of Longspar was appropriate, the court found. It said it would not endorse either expert’s calculations, but it agreed with the IRS expert’s proposed 5% minority discount.

Both experts agreed that a DLOM was appropriate. The petitioners’ expert used a 30% rate; the IRS’ expert proposed a 25% DLOM. The court, finding the IRS expert’s analysis of this issue was more thorough, nevertheless declined to adopt his 25% rate, finding the expert did not adequately justify his selection of 25% over 30%. The court decided to apply a 28% DLOM, noting this was the median of the ranges the IRS’ expert calculated under various analyses.

Conclusion. The Tax Court found the transferred limited partner interests in Longspar were percentages rather than specific dollar amounts.

Further, the court found the starting point of the valuation was a fair market value determination of WEC common stock, the holding company that made up most of the value of Longspar. In that connection, the court found that the valuations of WEC subsidiaries produced values of interests with some elements of control. As this was the case, a reduced discount for lack of control was appropriate (15%). Not to allow for any minority discount would be unreasonable. A 30% DLOM also applied.

Using the fair market value of WEC common stock as the starting point for valuing the limited partner interest in Longspar, the court also applied a 28% DLOM and a 5% minority discount to the LP valuations.

Buy-Sell Stock Agreement Does Not Determine Value of Owner Spouse’s Separate Property

Bates v. Bates, 2020 Tenn. App. LEXIS 312 (July 9, 2020)

This divorce case essentially was an appreciation in value case. The question was whether the trial court undervalued the husband’s separate property by improperly relying on a buyout provision in a corporate agreement. The value of the separate property was the starting point in determining the extent to which the husband’s interest had increased in value by the time of the divorce proceedings. The higher the value of the separate property, the lower the increase in value and, by extension, the amount subject to equitable division. The appeals court found the agreement was not applicable but substituted an alternate valuation the wife’s expert had prepared for trial that valued the company using standard methods. One takeaway from this case is that it may serve a litigant to offer an alternate valuation, as doing so may shorten the litigation.

Husband acquires interest in car dealership. The husband and wife were married twice, a fact that had a bearing on the valuation issues in the case.

During the first marriage, in 1994, the husband acquired a 20% interest in the car dealership for which he worked. The owner of the dealership and the husband signed a buy and sell stock agreement (agreement) that said the owner would transfer 80 shares to the husband in exchange for the husband’s continuing work as general sales manager. The agreement said the husband’s 80 shares were worth $2,500 each. The company’s value was stated as $1 million. Accordingly, the husband’s interest at that time was worth $200,000 and the owner’s interest was worth $800,000.

The agreement also provided that, if the company terminated the husband for a specified reason, he had to sell back to the company the 80 shares acquired under the agreement for $1,250 per share. He had to sell back shares later purchased, if any, for $2,500 per share. The agreement also provided that the company would buy the owner’s shares in case of incapacitation or death for $2,500 per share and that both parties would see to a smooth transition of the remaining ownership interest to the husband.

The husband and wife first divorced in 1997.

The husband and wife remarried in 2001. The husband testified that at that time he still owned the 80 shares he had received under the agreement. However, following the owner’s death in 2007, the husband bought the late owner’s remaining shares (320) for $2,500 each to become sole owner of the dealership.

The husband and wife filed for divorce a second time in early 2018.

The issues during the divorce proceedings were the value of the husband’s 20% separate interest in the company at the time of the parties’ second marriage (2001) and the value of the company at the time of trial.

Both sides offered expert valuation testimony.

Two valuation dates. The parties agreed the 20% interest the husband had acquired before the 2001 marriage was separate property.

To capture the increase in value between the date of marriage (2001) and the date of divorce (2018), two separate valuations were necessary. The difference was marital property subject to division.

The wife’s expert valued the husband’s 20% interest under two different methods.

He first valued the company under the income, asset, and market approaches and combined the results (the court’s opinion does not provide details as to how he weighted the results). The expert concluded the company’s total value in 2001 was $2.1 million. Because the husband had a minority interest, the expert applied a 20% discount for lack of control; further, as this was a closely held company, the expert also applied a 20% discount for lack of marketability. He concluded the husband’s interest, using standard valuation methods, was worth $255,000.

However, the expert also testified the termination provision in the agreement, which required the husband to sell back his shares to the company, if terminated for cause, at $1,250 per share (half the price the husband had paid for the shares) was a “better indicator of value.” Under this provision, the value of the husband’s 20% interest was only $100,000.

The wife’s expert next valued the company at the time of trial. He said he “blended” the value of the tangible assets (book value) and the value of the company’s residual goodwill (intangible asset). He arrived at a total value for the company of $3.5 million.

