Nelson v. Commissioner, T.C. Memo. 2020-81, proved to be one of the most important valuation-related decisions of 2020. In Nelson, the Tax Court decided important issues related to the use of defined value language within transfer documents and tiered valuation discounts.
The case focused on whether the transfer of limited partner (LP) interests should be characterized as a transfer of: (1) specific dollar amounts that were stated in the transfer documents, or (2) specific ownership percentages that were to be determined based on the analysis of a qualified appraiser.
The court also focused on the appropriateness of valuation discounts within a tiered ownership structure when a holding entity owns a noncontrolling interest in another holding entity.
Background
Longspar Partners, Ltd. (Longspar) was formed in 2008 as a Texas limited partnership. On formation, all partners made initial capital contributions to Longspar in the form of shares of Warren Equipment Co. (WEC) common stock. Longspar was formed, in part, to ensure that WEC remained in business and under the control of its founding family members.
WEC was a holding company that had seven wholly owned subsidiaries. The largest WEC subsidiary was Warren Power & Machinery, L.P. (Warren Cat), a dealer of Caterpillar engines and heavy equipment and machinery.
The second largest WEC subsidiary was Compressor Systems, Inc. (CSI). CSI sold and rented gas compression equipment to the oil and gas industry and provided financing and maintenance services in connection with that equipment.
The five other WEC subsidiaries were: (1) Warren Administration Co. (Warren Admin), a provider of administrative services to WEC’s other subsidiaries; (2) Ignition Systems & Controls, L.P. (ISC), a dealer of ignition and control systems; (3) North American Power Systems, Inc. (NorAm), a seller of small light towers and generators; (4) Perkins South Plains, Inc. (PSP), a distributor of engines; and (5) Warren Real Estate Holdings, Inc. (WREH), a holding company that leased real estate to the WEC operating subsidiaries.
The WEC stock was subject to a shareholders agreement that restricted the stock’s transferability. The shareholders agreement provided that the WEC board must approve all transfers of WEC common stock, and any transfer made in violation of the shareholders agreement would be null and void. However, the shareholders agreement provided two avenues for a shareholder to sell its WEC shares. First, a shareholder could sell its shares to a permitted transferee. Second, a shareholder could exercise the put option included in the WEC shareholders agreement, which allowed a shareholder to sell a portion of its shares to the other WEC shareholders, and potentially to WEC, at book value.
Longspar owned approximately 27% of the WEC common stock, cash, marketable securities, a note receivable, accounts receivable and an LP interest in three partnerships.
The Longspar partnership agreement granted the general partners full control over all partnership activities. The partnership agreement also restricted the Longspar LPs’ ability to transfer their LP interests. If a partner attempted to transfer its LP interest to a third party, the partner would first have to offer the interest to Longspar and then to the other partners at the same (or better) terms than the third-party offer before the transfer could be made to the third party.
The Transfers
Mary P. Nelson made two transfers of Longspar LP interests. The first transfer was a gift of a Longspar LP interest “having a fair market value (FMV) of $2,096,000 as of December 31, 2008…, as determined by a qualified appraiser within 90 days of the effective date of this Assignment.”
The second transfer was a sale of a Longspar LP interest “having a fair market value of $20,000,000 as of January 2, 2009…, as determined by a qualified appraiser within 180 days of the effective date of this Assignment.”
Mary and James C. Nelson (the Nelsons) filed separate gift tax returns for 2008 and 2009. The Dec. 31, 2008 gift was classified as a split gift, and one-half of the gift was reported on each petitioner’s gift tax return.
The Nelsons hired an appraiser who determined that the FMV of a 1% LP interest in Longspar was $341,000 at the time of the transfers. Based on this result, the appraiser concluded that the transferred interests represented 6.14% and 58.65% LP interests in Longspar. Because the two transfer dates were so close together, the appraiser used Dec. 31, 2008 as the valuation date for both transfers.
Importantly, neither the memorandum of gift nor the memorandum of sale contained clauses defining FMV or subjecting the LP interests to reallocation after the valuation date. Also, Longspar’s partnership agreement was amended effective Jan. 2, 2009 to reflect transfers of the 6.14% and the 58.65% LP interests.
