The valuation of limited partnership (LP) interests in family limited partnerships (FLPs) is a subject that’s been written about extensively for over 30 years. Most of the literary record has been directed at the topic of applicable discounts. In this vein, the discount for lack of marketability (DLOM) has been discussed repeatedly—some might even say ad nauseam. After 30 years of discourse in the literature, countless seminars and webinars and numerous U.S. Tax Court cases, one would think this topic would now be fully resolved and agreed on. Nothing could be further from the truth.
IRS Guidelines
In October 2006, the Internal Revenue Service published a memo entitled “Appeals Coordinated Issue Settlement Guidelines” (the Memo), which related to discounts for FLPs.1 The Memo noted that in the (then) recent cases of McCord v. Commissioner,2 Lappo v. Comm’r,3 Peracchio v. Comm’r4 and Estate of Webster E. Kelley v. Comm’r,5 the Tax Court had developed a sophisticated valuation analysis for these FLPs that held, for the most part, cash and marketable securities. The range of DLOM determined was from 20% to 25%.6
Despite the Memo’s claim of the sophistication of the Tax Court’s analyses, in all cases but McCord, the analysis was really quite simplistic. The Lappo, Peracchio and Kelley opinions simply relied on McCord’s logic, methodology and result.
In McCord, the IRS expert’s opinion of DLOM, 7.23%, was based on the regression analysis from what’s now known as the “Bajaj Study.” The Tax Court found this methodology unpersuasive. However, as a part of the underlying data for the study, the authors compiled a database of 88 private placement transactions in which investors acquired minority equity interests in publicly traded companies.7 The average DLOM was found to be 22%. The Tax Court, finding this data useful, determined a DLOM of 20%.
In all cases, including McCord, the taxpayers’ valuation experts relied on restricted stock studies for determining DLOM.8 DLOMs ranged from 29% to 40%. The Tax Court found flaws in the analyses of all the taxpayers’ experts. In McCord, even though the preponderance of the taxpayer’s expert’s DLOM analysis focused on restricted stock studies, the Tax Court chose to concentrate its criticism on the pre-initial public offering (IPO) studies the expert cited. With respect to the restricted stock studies, the Tax Court also emphasized that the assets were primarily marketable securities and the restricted stock studies reflect transactions of small, highly risky operating companies; thus, the taxpayer’s expert didn’t account for this risk differential. In Lappo, Perachio and Kelley, the Tax Court’s complaint against the taxpayers’ experts is that they simply cited averages of studies and provided no independent analysis of DLOM on their own.
On the other hand, in all cases, the Tax Court also rejected the analyses of every IRS expert as they all relied on the Bajaj Study regression analysis.9 The DLOM range found was from about 7% to 15%.
“Views on DLOM,” p. 29, describes the parameters of the various views on DLOM as exhibited by the parties. The Tax Court decisions reflect a “split the baby” pattern. But despite the IRS memo, how similar was McCord to the other three cases? The interests valued in McCord were assignee interests —not LP interests. This fact has been largely ignored.10 Furthermore, in Lappo, Peracchio and Kelley, the Tax Court awarded an additional amount of DLOM for the restrictive “bells and whistles” of the partnership agreements of these FLPs. However, because the McCord interests were assignee interests with no rights other than the right to receive income, the highly restrictive provisions considered in the other cases were already embedded in the McCord value. Thus, adding the effects of these factors to the McCord discount to derive the Lappo/Peracchio/Kelley DLOM would seem to be a double count.
The Family Bargain Approach
The gift tax case of Holman v. Comm’r was decided in 2008.11 The Holman Limited Partnership held shares of Dell Computer Corp. Four separate transfers were made between late 1999 and early 2001. The taxpayer’s expert determined a DLOM of 35%, which was based on the restricted stock studies and his assessment of the negative liquidity prospects of the LP interests. The latter also included the effects of the restrictive transfer provisions of the partnership agreement, most notably the right of first refusal found in
paragraph 9.3 of the agreement.
