Friday, March 29, 2013

How to transfer money from China to invest in the US

After months of negotiating an investment for a Chinese national to make an investment in the Pacific Northwest, a final hurdle puts the whole deal in jeopardy... How will the investor legally transfer the needed funds out of China when under China's currency laws no more than $50,000 can be transferred per person annually?

Enter Dorothy Kim, with the Law Firm of  Desh International with a series of solutions to what could otherwise be a deal-killing problem.

... Recently, Chinese investors have become the largest group of participants in the EB-5 visa program. Even with the risks involved in the EB-5 process, there is another challenge for the potential Chinese investor. According to the EB-5 visa program investors are required to invest $1 million or $500,000 into the U.S. Yet under China’s current currency laws, the State Administration of Foreign Exchange (SAFE) has restricted its citizens to exchanging only $50,000 U.S. dollars per person annually. This makes it very difficult for investors to legally transfer sufficient funds for their EB-5 investments.
So how do Chinese investors get their money out of China and into the U.S. EB-5 investments? There are a few ways to accomplish this. The first, and most common, solution that Chinese investors use is the assistance of family and friends. The investor transfers $50,000 worth of Chinese Yuan Renminbi to ten (or twenty) family members and friends, trust them to exchange the money into U.S. dollars, and then transfer it to the investor’s designated U.S. account.
            However this approach complicates the issue of tracing the source of funds. The investor must trace each transaction from the investor’s account to the ten (or twenty) family members and friends, then to the investor’s overseas account, and then finally to the Regional Center or new commercial enterprise. To make the funds easier to trace the investor should acquire bank statements that show the transfers between all the accounts involved, which also include the bank statements of the individuals that assisted the investor in transferring the money.
The second means of transferring money out of China is similar to the first approach, in that a third party is used. Here the money is transferred to a trusted third party’s China-based account, then the third party transfers money from their own Hong Kong-based account to the investor’s U.S. account. In this scenario, the investor should not only provide bank statements to demonstrate the transfers between all the accounts for tracing purposes, but also an affidavit from the third party to fill in the space that is created during the tracing of the funds.
            The third method is for the investor to take out a loan. This can be through a home equity loan or a loan through the investor’s own business. However the investor must prove that the loan is secured by the investor’s personal or real property, and not the investment itself. In the case of a home equity loan, the investor must provide both the loan origination documents and documents of home ownership to demonstrate the origin of the loan. However, if the loan is from the investor’s own business, then the investor must provide ownership of the company share, board of director approval, and payments on the loan.
            The fourth and final approach to this issue is for the investor to retain a Chinese licensed lawyer to assist them in getting approval from SAFE to transfer out more than $50,000. This is recommended under any approach to determine the best way to transfer funds out of China under the current currency restrictions.
            Whichever method a Chinese investor chooses, they must understand the issues on source of funds and tracing, or their EB-5 application may be delayed or rejected even though the money has been transferred to the U.S. Thus, careful planning and documentation of the lawful source of funds with understanding of the issues is necessary.

Friday, March 22, 2013

America’s 10 Greatest Presentation Fails

Don’t let your business dreams be ruined by the Powerpoint slides that accompany your pitch.

I recently blogged about overused images in presentations which leave the audience cringing.

I also run across many situations where the entrepreneur would have been better off “going solo”… ie talking to the audience without visuals

Here’s my list:

America’s 10 Greatest Presentation Fails

10) The projector burns out…leaving the presenter frustrated and angry. Bring paper copies of your slides to be safe.
9) Animation induces nausea

Great presentation poorly received by a group of angels when the presenter used excessive animation.

8) Presentation in the cloud…can’t get online

Remember not every office/venue has wi-fi!

7) Mac slides reformat in Windows

Defense attorney Joe Lopez learned this one the hard way last September with his client Drew Peterson’s life on the line.

6) Politically incorrect images

The cartoon that had those Rotarians rolling on the floor, may elicit a completely different reaction at the American/Asian Roundtable. Know thy audience!

5) The Remote takes on a life of its own

…want to move from slide 1 to slide 2…but it goes sailing past… along with slide 3, 4 and 5. Now how do I get back from slide 6 to slide 2…panic!

4) Too many slides, too little time

…guaranteed to induce panic in the speaker.

3) Dark font on a dark background

…and its ugly sister the light font on a light background.

2) Who fired the proofreader?

…typos send a loud message…I’m highly unprofessional.

1) You probably can’t see this but…”

…too much crammed on one slide rendering it unreadable…a waste of everyone’s time!

As the ability to present your business effectively is critical to the success of all entrepreneurs, my next post will deal with how to reduce the risk of your perfect pitch being destroyed by a huge fail in your accompanying slides!

Thursday, March 21, 2013

Seven not-so-obvious factors which influence private business valuations

Most businesses are complicated. As a result, assessing the financial value of a business is also complicated, which is why the services of an experienced valuation expert are often needed. There are countless factors that a valuator considers when valuing a business. Some of these are self-evident, whether or not you’ve ever seen a valuation report. Of course, a valuator will assess certain characteristics of the business, including products and services offered, industries served, key management, etc. The valuator will analyze the subject company’s financial statements (to get a grasp of historical performance and the current state of the business). The expert will also formulate, often with the help of management, financial projections for the company, under the premise that the value of a business is directly related to its future performance capabilities. Lastly, the expert will also evaluate the size of the ownership interest to be valued, mostly as it relates to a control or minority position in the subject company.

While these factors may be fairly obvious to financially-savvy businesspersons, there are other not-so-obvious factors that valuators consider as well. The factors discussed below, while they may be overlooked by managers or others, will be given proper attention by a quality valuator:

1 Company-Specific Risks:
Business risks can impact a company’s cash flows as well as its general health. Aside from normal business risks, such as the risk of an economic recession, there are company-specific risks. These risks are called non-systematic business risks in the financial world, and one of the most common risks for mid-market private companies is key management risk - when a company is dependent on a few key individuals or suffers from a general lack of management depth. Other company-specific risks include key customer risk (if the business has only a few major clients), key supplier risk, pending litigation, unnecessary debt burden, etc.

2 Working Capital Management:
Cash flow is the primary driver of a company’s value. Cash that is tied up in current assets such as accounts receivable or inventory is cash that cannot be distributed to shareholders, and may result in the need for additional debt financing (which would also impact value).

3 Upcoming Capital Purchases:
 In a similar vein, cash that will be needed for a large capital purchase (such as a building addition or a major piece of equipment) is cash that cannot be distributed. It will be important for management to determine whether the rate of return for such an expenditure justifies its purchase.

4 Other Classes of Equity:
 Stock options, warrants, phantom stock, and  other equity-based incentive compensation, can dilute the value of a company’s common stock. Stock options can cause dilution even when currently out-of-the-money (a popular misconception).

5 Shareholder Policies:
A discount for lack of marketability is typically applied to an ownership interest in a private company (particularly noncontrolling interests). There are certain shareholder policies that can often enhance or detract from a stock’s marketability. The existence of a buy-sell agreement (or another vehicle by which
a shareholder can achieve liquidity) enhances a stock’s marketability and generally leads to a lower marketability discount. Similarly, a distribution policy that provides shareholders with a meaningful, consistent return on their investment also enhances a stock’s marketability.