On Aug. 29, 2013, notices of deficiency were issued to the Nelsons. The notices indicated that the Internal Revenue Service determined an undervaluation related to the Dec. 31, 2008 gift transfer of $1,426,018 and to the Jan. 2, 2009 sale transfer of $13,607,038.
The Nelsons and the IRS agreed that the transfers were complete once the transfer documents were executed. However, the parties disagreed whether the Nelsons transferred: (1) Longspar LP interests of $2,096,000 and $20,000,000, as argued by the Nelsons, or (2) LP interests of 6.14% and 58.65%, as argued by the IRS.
The Nelsons and the IRS also disagreed over the valuation of the transferred LP interests. Most of this difference in valuation was related to the selection of valuation discounts.
Court’s Analysis
The Tax Court addressed two primary issues—whether the transferred LP interests were fixed dollar amounts or percentage interests in Longspar and what was the FMV of the transferred interests.
Transferred interests. The Nelsons argued that the transfer documents showed that Mary transferred specific dollar amounts and not fixed percentage LP interests in Longspar. In arguing their position, the Nelsons also cited various cases that had respected formula clauses as transferring fixed dollar amounts of ownership interests. In each of these cases, the court respected the terms of the formula, even though the percentage amount wasn’t known until the FMV of the transferred interest was subsequently determined by appraisal.
The Nelsons argued that the court should interpret the language in the transfer documents as “formula clauses” that were upheld by the court in prior cases and, thus, read the language as transferring dollar amounts rather than specific ownership percentages.
In its analysis, the court noted that the transferred LP interests are expressed in the transfer documents as an interest having “a fair market value of a specified amount as determined by an appraiser within a fixed period.” The court stressed that the language only calls for value to be determined by an appraiser within a fixed period and that value wasn’t qualified further, such as that determined for federal estate tax purposes.
In reaching its decision, the court distinguished the language in this case from prior cases in that FMV in the current case is already expressly qualified. The court noted that interpreting the language in the transfer documents as transferring dollar values of LP interests on the basis of FMV as later determined for federal gift and estate tax purposes essentially asks the court to ignore the “qualified appraiser” reference in the language and replace it with “for gift and estate tax purposes.”
According to the court, the transfer documents, as stated, required a qualified appraiser within a fixed period to ascertain the LP interests being transferred. This is exactly what the Nelsons’ appraiser did. As a result, the court concluded that Mary transferred a 6.14% and a 58.65% LP interest in Longspar.
Valuation of transferred interests. Having concluded that the transferred LP interests were percentage interests rather than fixed dollar amounts, the court turned its focus to the proper valuation of the transferred interests.
At trial, each party presented a valuation expert who determined the FMV of the transferred LP interests in Longspar. Both valuation experts relied, at least in part, on the valuation opinion of a third expert who valued the WEC common stock held by Longspar (the WEC expert).
Valuation of WEC common stock. The WEC expert estimated the value of WEC by calculating the FMV of each of the WEC subsidiaries and then combining the value of subsidiaries at the WEC holding company level. Based on her analysis, the WEC expert estimated the FMV of the WEC common equity to be $363.7 million, or $1,532 per share, on a controlling interest basis before any valuation discounts. The WEC expert then applied a 20% discount for lack of control (DLOC) and 30% discount for lack of marketability (DLOM) to arrive at an FMV of $860 per WEC common share on a noncontrolling and nonmarketable basis.
The Nelsons’ expert accepted the WEC expert’s conclusions as the starting point for his analysis of the transferred LP interests. In contrast, the IRS’ valuation expert accepted the WEC expert’s undiscounted conclusion of $1,532 per share and her concluded DLOM of 30%, but contended that a DLOC wasn’t appropriate because the value of the WEC subsidiaries was already stated on a noncontrolling interest basis.
The court evaluated the WEC expert’s valuation of the WEC subsidiaries to determine whether a DLOC was appropriate at the WEC holding company level.
First, the court reviewed the valuation of Warren Cat, ISC and PSP. In each case, the WEC expert used a cost approach to value the subsidiary. In most instances, a cost approach results in a controlling interest value, and in this particular instance, the court agreed that the WEC expert’s valuation of each of Warren Cat, ISC and PSP resulted in a controlling interest value for each subsidiary. As a result, the court concluded that the WEC expert’s valuation of Warren Cat, ISC and PSP supported the application of a DLOC at the WEC holding company level.