The IRS complained that the expert’s overly pessimistic views of the potential prospects for resale of the interests appeared to even dismiss the possibility of a private sale. According to the IRS, if that were the case, the taxpayer’s expert was effectively saying the value of the interests was zero, and the expert’s DLOM was, therefore, arbitrary. The Tax Court agreed with this assessment and found that the taxpayer’s expert’s opinion was unsupported by the facts.
The IRS’ expert in Holman, while also referencing the restricted stock studies, had a novel view of their implications. The expert settled on a DLOM of 12.5% based on lower discounts in more recent studies and the fact that the partnership held only highly liquid common stock. He made no adjustment for a long holding period, noting that the partners could agree to dissolve the partnership. Furthermore, the expert stated that he couldn’t envision an economic reason why the partnership wouldn’t be willing to let somebody be bought out. Here’s the logic of the IRS expert’s family bargaining rubric justifying his DLOM:
Indeed, given the significant minority interest and marketability discounts from an LP unit’s proportional share of the partnership’s NAV that each expert would apply in valuing the gifts, it would appear to be in the economic interest of both any limited partner not under the economic necessity to do so but wishing to make an impermissible assignment of LP units and the remaining partners to strike a deal at some price between the discounted value of the units and the dollar value of the units’ proportional share of the partnership’s NAV. The wishing-to assign partner would get more than she would get in the admittedly ‘thin’ market for private transactions, and the dollar value of each remaining partner’s share of the partnership’s NAV would increase.12
In Holman, the IRS initially asserted that the transfer of the LP interests was actually an indirect gift of Dell shares to the donees. In that case, no valuation discounts would apply. Further, the IRS claimed that even if LP interests were transferred, Internal Revenue Code Sections 2704(b) and 2703(a) applied and would serve to greatly diminish any discounts. The Tax Court denied the indirect gift claim, and the IRS later abandoned its IRC Section 2704(b) argument. The IRC Section 2703(a) issue remained.
Section 2703(a) provides that the value of any property transferred by gift is determined without regard to any right or restriction found in the partnership agreement or other contract relating to the property. (Here, the LP interests.) This regulation doesn’t apply if the restriction meets each of the following three requirements found in Section 2703(b): (1) it’s a bona fide business arrangement; (2) it isn’t a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and (3) its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction.
The Tax Court found that the partnership agreement restrictions challenged by the IRS all failed, in one way or another, to qualify for the provided exceptions. Accordingly, Section 2703(a) applied, and all special transfer restrictions found in the partnership agreement were disregarded for valuation purposes.
According to the IRS’ valuation expert, disregarding these restrictions had a profound effect on discounts. He opined that, if the restrictions were considered, his combined discount (minority interest and lack of marketability) would have been 34.9% for the first transfer date.13 With the restrictions, his combined discount was 22.3%. DLOM, which was determined without regard to the restrictions and considering the family bargaining process, was determined to be 12.5%.
The taxpayer’s appraiser determined discounts with a view that the restrictive provisions of the partnership agreement did apply. In considering the effect on value if the restrictive agreements were disregarded, the expert’s testimony reflected only a very small adjustment.
The Tax Court was persuaded by the IRS expert’s family bargaining argument and set the DLOM at 12.5%. The decision was appealed by the taxpayers to the U.S. Court of Appeals for the Eighth Circuit, but that court affirmed the Tax Court opinion.
Now, 15 years later, questions about the veracity of this decision remain.
First, the logic of the bargaining process is inescapable. It’s likely what would happen in situations in which a family member sought to withdraw from the partnership. However, it would seem that this construct only works if the family member/limited partners: (1) are on “speaking” terms; (2) have sufficient personal liquidity to acquire the interests; and (3) aren’t, as was the case in Holman, using trusts managed by family members for the benefit of minor children. It’s hard to envision how an LP with the any of the foregoing factors could effect an arm’s-length transaction. Thus, the likelihood that such a family bargain might occur begins to take on a significantly speculative tenor.