6 Existence of Potential Buyers:
Similar to buy-sell agreements and a shareholder-friendly distribution policy, the existence of potential buyers of the subject company is beneficial to shareholders, particularly minority interest shareholders. The availability of potential buyers shortens the expected holding period for an investor and increases the likelihood of a liquidity event. Which companies have the most potential buyers? Often those in industries that are targeted by private equity investors or subject to consolidation trends.

7 Public Stock Performance/Interest Rates:

A tried and tested economic principle states that the price of a good is influenced by the availability of substitutes. If a potential investor in a private company has more attractive options available
(such as a high interest rate on a bond or booming public stock prices), the investor is willing to pay less for private company stock.

Source BCQ Consulting

How to Achieve Safe Harbor for Stock Options Under S 409a

Trent Dykes on March 09, 2012

As a general rule, all stock option grants need to have an exercise price at or above the fair market value of the company’s common stock on the date such grant is made. This requirement, and its many related complexities, generally comes from Section 409A of the Internal Revenue Code and the related Internal Revenue Service (“IRS”) regulations (collectively, “Section 409A”). Section 409A was enacted several years ago in response to perceived abuse of deferred compensation arrangements brought to light during various high-profile corporate scandals.

The two main penalties imposed by Section 409A for granting a stock option with an exercise price below fair market value are (i) immediate tax upon vesting of the option (as opposed to at exercise or sale) and (ii) an additional 20% federal tax penalty (on top of the regularly applicable federal and state taxes). In addition, some states, such as California, may impose their own Section-409A-equivalent penalty tax. In order to avoid these penalties, the IRS requires that a stock option must be granted with an exercise price no less than the underlying shares’ fair market value determined as of the grant date and that such fair market value must be “determined by the reasonable application of a reasonable valuation method.”

The good news is that Section 409A provides three “safe-harbor” methods for determining fair market value, two of which are most commonly relied upon by startups and venture-backed companies (discussed below). If one of these safe harbor methods is used, then the resulting fair market value is presumed to be “reasonable” unless the IRS can establish that the company’s determination was “grossly unreasonable.”

Most Common Safe Harbor Valuation Methods for Startups

In addition to prescribing general valuation guidelines (discussed below), Section 409A creates a presumption that certain safe harbor valuation methods will result in a reasonable valuation. However, a method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the company’s common stock. Further, a company may not rely on any valuation for more than 12 months. In other words, a company’s valuation must be updated after the earlier of (i) the occurrence of a development that impacts the company’s value (e.g., the resolution of material litigation, the issuance of a material patent, a financing, an acquisition, a new material customer or other significant corporate event) or (ii) 12 months after the date of the prior valuation. The following two safe harbors are most commonly used by startups and venture-backed companies:

1. Independent Valuation.  A valuation will be presumed to meet the requirements of Section 409A if it was performed by a qualified independent appraiser. These qualified independent appraisers range from valuation groups within very large accounting firms to small boutique shops and individuals that focus only on valuation work. In my experience, the cost of an initial independent valuation report ranges from $5,000 to $35,000, depending on the name brand of the firm conducting the valuation and the complexity of the company being valued (i.e., its financials, operations and capitalization). Subsequent “bring-down” updates to the initial valuation are often less expensive than the initial report. That said, given the cost associated with obtaining an independent appraisal (and its subsequent bring-downs), later-stage venture-backed companies often grant stock options less frequently (and instead batch them for board approval in bulk), in order to minimize the need for potentially costly and time consuming bring-down updates.

2. Illiquid Startup Inside Valuation.  A valuation will also be presumed to meet the requirements of Section 409A if it was prepared by someone that the company reasonably determines is qualified to perform such a valuation based on “significant knowledge, experience, education or training.”  Section 409A defines “significant experience” to mean at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the company’s industry. This person does not need to be independent from the company. However, in order to rely on the illiquid startup insider valuation safe harbor:

  • the company must have been conducting business for less than 10 years;
  • the company may not have a class of securities that are traded on an established securities market;
  • neither the company, nor the recipient of the option, “may reasonably anticipate” that the company will be acquired within 90 days or go public within 180 days; and the common stock must not be subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost).

A word of caution, though, given the potential liability involved with performing a valuation in-house:  a startup will want to make sure that they have appropriate D&O insurance coverage and indemnification agreements in place if relying on such safe harbor in order to protect directors and officers from potential future claims related to such valuation.

General Valuation Guidelines

As noted above, in addition to the foregoing safe harbors, Section 409A also contains general guidelines that apply to all valuation methodologies (safe harbor or otherwise) – and a valuation method will not be considered reasonable if it does not take into consideration all available information. Under the general guidelines, all valuation methods must consider the following factors, as applicable:

  • the value of tangible and intangible assets of the company;
  • the present value of anticipated future cash-flows of the company;
  • the market value of stock or equity interests in similar companies and other entities engaged in trades or businesses substantially similar to those engaged in by the company, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm's length private transaction);
  • recent arm's length transactions involving the sale or transfer of such stock or equity interests;
  • and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors.

Which Safe Harbor is Right for My Company?

While understanding these formal legal requirements and the available valuation options is important for any startup granting stock options, in my experience, the safe harbor method a company selects is usually determined largely by its stage of development and available resources (both cash and appropriate personnel).

At Formation.  At formation, before a startup has begun operations or has tangible assets, any valuation method will be difficult to apply. As such, companies often elect to sell or grant restricted stock (rather than stock options) at formation, since restricted stock is generally outside the scope of Section 409A and an error in valuation would not raise the same concerns as with stock options.

Post-Seed Funding.  After a startup has obtained its initial round of seed funding (typically from angels, friends and family), the company will often rely on the illiquid startup insider valuation safe harbor. At such point in a startup’s life, the company will often have an officer who is running the startup’s financial operations and who would qualify to perform such a valuation – where such an officer does not exist, the company may elect to rely on an advisor or board member who possesses the appropriate set of skills.

Post-Venture Capital Funding or Pre-Liquidation Event.  After a startup either has (i) accepted an investment from a venture capital fund (and a VC designated director has joined the board) or (ii) “may reasonably anticipate” that the company will be acquired or go public in the foreseeable future, the company will typically rely on the independent valuation safe harbor. That said, if a venture-backed company is not yet earning revenue and/or a liquidity event in not on the near-term horizon (and the company is very focused on cash conservation), it is not usual for such a company to continue relying on the illiquid startup insider valuation safe harbor (assuming they can get their VC director(s) comfortable with that approach).

As indicated above, an alternative to dealing with Section 409A’s fair market value exercise price requirement is to grant restricted stock, which is not subject to Section 409A. However, it is important to also note that restricted stock grants pose a different challenge – the receipt of restricted stock for services is considered taxable income as the stock vests. See our prior post here regarding restricted stock and making a Section 83(b) election in connection with receipt of such grant.

While not within the scope of this post, it is important to note that the requirements of Section 409A are independent of accounting considerations associated with granting options below fair market value, such as the SEC’s concern with the proper accounting for “cheap stock.”  Such “cheap stock” accounting assessments are performed by the SEC (typically in connection with a company’s IPO registration process) and may result in one-time, non-cash earnings charges on the company’s financial statements

How to value your start-up

"What is the appropriate valuation of my business?" It's one of the questions I get the most often from aspiring entrepreneurs. And what usually sparks it is an upcoming financing or pending takeover offer.
The answer is quite simple: Just as with anything, your business is worth what somebody is willing to pay for it. And the methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry. Here are some ways to value your business in a way that will make sense to you and line up with investor expectations.