For his part, the husband’s expert agreed with the wife’s expert that the company’s total value in 2001 was $2.1 million as concerned the 20% interest. However, he also claimed the agreement had capped the value of the late owner’s 80% interest at $800,000. Therefore, the remaining $1.3 million belonged to the husband as accrued equity, the husband’s expert maintained.

As for the value of the company on the date of trial, the husband’s expert said he used a methodology similar to that used by the opposing expert. But, the husband’s expert said, he used nondepreciated values to calculate the net value of tangible assets; he said the opposing expert had used depreciated values. The husband’s expert concluded the company was worth about $3.1 million.

There was a question as to how to treat a $935,000 debt the husband had incurred in connection with buying the outstanding shares in the company. The husband had gotten a bank loan and then used funds from the company to pay off the loan by creating a shareholder receivable.

The wife’s expert said his valuation of the company at the time of trial did not account for the debt, which was money the husband owed the company. He said the trial court either could deduct the amount from the value of the company or could include the amount with the marital debt.

The husband’s expert included the $935,000 in his value determination of the company at trial.

The trial court found the testimony of the wife’s expert more credible than the opposing testimony. For purposes of setting the value of the 20% interest that was separate property, the court agreed with the wife’s expert that the termination provision in the agreement was controlling. The court said it was “the most compelling evidence of the value of the stock because it was agreed to by [Husband and the late owner].” The court subtracted this amount from the total value of the company, as stated by the wife’s expert (i.e., $3.5 million), to arrive at an increase in value of $3.4 million. The court said this amount was a marital asset. It divided the entire marital property “50-50” and awarded each party $2.3 million.

Classification and valuation of property. The husband appealed the value findings with the state’s appeals court. The main contention was that the trial court undervalued the 20% separate interest, in part by relying on the termination provision in the agreement.

The state Court of Appeals first explained the applicable law.

Tennessee is a dual property state, requiring the trial court to first classify the parties’ assets as separate or marital property and then valuing the assets for the purpose of equitable division.

Only marital property is subject to division. In essence, separate property is property a spouse owns before marriage. This may include “[i]ncome from and appreciation of property owned by a spouse before marriage except when characterized as marital property under the statute.” See Tenn. Code Ann. § 36-4-121(b)(1) and (2).

After classifying the property, the court should “place a reasonable value on each piece of property subject to division.” In valuing a marital asset, the court should consider “all competent and relevant evidence pertaining to the valuation of that asset.” Classification and valuation issues are questions of fact. For purposes of review, the appeals court will presume the trial court’s findings are correct “unless the evidence preponderates otherwise.” The appeals court gives “considerable deference” to the trial court’s assessment of a witness’s credibility.

The Court of Appeals agreed with the husband that the trial court erred in basing the value of the 20% separate interest on the agreement.

The court noted that, in a prior 2000 decision, Harmon v. Harmon, after reviewing case law from other jurisdictions, the Court of Appeals adopted the majority view that “the value established in the buy-sell agreement of a closely-held corporation, not signed by the nonshareholder spouse, is not binding on the nonshareholder spouse but is considered, along with other factors, in valuing the interest of the shareholder spouse.” See 2000 Tenn. App. LEXIS 137, 2000 WL 286718 (March 2, 2000) (available at BVLaw).

The court said, here, the wife had not signed the agreement and the values stated in the agreement were not binding on her.

There were other reasons why the termination agreement did not control the valuation of the 20% interest, the court found. It noted the agreement became effective only if the husband was terminated, which he never was. Further, the husband had no intention of selling his shares. For all of these reasons, it was a mistake for the trial court to use the agreement to value the 20% interest, the Court of Appeals concluded.

At the same time, the appeals court found the alternate valuation the wife’s expert proposed “provided the appropriate valuation.” It was based on accepted valuation methods, the court noted. Further, the expert considered the value of the company’s goodwill, and he explained the reasons for applying discounts. “[T]he evidence does not preponderate against discounting the value by 40%.” The Court of Appeals increased the value of the 20% separate interest from $100,000 to $255,000.

The husband further argued that the value of his separate interest was even higher because of blocking rights and stock options assigned to him in the agreement.

The trial court had dismissed these claims and so did the Court of Appeals, citing to the text of the agreement. There was no language in the agreement that capped the owner’s interest at $800,000 or stated that equity in excess of that amount belonged to the husband, the court noted. Further, there was no language in the agreement that assigned the husband a stock option.

The Court of Appeals did agree that the trial court erred in the division of the marital estate as it did not account for the additional $935,000 in shareholder receivables debt. Therefore, the appeals court remanded for “further consideration in accordance with this opinion.”

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