Since Holman was decided, there have been at least three Tax Court cases with opinions that engendered a speculativeness question. First, in Estate of Elkins, the U.S. Court of Appeals for the Fifth Circuit found the Tax Court’s construct of a family bargain to be erroneous:
While continuing to advocate the willing buyer/willing seller test that controls this case, the Tax Court inexplicably veers off course, focusing almost exclusively on its perception of the role of ‘the Elkins children’ as owners of the remaining fractional interests in the works of art and giving short shrift to the time and expense that a successful willing buyer would face in litigating the restraints on alienation and possession and otherwise outwaiting those particular co-owners. Moreover, the Elkins heirs are neither hypothetical willing buyers nor hypothetical willing sellers, any more than the Estate is deemed to be the hypothetical willing seller.14
In Estate of Guistina v. Comm’r, the Tax Court postulated a scenario whereby the limited liability company (LLC) would be liquidated. The U.S. Court of Appeals for the Ninth Circuit stated:
We conclude that it was clear error to assign a 25% likelihood to these hypothetical events. As in Estate of Simplot v. Commissioner, 249 F.3d 1191, 1195 (9th Cir. 2001), the Tax Court engaged in ‘imaginary scenarios as to who a purchaser might be, how long the purchaser would be willing to wait without any return on his investment, and what combinations the purchaser might be able to effect’ with the existing partners.15
In the 2020 gift tax case of Grieve v. Comm’r, the IRS’ expert, in valuing the 99.8% non-voting interest transferred, opined that it was permissible to presume the holder of the .2% voting interest would also agree to sell her interest as a part of the hypothetical construct of this case.
The Tax Court found this assumption unreasonable, stating:
The facts do not show that it is reasonably probable that a willing seller or a willing buyer of the class B units would also buy the class A units and that the class A units would be available to purchase.16
If, hypothetically, we assume the Tax Court’s embrace in Holman of the family bargain construct was misplaced but the rejection of the applicability of paragraph 9.3 was correct, exactly where are we from a DLOM standpoint? First, we recognize that the Tax Court accepted the restricted stock studies as the Rosetta Stone in this case. There’s no evidence that the discounts from these studies are in any way influenced by a right of first refusal. So, vis-a-vis DLOM, the absence of Holman’s paragraph 9.3 only goes to mitigate that amount of discount that was especially provisioned for the Holman LP interests after consideration of the effects of the studies.
The taxpayer’s expert, who didn’t contemplate the family bargain scenario, cited restricted stock studies with a median discount of about 25%. In his opinion, this was an appropriate starting place for his analysis. In view of the Tax Court’s opinion on Section 2703(a), perhaps this was the appropriate ending point for DLOM as well.
Astleford v. Comm’r
This very interesting case17 actually has little good information about DLOM but quite a lot on some other issues such as absorption (blockage) discounts, tiered discounts and discounts for a 50% general partnership (GP) interest.
The Astleford Family Limited Partnership (AFLP) owned various real estate properties and interests in real estate properties and a 50% interest in Pine Bend Development Co. (Pine Bend), a Minnesota GP holding agricultural real estate near Minneapolis. In 1996 and 1997, the taxpayer/petitioner gave each of her three children LP interests in AFLP, retaining for herself a 10% AFLP GP interest.
The IRS disputed the real estate value of Pine Bend. First, its overall value was 13% higher, and it didn’t allow an absorption (or “blockage” discount). The taxpayer’s appraisal included a 25% absorption discount because the acreage block was so large relative to the local market. The Tax Court allowed a 20% blockage discount but on the government’s higher real estate value.
The taxpayer’s appraiser valued the 50% GP interest AFLP held in Pine Bend at a 40% combined discount. The Tax Court decided on a 30% combined discount. Thus, the interest AFLP held in Pine Bend constituted about 10% of AFLP’s overall net asset value (NAV).
The taxpayer’s appraiser applied lack of control (minority interest) discounts of 40% and 45% for the two dates. Using the Bajaj Study regression method, the IRS’ expert determined discounts of 7.14% and 8.34%. As in McCord, Peracchio, Lappo and Kelley, the Tax Court rejected this method. The Tax Court allowed a 17.47% discount for lack of control.
The taxpayer’s appraiser’s DLOM was 15%. But this low DLOM is misleading as the 40% to 45% discount for lack of control the appraiser already took is derived from a secondary real estate partnership transaction database so it’s not possible to know how much of the observed discount is attributed to lack of control and how much to lack of marketability. Due to this overlap, it might be better to look at the taxpayer’s appraiser discount as a combined one of 49% and 53%.