To start, let's not forget about the obvious: The natural economic principles of supply and demand apply to valuing your business as well. The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and taking up valuation in the process). And, if you cannot create "real demand" from multiple investors, "perceived demand" can often work the same when dealing with one investor.
So, never have an investor think they are the only investor pursuing your business. That will hurt your valuation. And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation. A competitive commodity business or "me too" story, will be less demanded, and hence require a lower valuation to close your financing.

Another important factor: the industry in which you operate. Each industry typically has its unique valuation methodologies. A next-generation biotech or clean energy business would get priced at a higher valuation than yet another family diner or widget manufacturer. As an example, a new restaurant may get valued at three to four times earnings before interest, taxes and other items, and a hot dot-com business with meteoric traffic growth could get valued at five to ten times revenues. So, before you approach investors with valuation expectations, make sure you have studied the valuations achieved in recent financing or M&A transactions in your industry. If you feel you do not have access to relevant valuation statistics for your industry, engage a financial adviser who can assist you.

Investors will study things like: (i) revenue, cash flow or net income multiples from recent financings in your industry; (ii) revenue, cash flow or net income multiples from recent M&A transactions in your industry; and (iii) a discounted cash flow analysis of forecasted cash flows from your business. These multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ballpark, assume earnings multiples can range from three times to ten times, depending on your "story." And forecasted earnings growth is typically the No. 1 driver of your valuation (e.g., a 25 percent annual net income grower may see a 25 times net income multiple, and a 10 percent annual net income grower may see a 10 times multiple).
If there are no earnings yet, with your business plowing profits into long-term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5 to 1 times range, but in extreme scenarios, can get as high as 10 times for high-flying dot-commers with explosive growth. But that is by far the exception to the rule. And, if there are no revenues for your business -- unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples -- raising funds for your business at any valuation will be very difficult. Investors need some initial proof of concept to get their attention.
Also note: Private company valuations typically get a 25 percent to 35 percent discount to public company valuations. While at the same time, M&A transactions can come at a 25 percent to 35 percent premium to financing valuations, as the founders are taking all their upside off the table.

And, remember, at the end of the day, the investor will have a very good sense to what a business is worth and what they are willing to pay for it. As they see deals all the time and typically have their finger on the market pulse. So, collect a few term sheets from multiple investors, and compare and contrast valuations and other terms, and play them off each other to get the best deal. As a rule of thumb, expect to give up 25 percent to 50 percent of your equity, in your first financing round, depending on the size of the investment and the type of investor (e.g., angel vs. venture capitalist).

Most important, you need to put on the hat of your investor in setting valuation. To get them excited about your startup vs. the hundreds of other startups they see each year, they are looking for that next 10-times return opportunity. So, make sure your three- to five-year forecasted earnings will grow large enough in that time frame to afford them a 10-times return. So, as an example, if you are worth $5 million today, post financing, and the new investor owns 25 percent of the company (a $1.25 million stake), they are going to need a financial plan that will get their stake up to $12.5 million (and the company up to $50 million) within three to five years. Which could mean driving earnings up to $5 million to $10 million within that period. So, do not show them a forecast that grows less than that and make sure you have built a credible financial plan to achieve these levels before approaching investors

By George Deeb
Source Crain Chicago Business

Over-valued Commerical Real Estate Appraisals are rampant

An article in today's New York Times confirms what many have suspected for many years...that the residential real estate appraisal profession needs an overhaul...

...In the recent economic crisis, commercial landlords and lenders discovered myriad ways to find themselves on the brink of financial disaster. Excessive purchase prices — many based on faulty property appraisals — were a major factor, specialists say.

Now, a new study has found just how inaccurate these appraisals can be. Using data from thousands of securitized real estate bonds in which the properties were foreclosed on and liquidated, the study, by KC Conway, an executive managing director at the brokerage firm Colliers International, and Brian F. Olasov, a managing director at the law firm McKenna Long & Aldridge, found a wide discrepancy between the appraisal values and the eventual sales prices of the properties.

“This study confirms what many of us have thought but heretofore have only known anecdotally: That appraisals are not very accurate,” Mr. Conway said. It was published in the winter edition of CRE Finance World, the publication of the CRE Finance Council, and is based on data from the research company Trepp L.L.C. for March 2007 through September 2011.

In general, appraisals overvalued the properties, the study found. Of the 2,076 properties it examined, 64 percent were appraised at values that exceeded the sale price, by a total of $1.4 billion, while 35.5 percent were appraised at less than the sale price, by a total of $661 million.

At the extremes, in 121 instances, the appraised value was more than double the sale price, and in 132 examples, the appraisal was less than 70 percent of the sale price. It is like “a game of horseshoes and throwing grenades,” the authors wrote of the results. “Close is good enough.”

Jay A. Neveloff, a partner at the law firm Kramer Levin Naftalis & Frankel, said, “Appraisals are important in nearly every aspect of a real estate deal, whether it is originating a loan, working out a loan, the decision to buy or sell a property and even bankruptcy.”

Marion T. Jones, a director of the brokerage firm Eastern Consolidated, said a recent appraisal of a development site in Brooklyn overstated the buildable area of the 100,000-square-foot site by as much as 40 percent. “As a result, the entire capitalization of the deal — including the acquisition price and the bank loan — was wrong,” Ms. Jones said.

When the developer realized the mistake, he stopped paying the debt, forcing the bank to foreclose. “The entire deal was derailed by this one bad appraisal, and now the lender is stuck with a site that they never intended to own,” said Ms. Jones, who is showing the site to several potential buyers but declined to name its location because the bank is not officially marketing it.

John Cicero, a managing principal of the appraisal firm Miller Cicero, said: “It is a broken profession in a lot of ways. The appraisal industry has become commoditized, where lenders see appraisals as simply a commodity to be purchased by a vendor and where more emphasis is placed on the price of an appraisal than the expertise of the appraiser.”

For example, Mr. Cicero said, in the past lenders would often have long discussions about the project and the appraiser’s qualifications before hiring. Now, it is more common for lenders to use an online bidding system, where they issue a request for proposals from appraisers and often choose the least expensive. “They actually refer to us as vendors submitting a bid, not educated professionals who are providing an important service,” he said.

Appraisers can serve multiple functions, used by lenders to help determine the size of a loan or by lawyers in litigation or sometimes buyers or sellers looking for market clarity. To conduct an appraisal, they visit sites, speak to brokers in the area, review financial statements like income and expense histories, and examine individual leases. The fee for an appraisal on a small commercial building in Manhattan can be less than $10,000.

“We are supposed to verify the information as much as is reasonably possible,” Mr. Cicero said, “but, unfortunately, so many appraisers rush through the process and don’t do all their homework.”

Bill Garber, the director of government and external relations for the Appraisal Institute, a group that represents about 23,000 appraisers nationally, questioned how the study had been conducted. “The sale price isn’t a good way to evaluate the accuracy of an appraisal,” Mr. Garber said.

“The motivation for why the loans were sold are unclear — maybe they were liquidated under duress and the market price didn’t even play a role,” he said. The only way to judge the accuracy of an appraisal, he argued, is to look at them individually and examine the factors that were used to reach the results.