Next, the court reviewed the WEC expert’s valuation of CSI, PSI and NorAm. In each case, the WEC expert used an income approach and a market approach to value the subsidiary. The WEC expert concluded that these valuation approaches, as applied by her, resulted in controlling interest values for the three subsidiaries. In its evaluation of CSI, PSI and NorAm, the court wasn’t entirely persuaded by the WEC expert’s opinions and determined that the characteristics of the subsidiaries were such that the DLOC applied by the WEC expert should be reduced, but not eliminated.
Next, the court turned its attention to the WEC expert’s valuation of WREH and Warren Admin. In evaluating these subsidiaries, the court noted that, like CSI, PSI and NorAm, WEC’s interests in the subsidiaries involve shares with elements of control for which a DLOC should be reduced but not eliminated.
In summary, the court concluded that the WEC expert’s valuation of the WEC subsidiaries produced values with at least some elements of control, and, as a result, some DLOC should be applied when valuing a noncontrolling ownership interest in the WEC common stock. However, the court rejected the 20% DLOC concluded by the WEC expert and, instead, concluded that a 15% DLOC better reflects the lack of control associated with a noncontrolling interest in the WEC common stock.
As presented in “Valuation Discounts for WEC Common Stock,” p. 56, the DLOC and the DLOM quantified by the WEC expert and adopted by the Nelsons’ expert, when applied in succession, resulted in a combined valuation discount of approximately 44% for the WEC common stock. The DLOC and DLOM selected by the IRS’ expert resulted in a combined valuation discount of 30% for the WEC common stock. The court’s concluded DLOC and DLOM of 15% and 30%, respectively, when applied in succession, resulted in a total combined discount of approximately 41% for the WEC common stock held by Longspar.
Valuation of Longspar LP interests. In estimating the FMV of the transferred LP interests, both the Nelsons’ expert and the IRS’ expert relied on a net asset value method, but they disagreed on what DLOC and DLOM should be applied to the Longspar net asset value.
The Nelsons’ expert valued the Longspar LP interests by applying a DLOC of 15% and a DLOM of 30%. In contrast, the IRS’ expert valued the transferred interests by applying a DLOC of 5% and DLOM of 25%.
Both experts relied on public market valuations of closed-end mutual funds to justify their selected DLOC. However, the IRS’ expert also considered that, in his view, there would be almost no possibility that a noncontrolling partner of Longspar would be disadvantaged due to its lack of control over the partnership. The court agreed and accepted the IRS’ expert’s DLOC of 5%.
The Nelsons’ expert based his selected DLOM, in part, on restricted stock studies and pre-initial public offering stock studies. The IRS’ expert examined these studies as well but also included certain quantitative models in his analysis of the appropriate DLOM. The court concluded that the IRS’ expert conducted a more thorough analysis, but he failed to justify his selected DLOM of 25%. Based on its own analysis of the data reviewed by the IRS’ expert, the court concluded a DLOM of 28% was appropriate for the transferred LP interests in Longspar.
As presented in “Longstar Valuation Discounts,” this page, the DLOC and the DLOM quantified by the Nelsons’ expert, when applied in succession, resulted in a combined valuation discount of approximately 41% for the transferred LP interests in Longspar. The DLOC and DLOM selected by the IRS’ expert resulted in a combined valuation discount of approximately 29%. The court’s concluded DLOC and DLOM of 5% and 28%, respectively, when applied in succession, resulted in a total combined discount for the transferred LP interests in Longspar of approximately 32%.
While the Nelsons didn’t prevail in their attempt to convince the court that the Longspar transferred LP interests were fixed dollar amounts rather than percentage interests, all wasn’t lost, because the court concluded that significant valuation discounts were appropriate in the valuation of the transferred interests due, in part, to the tiered ownership structure of WEC and Longspar.
Based on the court’s concluded values, the Nelsons undervalued the 6.14% transferred interest by $428,983 and the 58.65% transferred interest by $4,118,933.