The IRS’ DLOM was 21.23%. The Tax Court decided to use the higher IRS’ DLOM as its own. In this rare case in which we find that the IRS’ DLOM is higher than the taxpayer’s, it’s worth noting that the IRS also argued for: (1) a very low discount on the absorption issue; (2) a zero discount on the Pine Bend GP interest; and (3) an “unreasonably low” (to quote the Tax Court opinion) lack of control discount.
Grieve v. Comm’r
I’ve mentioned this case previously but in this 2020 gift tax case, the Tax Court affirmed the use of the “traditional asset-based methodology.” The case involved two nearly identical LLCs holding mostly marketable securities. Based on the testimony during the trial, the clear meaning of this term is the valuation process applying discounts to NAV. The only methodology discussed for determining DLOM by the traditional method was the restricted stock studies. The DLOM determined by the taxpayer’s expert was 25%. The Tax Court accepted this result.
The taxpayer’s expert testifying at the trial was from a different appraisal firm than the firm whose valuation opinion was attached to the Form 709 gift tax return. The testifying expert used both the traditional method and an income approach. While the testifying expert’s appraisal represented a second opinion of value, the result wasn’t significantly different from the opinion of the original appraiser. The Tax Court elected to reject entirely the IRS expert’s novel valuation methodology and to adopt the value and discounts determined by the original appraisal firm.
While the Tax Court gave a rationale for using the original appraiser’s work and not the testifying expert’s, it’s very likely an important driver of this decision was the fact that the IRS and the taxpayers had stipulated to the NAV in the original appraiser’s work. The NAV determined by the testifying expert was slightly different. Because the valuation results were so similar, having to procedurally deal with this issue was undoubtedly viewed as an unnecessary step.18
Estate of Streightoff v. Comm’r
The taxpayers in this case19 argued that the 88.99% interest held by the decedent was an assignee interest and not an LP interest. A DLOM of 27.5% using restricted stock studies was determined. The trial centered around establishing whether the interest was an assignee interest. If the interest were an LP interest, it would have full control of the partnership. At trial, the expert stated that if the interest had been deemed to be an LP interest, the opinion would have been “different” (that is, much lower).
The IRS’ expert, valuing the interest as an LP interest, rejected a minority interest discount but, citing recent restricted stock studies, allowed a DLOM of 18%. The court held the interest wasn’t an assignee interest and adopted the IRS’ DLOM.
Nelson v. Comm’r
This 2020 gift tax case is of great importance. With respect to DLOM, it highlights the fact that despite all of the discussion about restricted stock studies in previous cases, the efficacy of the studies for FLPs isn’t a settled issue. Rather than avoiding the issue by merely citing that the studies had been accepted in previous cases, in Nelson the Tax Court chose to elucidate why it was unpersuaded that the studies are an acceptable foundation for valuing an FLP.
The value disputed in this case is derived from Warren Equipment Co. (WEC), a Delaware holding company owning 100% of the stock of Warren Cat, a Caterpillar equipment dealership in West Texas and Oklahoma, which made up 51% of WEC’s combined value. On the valuation date, 27.7% of the stock of WEC was held by Longspar Partners, Ltd., a Texas LP. On Dec. 31, 2008, gifts of minority interests in the LP were made.
Longspar’s valuation involved a closely held operating company stock ownership held by the LP. Both the IRS and taxpayer agreed on the DLOM (30%) applicable to the WEC interest. The Tax Court accepted this result. No discussion on methodology was provided.
In valuing the LP interests in Longspar, the taxpayer’s expert’s DLOM of 30% was derived from both the restricted stock studies and the pre-IPO studies. The IRS’ expert compiled a range of discounts from 22% to 34% by using quantitative models that employed the Black-Scholes option model and considered hypothetical rates of return on Longspar’s assets. He also examined several studies on the sales of restricted stock and pre-IPO stock, selecting a range of discounts of 20% to 35%. The IRS’ expert reconciled these two ranges of discounts and determined that a 25% discount should apply because 25% reflected the mid-point of these two ranges and his reasoning that the DLOM at the LP interest level should be less than the 30% DLOM found at the asset level.