Still, even a whiff of inaccuracy in appraisals could have broader implications for the commercial real estate market, the authors of the study say. The impact on banks, in particular, could be enormous. While the study tracked only securitized real estate bonds, for which much information is publicly available, they said, details of real estate loans made directly by banks, which are generally not available, would most likely show similar discrepancies.

In the next four years, $1.7 trillion in real estate debt will come due, and banks own roughly half of it, or some $867.5 billion, according to Trepp. So, if appraisals are as inaccurate as this study indicates, it could be assumed that the values of the real estate loans that banks are holding are also far off the mark.

“When you take a look at the 400-plus bank failures that have taken place going back to 2009, the precipitating cost was declining appraisal values” on real estate portfolios, Mr. Olasov. He said that appraisals that indicate a property’s value has declined often force banks to take write-downs, charge-offs and increase loan loss reserves, all of which drain bank capital and, in extreme cases, can lead to bank failures. Mr. Olasov is working with some federal banking regulators to see how the data from this study can be broadly applied to the value of bank real estate loans, although the lack of data on individual loans is slowing the research, he said....

Source New York Times May 8 2012 By Julie Satow

Fair market value of art that can not legally be sold

The IRS's Art Appraisal Unit values a unique piece of art at $65,000,000 by looking at "comparables" even though selling the piece which includes a stuffed eagle is forbidden by Federal Law. Accordingly the beneficiaries had valued the piece at zero for estate tax purposes.

Source New York Times
Art’s Sale Value? Zero. The Tax Bill? $29 Million.

What is the fair market value of an object that cannot be sold?

The question may sound like a Zen koan, but it is one that lawyers for the heirs of the New York art dealer Ileana Sonnabend and the Internal Revenue Service are set to debate when they meet in Washington next month.           The object under discussion is “Canyon,” a masterwork of 20th-century art created by Robert   Rauschenberg that Mrs. Sonnabend’s children inherited when she died in 2007.

Because the work, a sculptural combine, includes a stuffed bald eagle, a bird under federal protection, the heirs would be committing a felony if they ever tried to sell it. So their appraisers have valued the work at zero.

But the Internal Revenue Service takes a different view. It has appraised “Canyon” at $65 million and is demanding that the owners pay $29.2 million in taxes.

“It’s hard for me to see how this could be valued this way because it’s illegal to sell it,” said Patti S. Spencer, a lawyer who specializes in trusts and estates but has no role in the case.

The family is now challenging the judgment in tax court and its lawyers are negotiating with the I.R.S. in the hope of finding a resolution.

Heirs to important art collections are often subject to large tax bills. In this case, the beneficiaries, Nina Sundell and Antonio Homem, have paid $471 million in federal and state estate taxes related to Mrs. Sonnabend’s roughly $1 billion art collection, which included works by Modern masters from Jasper Johns to Andy Warhol. The children have already sold off a large part of it, approximately $600 million worth, to pay the taxes they owed, according to their lawyer, Ralph E. Lerner.

But they drew the line at “Canyon,” a landmark of postwar Modernism made in 1959 that three appraisers they hired, including the auction house Christie’s, had valued at zero. Should they lose their fight, the heirs, who were unavailable for comment, will owe the taxes plus $11.7 million in penalties.

Inheritances are generally taxed at graduated rates depending on their value. In this case, the $29.2 million assessment for “Canyon” was based on a special penalty rate because the I.R.S. contends the heirs inaccurately stated its value.

While art lovers may appreciate the I.R.S.’s aesthetic sensibilities, some estate planners, tax lawyers and collectors are alarmed at the agency’s position, arguing that the case could upend the standard practice of valuing assets according to their sale in a normal market. I.R.S. guidelines say that in figuring an item’s fair market value, taxpayers should “include any restrictions, understandings, or covenants limiting the use or disposition of the property.”

In this instance, the 1940 Bald and Golden Eagle Protection Act and the 1918 Migratory Bird Treaty Act make it a crime to possess, sell, purchase, barter, transport, import or export any bald eagle — alive or dead. Indeed, the only reason Mrs. Sonnabend was able to hold onto “Canyon,” Mr. Lerner said, was due to an informal nod from the United States Fish and Wildlife Service in 1981.

Even then, the government revisited the issue in 1998. Rauschenberg himself had to send a notarized statement attesting that the eagle had been killed and stuffed by one of Teddy Roosevelt’s Rough Riders long before the 1940 law went into effect. Mrs. Sonnabend was then able to retain ownership as long as the work continued to be exhibited at a public museum. The piece is on a long-term loan to the Metropolitan Museum of Art in New York, which Mr. Lerner said insures it, but the policy details are confidential.

Mr. Lerner said that the I.R.S.’s handling of the work has been confusing. Last fall, the agency sent the family an unsigned draft report that it was valuing “Canyon” at $15 million. After Mr. Lerner replied that the children were refusing to pay, the I.R.S. then sent a formal Notice of Deficiency in October saying it had increased the valuation to $65 million.

That figure came from the agency’s Art Advisory Panel, which is made up of experts and dealers and meets a few times a year to advise the I.R.S.’s Art Appraisal Services unit. One of its members is Stephanie Barron, the senior curator of 20th-century art at the Los Angeles County Museum of Art, where “Canyon” was exhibited for two years. She said that the group evaluated “Canyon” solely on its artistic value, without reference to any accompanying restrictions or laws.

“The ruling about the eagle is not something the Art Advisory Panel considered,” Ms. Barron said, adding that the work’s value is defined by its artistic worth. “It’s a stunning work of art and we all just cringed at the idea of saying that this had zero value. It just didn’t make any sense.”

Rauschenberg’s combines, which inventively slapped together everyday objects he found on the street, helped propel American art in a new direction.

Though the I.R.S. usually accepts the advisory panel’s recommendations, it is not required to; last year it did not follow the group’s opinion in 7 percent of the cases, according to panel’s annual 2011 report.

So how did the panel arrive at the $65 million figure? Ms. Barron said, “When you come up with a valuation you look at comparable works and what they have sold for at public or private sales.”

The I.R.S. declined to comment.

Mr. Lerner told Forbes magazine, which reported the dispute in February, that Joseph Bothwell, a former director of the agency’s Art Appraisal Services unit, had told him “there could be a market for the work, for example, a recluse billionaire in China might want to buy it and hide it.” Mr. Bothwell has since retired from the I.R.S. Ms. Barron said she did not consider any hypothetical black-market buyer.

Still, the notion that the I.R.S. might use the black market in this way to determine a fair market value has surprised some tax experts. James Joseph, a tax lawyer with Arnold & Porter in Washington, noted that the I.R.S. has taxed illegal contraband at its market value, but added: “I don’t know of any instance where the I.R.S. has assumed taxpayers will engage in an illegal activity in order to value their assets at a higher amount. Al Capone went to jail for not paying income taxes on his illegal income, but this is very different than that.”

At the moment, tax experts note that the I.R.S.’s stance puts the heirs in a bind: If they don’t pay, they would be guilty of violating federal tax laws, but if they try to sell “Canyon” to zero-out their bill, they could go to jail for violating eagle protection laws.

Mr. Lerner said that since the children assert the Rauschenberg has no dollar value for estate purposes, they could not claim a charitable deduction by donating “Canyon” to a museum. If the I.R.S. were to prevail in its $65 million valuation, he said the heirs would still have to pay the $40.9 million in taxes and penalties regardless of a donation.

Then, given their income and the limits on deductions, he said, they would be able to deduct only a small part of the work’s value each year. Mr. Lerner estimated that it would take about 75 years for them to absorb the deduction.

“So my clients would have to live to 140 or so,” he said.

Valuation Red Flags for Estate Tax Purposes

On April 28, 2011, the Tax Court held in Estate of Mitchell, T.C. Memo 2011-94, that an estate properly valued both real estate and artwork. The IRS had previously examined the estate’s federal estate tax return and claimed that the estate underreported the fair market values (FMVs) of paintings and interests in several real properties. In response, the executor of the estate filed a petition with the Tax Court to contest the entire deficiency. While the parties were able to resolve most valuation and other estate tax issues, they still disputed the FMV of fractional leased-fee interests in two real properties and of two paintings. Both parties agreed on discounts ranging between 19% and 40% for the real property interests.

Asked to determine the FMV of the real property interests and paintings, the court noted that valuing these types of assets “can be an ambitious task,” because they “are unique and infrequently exchange hands,” and the value of art “often lies in the proverbial ‘eye of the beholder.’” Both the estate and the IRS discarded the initial valuations used on the estate tax return and in the notice of deficiency and presented new valuations at trial. The court stated that this case illustrated the difficulty in ascertaining FMV, the “quintessential fact question.” The court held that the estate properly determined the FMV of the decedent’s real property interests and paintings.

Valuation Issues
Under Sec. 2031, the value of the gross estate of the decedent is determined by including the value of real, personal, tangible, and intangible property held by the decedent at the time of his or her death. Regs. Sec. 20.2031-1(b) indicates that the value discussed in Sec. 2031 equals the property’s FMV. The regulations define FMV as the price at which 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. Furthermore, the value of tangible property must reflect its highest and best use as of the valuation date (Estate of Kahn, 125 T.C. 227 (2005)).

As indicated in Mitchell, ascertaining FMV is a question of fact that can cause controversy and litigation, particularly when the assets being valued are distinctive. If a decedent’s estate contains assets that have marked artistic or intrinsic value that totals more than $3,000, Regs. Sec. 20.2031-6(b) requires the appraisal of an expert, executed under oath, to be filed with the estate tax return. The regulations also require care to be taken to ensure that the expert appraisers are reputable and recognized as competent to appraise the assets involved.

Because of the frequency of disagreements regarding the valuation of artwork, Rev. Proc. 96-15 instituted a procedure by which a taxpayer may, after transferring artwork valued at $50,000 or more, obtain an IRS statement of value on which the taxpayer may rely in filing the income, gift, or estate tax return reporting the transfer. A taxpayer must attach to and file with his or her return a copy of the statement of value, regardless of whether the taxpayer agrees with it. If the taxpayer disagrees with the statement of value, the taxpayer may submit additional information with the tax return to support a different value.

When the taxpayer and the IRS do not agree on an asset’s value, both parties may obtain appraisals from valuation experts. The taxpayer technically has the burden of proving that the IRS’s valuation is wrong. However, in a valuation case, if the taxpayer submits an appraisal to support its valuation, the dispute becomes a battle of the experts. While a court may hesitate to decide the value, it will do so when required. Many times, a court will merely use the better of the appraisals. In other instances, the court may balance or even average the appraisals. It is obvious that the courts are requiring qualified experts to have a well-documented approach to their appraisals and to explain them thoroughly. The court will carefully consider all the facts, weigh all relevant evidence, and draw appropriate inferences and conclusions in determining FMV.

The Estate’s Assets
Mitchell’s estate reported a $17 million gross estate value. Its two largest assets were beachfront property and a ranch. The beachfront property was subject to a 20-year lease to an unrelated party, which accomplished the decedent’s goal of keeping the property in his family. The lease also transferred the cost of upkeep to the tenants and provided income to the decedent’s family. The ranch property was subject to a long-term lease to cattle ranchers. Leasing the ranch property accomplished the decedent’s goal of keeping the property maintained until it would be distributed to his two sons.

The decedent’s revocable trust held his assets, including the beachfront and ranch properties. The trust provided that, after the decedent’s death, both properties would be held for the benefit of his sons and distributed to them once the younger of them attained the age of 45. Shortly before the decedent’s death, he gifted a 5% interest in both properties to a separate children’s trust for the benefit of his sons.

The decedent’s estate also consisted of several paintings by well-known American Western artists. The two paintings subject to the Tax Court’s review were an oil painting, “Casuals on the Range,” by Frederic Remington, and a watercolor, “Creased,” by Charles M. Russell.

In valuing the real estate interests, the court noted that the parties had agreed that 19% and 32% fractional interest discounts applied to the 95% and 5% leased-fee interests, respectively, in the beachfront property. In addition, the parties had agreed to apply 35% and 40% fractional interest discounts to the 95% and 5% leased-fee interests, respectively, in the ranch. Therefore, the court had only to decide the value of a 100% interest in both properties to determine the discounted value of the interests in the estate.

The estate used an income-capitalization method to determine the property interest value, whereas the IRS used a lease-buyout method. The income capitalization method values income-producing property by estimating the present value of anticipated future cashflows. The IRS’s experts indicated that the lease-buyout method equals the property’s fee simple value less the amount necessary to buy out the tenant’s lease.

The IRS’s experts also indicated that appraisers generally use the income-capitalization method only with respect to commercial property leases, not residential leases. The court disagreed with this claim and stated that any property that generates income can be valued using the income-capitalization approach.

The decedent treated the beachfront property as an investment and leased it for a profit. Furthermore, the decedent did not intend to live in the property or use it as his residence. The court found that leasing the beachfront property was an income-producing activity that put the land to its best use. The ranch, which the decedent had been leasing for 25 years, provided the decedent with annual income and reallocated the normal maintenance cost to third-party caretakers. The court found the IRS’s lease buyout method to be “speculative at best,” stating that the method had not been accepted by any court or generally recognized by real property appraisers. Rejecting the IRS’s method, the court ruled that the estate’s income capitalization method was the best method for determining the value of the 100% leased-fee interest of both properties.

In valuing the artwork, the court noted that experts consider several different criteria or “art valuation factors,” including thematic appeal, period of work, style, overall quality, provenance, condition of artwork, and market conditions. The court received appraisals from the estate, the IRS, and the IRS Art Advisory Panel. The IRS’s experts did not have expertise or an extensive background in American Western art. All of the experts used the comparable-sales approach to valuing both paintings.

The court found that one IRS expert used poorly documented private sales to value one of the paintings, while the estate used public sale comparables. The court found that the public auction prices were a better indication of FMV. With respect to the second painting, the court found that the IRS experts had failed to adjust their valuation for the painting’s inferior status, poor paper quality, and poor “back boarding.” The court found that the estate’s expert’s reports were the better indicators of value, as they were more understandable, reasonable, and well supported.

Lessons Learned
Determination of value: As demonstrated in the Mitchell case, the determination of value in the Tax Court often operates like arbitration. The court will rule on which valuation best arrives at FMV. It is the taxpayer’s responsibility to conduct due diligence to arrive at an appropriate value. Otherwise, the court may determine that the taxpayer did not properly establish a value.