Even though the taxpayer’s expert’s DLOM was only 5% more than the government’s expert’s figure, and even though he looked at restricted stock and pre-IPO studies, as did the government’s expert, the Tax Court, nonetheless, rejected the taxpayer’s expert’s DLOM:
[Taxpayer’s valuation expert’s] analysis depends on several studies on the sale of restricted stock and private, pre-IPO stock that have been brought to the attention of this Court before. See Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148, 2011 WL 2559847, at *20; Estate of Bailey v. Commissioner, T.C. Memo. 2002-152, 2002 WL 1315805, at *10; Furman v. Commissioner, T.C. Memo. 1998-157, 1998 WL 209265, at *17 (listing examples of cases from 1978 through 1995 involving these studies). And in those cases we have repeatedly disregarded experts’ conclusions as to discounts for long-term stock holdings when based on these studies. See Estate ofBailey v. Commissioner, 2002 WL 1315805, at *10; Furman v. Commissioner, 1998 WL *49 209265, at *17. Accordingly, we will disregard [Taxpayer’s valuation expert’s] conclusions as to a discount for Longspar which was based on these studies.20
When we read the above citations, we realize that what the Tax Court is saying is that the referenced studies are inapposite because they relate to investments with a short-term horizon, and the subject interest has a very long holding period of, perhaps, decades.
This is different from what the Tax Court said in McCord and all of the cases that cited it. In McCord, the Tax Court relied on the testimony of the government’s expert who cited an academic paper which, he claimed, proved that the level of discount doesn’t continue to increase with the time period of impaired marketability. According to this logic, even though the holding period of the FLP limited partner might be vastly longer than the holding period of the buyers of restricted stocks, the differential is irrelevant because the hypothetical buyers of the FLP interests don’t price illiquidity beyond a much shorter time horizon. Unfortunately, the Tax Court’s reliance on the expert was misplaced because this isn’t what the paper said.
In “Asset Pricing and the Bid-Ask Spread,” New York University professors Yakov Amihud and Haim Mendelson stated:
Our model predicts that higher-spread assets yield higher expected returns, and that there is a clientele effect whereby investors with longer holding periods select assets with higher spreads. The resulting testable hypothesis is that asset returns are an increasing and concave function of the spread. The model also predicts that expected returns net of trading costs increase with the holding period, and consequently higher-spread assets yield higher net returns to their holders. Hence, an investor expecting a long holding period can gain by holding high-spread assets.21
Nowhere in the paper does it state that the cost of illiquidity stops growing after a certain time period. The word “concave,” however, does signal that the cost of illiquidity isn’t a linear relationship with time. It continues to grow but at an ever decreasing rate.22
As a practical matter, except for the first few years of a long-term holding period, the increase in the cost of illiquidity from one year to the next is usually insignificant. But in the case of an FLP with a very long holding period (in McCord, as long as 30 years), the difference in the illiquidity cost between, say, Year 10 and Year 20 would be significant indeed.
Today, the Tax Court seems to be internally divided as to how to treat the use of restricted stocks in determining DLOM for FLPs. One school holds that these studies are irrelevant, and one holds that only the recent studies (with shorter holding periods and, therefore, lower DLOMs) are relevant. Both schools do agree that the business appraisal community has historically ignored the fact that FLPs hold assets that are far less risky than the subjects of the restricted stock studies. So far, in the use of restricted stock studies, the appraisers haven’t provided a persuasive answer to this issue.
As Harry Nilsson eloquently put it in his song, Everybody’s Talkin, “Everybody’s talking at me, I don’t hear a word they’re saying…” For 20 years now, regarding the use of the traditional approach to FLP valuation, the IRS (and, very often, the Tax Court) has shouted, “low risk!” while the appraisers have responded with, “long holding period!”