Valuation and the taxpayer’s and tax preparer’s responsibility: Under Sec. 6662, the taxpayer can be subject to substantial accuracy-related penalties that start at 20% of the understatement and can be higher with a substantial understatement of tax. In turn, the tax preparer can also be subject to understatement penalties under Sec. 6694. Therefore, the tax preparer must take due care that valuations disclosed on the return have appropriate support.

Determining the examination trigger of a valuation: Recently, the IRS has increased its scrutiny of high-income and high-net-worth taxpayers. According to the IRS’s Fiscal Year 2011 Enforcement and Service Results report, the IRS examined approximately 12% of taxpayers earning at least $1 million annually in 2011. That is an increase from 8% in 2010 and 6% in 2009. In comparison, approximately 1% of taxpayers earning less than $200,000 had their income tax returns examined in 2011. Clearly, returns with large reportable income, taxable gifts, or taxable estates face a heightened risk of IRS exams.

In the estate and gift tax arena, the number of experienced IRS agents has also increased. This investment in manpower has resulted in a heightened review of estate and gift tax returns, which in turn results in a greater number of IRS notices and examinations. In essence, a perfectly prepared return can still result in an examination for no other reason than that the taxable gift or bequest is large.

The IRS approach: As evidenced by the Mitchell case, the IRS has been aggressive regarding valuation challenges. Many of the IRS challenges assert estate valuations substantially larger than, and in some cases more than double, the taxpayer’s valuation. It is apparent that the Tax Court’s determinations center on which side presents the best data to support its values. In circumstances where the taxpayer fails to adequately substantiate an asset’s FMV, the additional tax costs can be substantial.

Valuation Red Flags
Several return disclosures can heighten the risk of an examination. Some are unavoidable, such as related-party transactions, while others can be avoided with proper planning.

Related-party transactions: Transactions between related parties (as defined under Sec. 267) have a heightened risk of examination due to perceived attempts to pass value to the younger generation by a discounted sale. If the IRS can prove that the transaction passed a disproportionate benefit to the younger generation, the IRS will assert that the younger generation received a value above the discounted sale and that the difference between the real value and the transacted value is a taxable gift.

In contrast, transactions between un-related parties have a rebuttable presumption of being negotiated fairly. Please note, however, that this presumption is not absolute. Some transactions between unrelated parties can result in IRS review, since there still can be “sweetheart” transactions similar to related-party transactions, such as those between common law partners.

Arbitrary value: Many buy-sell agreements use book value as the basis for an asset sale. When attached as exhibits to a taxpayer’s return, these agreements dramatically increase the risk of examination. Whether book value appropriately represents FMV is not relevant, since upon review, the IRS will assume that book value is arbitrary. Again, if the IRS challenges this valuation and, in turn, supports its valuation with appraisals and technical support, the taxpayer runs the risk of a larger tax liability.

Stale valuations: Reliance on old valuations or out-of-date information also creates problems. Timing is everything. Many taxpayers rely on a rule of thumb, such as appraisals within three months of the transaction; however, this rule can be problematic if the asset has wild swings in value that can make the appraisal’s assumptions obsolete.

Ways to Mitigate Examination Risk
The qualified appraisal: Although a qualified appraisal (one that meets the requirements under Regs. Sec. 1.170A-13(c)(3) for certain charitable contributions) is not required to substantiate the FMV of property for purposes of determining the size of the decedent’s taxable estate, a qualified appraisal provides a strong foundation to establish FMV. Keep in mind, however, that qualified appraisals do not completely protect the taxpayer from examination. The IRS challenges many taxpayers’ qualified appraisals, based on issues that estates can avoid.

Is the appraiser qualified? Taxpayers should ensure the appraiser meets the definition of “qualified” under Regs. Sec. 1.170A-13(c)(5).

Is the appraisal objective? Disclosing the reason for the appraisal in the report may provide the IRS reasons to challenge the report. For example, if the appraisal or the appraiser’s cover letter discloses that the appraisal relates to a related-party sale, the IRS may argue that the value is not objective, since the taxpayer’s goal is a lower value and not necessarily FMV.

Are the appraisals consistent? If more than one appraiser provides a report, each appraiser may be using different assumptions to reach FMV. For example, differing discount rates used to calculate value under the capitalization-of-earnings method may create a red flag for the IRS. When using different appraisers, taxpayers should share information with them from prior appraisals to establish a consistent approach.

Review the planning documents: Advisers should review documents related to buy-sell agreements, articles of incorporation, and voting trusts that have transaction provisions. Furthermore, prior transactions, whether related or unrelated, should also be reviewed. The key is to correct red flags that can lead the IRS to assume that the estate has used an arbitrary value or an inconsistent valuation. Transactions that consistently meet the qualified appraisal requirements provide the taxpayer with greater protection against examination.

The Mitchell case provides a reminder for taxpayers to assess and correct their appraisal processes. It is clear that proper valuation planning can supply the taxpayer with the ability to mitigate the examination risk and increase protection on future returns. Taxpayers with high income and high net worth should be diligent regarding the valuation process and ensure they have used thorough and well-documented appraisal methodologies. Otherwise, the taxpayer may end up triggering a large tax liability, along with interest and penalties.

Source Tax Letter from the AICPA 
Authors Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP

Stock Option Valuation...When and Why?

What does §409A say and how are the IRS applying the rules?

This section of the Code was enacted in October 2004 and final regulations were issued on April 10, 2007. §409A applies to compensation that workers earn in one year but that is paid in a future year. The Code defines this as "nonqualified deferred compensation." It is important to note that this is different from deferred compensation in the form of elective deferrals to qualified plans. Stock options, stock appreciation rights, or similar instruments can qualify as nonqualified deferred compensation.

§409A sets forth certain extensive requirements that the deferred compensation must meet. If the deferred compensation does not meet these requirements, the compensation is includable in gross income. For example, if a stock option has an exercise price that is less than the fair market value of the common stock as of the issuance date, this will result in adverse tax consequences for the option recipient and the company. Overall, the compensation is subject to certain additional taxes, including a penalty of an additional 20% income tax. Furthermore, the company will be required to withhold income and employment taxes as the time of the option vesting. Thus, every time stock options are issued, a sound valuation of the common stock is necessary. Put simply, the exercise price of the option must be equal or greater than the fair market value of the common stock as of the option's issue date. In order to abide by §409A and avoid early income recognition and additional taxes by the option holder, §409A's valuation rules must be followed.

In 2010, the Internal Revenue Service released Notice 2010-6  that puts into effect a correction program for non-compliant deferred compensation documents. If the deferred compensation documents do not comply with §409A, there is a slight opportunity to escape or mitigate the consequences. The correction program does not allow the correction of all errors. However, the Notice does permit most inadvertent and unintentional document failures to be corrected. The Notice sets forth the specific correction procedure that must be followed to obtain relief.

What are §409A's valuation rules for private company stock?
According to §409A, "in the case of service recipient stock that is not readily tradable on an established securities market, the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method." To be considered reasonable, a valuation method must take into consideration all available information, facts, and circumstances as of the valuation date. 

The Code goes on to list specific factors that must be considered under a reasonable valuation method. Factors that must be considered under a reasonable valuation method include:
The value of tangible and intangible assets of the corporation;
The present value of anticipated future cash-flows of the corporation;
The market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation of the stock of which is to be valued, the value of which can be readily determined through nondiscretionary, objective means;
Recent arm's length transactions involving the sale or transfer of such stock or equity interests; and
Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.