The Rise of the Income Approach
Valuation is all about the present value of expected economic returns. This topic has been notably absent from the historical record of FLP valuation disputes. However, in three of the recent cases cited—Elkins, Grieve and Nelson—the appraisers who incorporated the use of the income approach to value fared very well. The engine of the income approach is the holder’s expected economic return. This is as it should be. After all, investors invest to make a profit. Geared to the return are the elements of risk and time. In the final resolution of these cases, the opinions from the bench cast no negative light on the income approach. In Elkins and Nelson, the courts openly applauded the use of the income approach.
The recent success of the income approach doesn’t mean the traditional method of valuing FLP interests should be abandoned. The courts have accepted this methodology time and again. But the appraisers and the estate-planning community that uses their services would do well to hear what the courts have been saying.
Endnotes
1. See Internal Revenue Service UIL no. 2031.01-00, www.timbertax.org/publications/irs/Appeals_Settlement_Guidelines_10_20_06.pdf.
2. McCord v. Commissioner, 120 T.C. 358 (2003).
3. Lappo v. Comm’r, T.C. Memo. 2003-258.
4. Peracchio v. Comm’r, T.C. Memo. 2003-280.
5. Estate of Webster E. Kelley v. Comm’r, T.C. Memo. 2005-235.
6. The IRS memo was critical of the “large” discount allowed by the Tax Court in Kelley, ibid., which held only cash. The memo described the decision as an anomaly that doesn’t offer valuable guidance.
7. The fact that 37 of the 88 transactions were private placements for fully registered shares means this study must be referred to as a “private placement” study and not a restricted stock study.
8. In McCord, supra note 2, the taxpayer’s expert also relied on the pre-initial public offering method, but this was rejected. The restricted stock studies refer to numerous compilations made at various points in time that reflect the pricing of private purchases of restricted stock in publicly traded companies. Such transactions almost always take place at a price that’s at a discount to the market price of the unrestricted shares.
9. Mukesh Bajaj, David J. Denis, Stephen P. Ferris and Atulya Sarin, “Firm Value and Marketability Discounts” (Feb. 26, 2001), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=262198.
10. Even the McCord court struggled with this point as it took issue with the taxpayer’s appraiser’s failure to take into account the fact that the interest transferred was a 40% block. However, the significance of this relates to the pricing of such a large block of restricted shares as found in the studies. Because these are voting shares, a 40% block would convey significant power and control and, hence, a lower discount. Assignee interests, however, are non-voting.
11. Holman v. Comm’r, 130 T.C. No. 12 (2008).
12. Ibid., at p. 65.
13. The combined valuation discounts were slightly different at each of the four transfer dates.
14. Estate of James A. Elkins, Jr., et al. v. Comm’r, No. 13-60472 (5th Cir. 2014), at p. 14.
15. Estate of Natale B. Giustina v. Comm’r, (9th Cir. 2014 ), No. 12-71747, at p. 3.
16. Grieve v. Comm’r, T.C. Memo. 2020-28, at p. 34.
17. Astleford v. Comm’r, T.C. Memo. 2008-128 (2008).
18. It’s interesting to note that, in determining net asset value, the original taxpayer’s appraisal report valued the marketable securities portfolio based on closing market prices instead of the average of the high and low prices for that day as required by Treasury Regulations Section 25.2512-2. Furthermore, an intra-family note that used the applicable federal rate was mark to market using prevailing market interest rates. While this would seem to be permissible for estate tax purposes, for gift tax purposes, this treatment of the value of such a note is problematic. See Steve R. Akers, Samuel A. Donaldson and Beth Shapiro, “Consistent Valuation of Promissory Notes,” Kaufman Recent Developments 2022, 57th Annual Heckerling Institute on Estate Planning, University of Miami Law School, at pp. 23-26.
19. Estate of Frank D. Streightoff v. Comm’r, T.C. Memo. 2018178 (2019), aff’d, No. 19-60244 (5th Cir. 2020).
20. Nelson v. Comm’r, T.C. Memo. 2020-81, at p. 18.
21. Yakov Amihud and Haim Mendelson, “Asset Pricing and the Bid Ask Spread,” Journal of Financial Economics (1986), at p. 224.
22. The well-known U.S. Treasury bond yield curve is an example of a concave function.