It is important to select a valuation expert who is knowledgeable about the requirements of §409A so that the valuation is valid.

How often are fair market valuations necessary?

To be considered a reasonable valuation, the valuation of a private company stock must provide a value "as of a date that is no more than 12 months before the relevant transaction to which the valuation is applied." For example, if a stock option is issued on December 1, 2011, a valuation date on or after December 1, 2010 must be used.

Additionally, the valuation is invalid if it does not reflect information available after the valuation date that materially affects the value of a private company... 

...If the valuation does not meet the requirements of the Code, both the recipient and the issuer are subject to unfavorable income tax consequences.


IRS issues guidelines on discount for lack of marketability

The IRS published on its website a practice aid for its examiners to help them critique methods used by tax-payers valuation firms in applying the subjective discount for lack of marketability

The practice aid is 112 pages long...but required reading for all valuation professionals.

Here's a link to the practice aid in PDF format

Valuation Discounts for Estate and Gift Taxes

Recent court decisions impacting the valuation discounts for estate and gift taxes as summarized in an article dated July 2009 in the Journal of Accountancy

One purpose of fixing a value on an interest in a closely held business is to determine gift and estate tax liability. CPAs called upon to provide such valuations know that this can be a painstaking task. It is not an exact science but an educated estimate when, as often is the case, there is no identifiable market for the interest. This uncertainty can cause unintended gift or estate tax consequences for transfers between related parties during the transferor’s life and at death.

The difference between what a person transferring an interest in a business believes is its fair market value and any higher amount the IRS determines is its fair market value can result in a greater gift tax liability. Likewise, a redetermination by the IRS of the fair market value of such interests held in an estate can spell an underpayment of estate tax. Fortunately for CPA valuation analysts, there are methods that, while not always yielding uniformly accepted results, are recognized by taxing authorities and courts as providing a valid basis for those estimates. In applying those methods, however, CPAs must take stock of recent court decisions for guidance. This article gives an overview of valuation principles for gift and estate tax purposes, reviews some current trends in determining fair market value for such purposes, and makes suggestions for seeking a qualified appraiser.

For gift and estate tax purposes, the fair market value of property transferred to another party is measured on the date of the transfer as “the price at which the property would change hands between a [hypothetical] 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 “willing-buyer, willing-seller test,” Treas. Reg. § 20.2031-1(b)).

For assets traded on an established market or that have a readily ascertainable value, the value for gift and estate tax purposes is their fair market value on the date of the transfer or death. For other assets, valuation must be established by an educated estimate.

Three types of valuation methods are generally used in calculating the fair market value of an interest in a closely held entity. The market method (also referred to as the comparable sales method) compares the closely held company with its unknown stock value to similar companies with known stock values. The income (or discounted cash flow) method discounts to present value the anticipated future income of the company whose stock is being valued. The net asset value (or balance sheet) method relies generally on the value of the assets of the company net of its liabilities.

The market method or income method is most often used when the closely held company carries on an active trade or business. The net asset value is most often used when a closely held company holds primarily real estate or investment assets and does not carry on an active trade or business.

The valuation of closely held entities for gift and estate tax purposes has been a hotly contested issue—especially with the proliferation of family limited partnerships and limited liability companies that are implemented primarily for estate planning purposes. In many instances these closely held entities do not carry on an active trade or business.
Court cases reveal that the valuation of closely held entities is a judgment call that relies upon the opinion of experts. Courts have long upheld a premise often reflected in expert opinions—that the value of closely held interests is usually less than the value of similar publicly traded interests. The factors underlying this premise include the inability to quickly convert the property to cash at minimal cost (“lack of marketability”) and the inability, if the interest held is less than a majority interest, to control managerial decisions and other aspects of the entity (“lack of control”).

In many instances, the courts insert their own opinion as to fair market value, siding with neither the taxpayer’s nor the IRS’ valuations and often taking a “splitthe- baby” approach. However, at a lecture in January 2009 at the Heckerling Institute on Estate Planning sponsored by the University of Miami, Judge David Laro of the U.S. Tax Court noted the uncertainty this approach has caused for parties to a sale. Judge Laro stated that the Tax Court is no longer taking such an approach and will insert its opinion only where it believes the valuations of the parties are based on erroneous assumptions.

Two types of empirical studies are commonly used to benchmark discounts for lack of marketability (DLOM)—restricted stock studies and pre-initial public offering (pre-IPO) studies.

Public companies often issue restricted stock (unregistered shares). SEC rules restrict the transferability of such shares by mandating a minimum holding period and by limiting the pool of eligible buyers for such shares. Restricted stock studies compare the price of publicly traded, unrestricted shares of companies with the private market price of restricted shares of the same companies and attribute the difference to the lack of marketability of the restricted shares. Approximately 15 such studies exist, showing discounts ranging from 13% to 45%. The SEC restrictions have become less stringent, and consequently the average discounts in the newer studies are lower than in previous studies.

Pre-IPO studies compare the price at which a stock was sold while its issuer was still closely held (and the shares were unregistered) with the price of the same company’s common stock at the time of an initial public offering. Sources of pre-IPO studies include Willamette Management Associates’ Valuation Advisors’ Lack of Marketability Discount Study and those developed by John D. Emory of Emory & Co. These studies generally show a discount for lack of marketability ranging from 18% to 59%—higher than in restricted stock studies.
Recent court decisions have made it clear that more important than the type of study used to quantify a discount is the analysis done by the appraiser to tie the study to the facts of the specific case. The District Court for the Eastern District of Texas in Temple v. United States (123 F.Supp.2d 605, 622 (2006)) said, “the better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner.”

The failure to tailor the analysis to specific facts can have drastic consequences. For example, one of the issues in Holman v. Commissioner (130 TC no. 12 (2008); see also “Tax Matters: FLPs Revisited,” JofA, Sept. 08, page 88) involved the valuation of limited partnership units in a partnership holding stock in computer maker Dell Inc. Experts for both the taxpayer and the IRS used restricted stock studies to determine the DLOM. The taxpayer’s expert cited 13 restricted stock studies that showed median and mean discounts of 24.8% and 27.4% and then adjusted the DLOM up to 35% based on vague and general observations about the investment quality of the partnership units. The Tax Court faulted him for not building from his observed sample median and mean discounts “by quantitative means.”

The IRS expert compared the restricted stock studies performed prior to 1990—the year the SEC implemented rule 144A that expanded the pool of eligible buyers of restricted stock—to restricted stock studies conducted between 1990 and 1997, the latter year being when the SEC reduced the holding period under rule 144 from two years to one.

The pre-990 studies showed an average discount of 34%, while the 1990–1997 studies showed an average discount of 22%. The IRS expert proposed that the 12% differential reflected the effect of the opening of a limited resale market and thus the portion of a marketability discount related to lack of a liquid market. He considered separately the holding period of restricted stock reflected in the 1990–1997 average discount of 22% and concluded its applicability in this case was negligible, adding, along with other factors, another 0.5%, for a total DLOM of 12.5%.

So why not take the portion of the discount related to the holding period restrictions into account? The IRS expert argued that he could not think of an economic reason why the partners in this situation would not agree to let another partner be bought out. Since the partnership agreement allowed for dissolution by unanimous consent and the sole asset held by the partnership was highly liquid Dell stock, the partners could dissolve the partnership by unanimous agreement, transfer the Dell stock pro rata to the exiting partner, and then reconstitute the partnership with the remaining partners with little economic risk.

Both parts of the decision are troubling— the Tax Court’s acceptance of the argument that the DLOM inherent in restricted stock studies is only 12%, and that the court accepted without much reasoning or computation of the likelihood of liquidation, that the partnership would be dissolved upon the request of a limited partner simply because the dissolution would pose little economic risk to the remaining partners.

The argument that the discounts shown by restricted stock studies contain components other than lack of marketability is not new. Another critic of restricted stock studies (and pre-IPO studies), Mukesh Bajaj, attempted to isolate the DLOM. He performed a study in 2001 with David Denis, Stephen Ferris and Atulya Sarin of registered and unregistered private placements and concluded (albeit controversially) that the average discount attributed exclusively to marketability is only 7.23% (“Firm Value and Marketability Discount,” Journal of Corporation Law, Vol. 27, No. 1).

Adding pressure to the argument for lowering discounts is the argument that the older restricted stock studies are outdated, since the restrictions placed on the securities by the SEC have been relaxed over time. This argument is flawed because, during that period, the inherent limitations faced by private companies have not changed. Nonetheless, the argument has been accepted by many courts, including the Tax Court in Litchfield v. Commissioner (TC Memo 2009-21 (2009)). InLitchfield, the Tax Court rejected the taxpayer’s DLOM of 36% and 29.7% for two companies as reflecting what the court considered outdated restricted stock studies and settled on discounts of 25% and 20%, respectively (the IRS had argued for discounts of 18% and 10%).


The discount for lack of control (DLOC—also referred to as a minority discount) is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds to the net asset value per share of the same funds. For entities holding real estate, the DLOC is determined by comparing the trading price of shares of a selected sample of registered real estate limited partnerships (RELPs) or real estate investment trusts (REITs) to the net asset value of the respective shares.
Citing mere averages or using generic samples of data is not sufficient. As with the DLOM, the appraiser’s skill in relating the sample of closed-end funds used to not only the asset type but also the size and other attributes of the assets of the entity being valued is critical.

In Holman, experts for the IRS and the taxpayer used closed-end fund data, but the court favored the IRS’ approach to dealing with outliers in the sample data and rejected the taxpayer’s use of seven specialized funds in his sample. Following the methodology suggested by the IRS’ experts and leaving the specialized funds out of the sample, the Tax Court calculated minority interest discounts of 11.32%, 14.34% and 4.63% of the respective gifts made in 1999, 2000 and 2001 (the taxpayer’s expert determined the discounts to be 14.4%, 16.3% and 10%).
In Jelke v. Commissioner (TC Memo 2005-131 (2005)), the taxpayer’s expert applied a 25% DLOC. He initially selected seven funds as comparables (with an average discount of 14.8%) but then rejected some of the funds with lower discounts. He ultimately derived the 25% discount by adjusting for various factors the average discount of just two of the seven funds.
The IRS’ expert started with a benchmark discount of 8.61% that he obtained from an article in theJournal of Economics and reduced it to 5%. The Tax Court said the choice of comparable funds by the taxpayer’s expert was flawed because he gave insufficient justification for eliminating two funds as comparables, and among those he retained in the sample, he ignored significant differences in investment strategy and risk between them and the interest being valued. Without explaining exactly how it determined the figure, the court held that the appropriate lack-ofcontrol discount was 10%.

In Astleford v. Commissioner (TC Memo 2008-128 (2008)), the issue was the value of limited partnership interests in Astleford Family Limited Partnership (AFLP) that were gifted during 1996 and 1997. AFLP held a 50% general partnership interest in another real estate partnership called Pine Bend, along with 14 other real estate investments.

The first question was whether separate discounts should be applied to the AFLP interest and the Pine Bend interest. The IRS’ expert stated that since Pine Bend was an asset of AFLP, no discounts were appropriate in valuing Pine Bend. The Tax Court disagreed with this argument, holding that tiered discounts (that is, discounts at the lower-tier entity level and the uppertier entity level) were appropriate where a taxpayer owned a minority interest in an entity that held a minority interest in another entity.

However, the court further stated that tiered discounts will be rejected when (a) the lower-level interest constituted a significant portion of the parent entity’s assets or (b) where the lower-level interest was the parent entity’s principal operating subsidiary. In this case, the court noted that the Pine Bend interest constituted less than 16% of AFLP’s net asset value and was only one of 15 real estate investments held by AFLP, making the use of tiered discounts appropriate.
The Tax Court specifically stated that it did not find either RELP or REIT data generally superior to the other and that courts have accepted expert valuations that used both. In valuing the Pine Bend interest, the taxpayer’s expert, using a sample of 17 RELPs to derive a lower (22%) and upper limit (46%) for the discount, concluded that the appropriate combined discount for lack of marketability and lack of control was 40% for Pine Bend. The Tax Court modified the sample of RELPs used by the taxpayer’s expert to arrive at a discount of 30% for Pine Bend.

With respect to the AFLP interest, the taxpayer’s expert selected a comparison sample of four RELPs (with discounts ranging from 40% to 47%) and concluded that the appropriate DLOC was 45% in the first year and 40% in the second year. The IRS’ expert, using REIT data, concluded that the lack-of-control discount was approximately 7% in one year and 8% the next year. The Tax Court said the sample of RELPs used by the taxpayer’s expert was not representative of AFLP. Two were five times the size of AFLP, and the other two were highly leveraged, unlike AFLP. The court chose to use the REIT data provided by the IRS’ expert as its starting point but used a higher adjustment, to end up with DLOCs of 16.17% and 17.47% for the respective years.


While the courts and the IRS have agreed that built-in gains (BIG) tax on a corporation’s appreciated assets should be taken into account in valuing its stock using the net asset valuation method, they have not agreed on the proper method for quantifying the discount.
Besides the DLOC issue discussed earlier in this article, a discount for BIG tax also was argued in Jelke, and on this issue, the taxpayer prevailed. The decedent owned a 6.44% interest in a closely held corporation whose assets consisted primarily of appreciated securities with a date-of-death value of $178 million. The estate argued that the entire BIG tax liability of approximately $51 million should be allowed against the fair market value of the securities in determining the company’s value using the net asset valuation method. The Tax Court rejected this argument and held that the IRS expert’s method of discounting the BIG tax liability over a 16-year period was reasonable because the facts in the case showed that an immediate liquidation of the company was unlikely, given the corporation’s historical asset turnover ratio.

The taxpayer appealed to the Eleventh Circuit (507 F.3d 1317 (2007)). That court, following the Fifth Circuit’s reasoning in Dunn v. Commissioner (301 F.3d 339 (5th Cir. 2002)), reversed, stating that 100% of the BIG tax must be taken into account when using the net asset valuation method (regardless of the likelihood of liquidation) because the threshold assumption of the net asset valuation method is that all assets are liquidated as of the date of valuation. Despite a strong dissent by Judge Ed Carnes, the Eleventh Circuit declined to rehear the issue en banc, and the U.S. Supreme Court denied certiorari. These two appeals court victories give taxpayers a strong position for taking 100% of BIG taxes into account in valuing C corporation stock by the net asset valuation method....