Reducing Taxable Wealth Yet Keeping It All In the Family (Courts' Views On Best Method To Take Discounts)

For many decades, estate planning professionals have advised their clients to share ownership of the senior generation's assets with the junior generation so when the senior generation passes away, it is without "full control" of their assets. In this way, valuation experts can legitimately apply discounts to asset values to reflect lack of control and lack of marketability, thus, significantly reducing the estate tax burden.  For decades, the determination of the discount for lack of marketability has been one of the "hot buttons" for Internal Revenue Service challenges (IRS). Until a few years ago, the taxpayer typically won these contests. Recently, however, the IRS is increasingly emerging victorious in the discount for lack of marketability battle in Court. 

Accordingly, if the taxpayer, estate planning professional and the valuation expert approach the discounting process as they have in the past, there is a strong possibility that they have unwittingly increased the chance for audit, if audited, decreased the chance of favorable compromise and, if taken to Court, increased the chance of losing.  This article will explore a series of Court cases on the discount for lack of marketability issue that, when taken together, provide a road map to increase the likelihood of having the IRS and Tax Court accept the discount determined.

Background

It has long been recognized that owning 100 percent of a company is more valuable, on a per share basis, then owning a minority interest. This is evidenced in the public marketplace when companies are acquired at a premium to the publicly traded "minority" price.  However, when owning a minority interest in a privately held company, the owner, in addition to lack of control, faces considerable difficulty in selling their minority interest to a third party.  Accordingly, Courts have long recognized that in determining the value of a private company minority interest a reduction in value for lack of marketability is appropriate.  The difficulty, of course, is how the discount is determined and what magnitude of discount is acceptable.

The Benchmark Average Method

In the past, the primary method to determine discounts was based upon the average discount found in restricted stock transactions. Because of concerns of market manipulation, the holders of large blocks or unregistered shares of a public company are restricted from freely selling their shares in the public marketplace by the Securities and Exchange Commission.  This restriction is often referred to as Rule 144.  Rule 144 requires a holding period after acquisition (currently one year), after which the investor can sell in the public marketplace every quarter, without restriction, the greater of (a) one-percent of the total shares outstanding, or (b) the average weekly trading volume over the prior four weeks. In 1971, the Securities and Exchange Commission published a study that, for the first time, examined the private sales of the restricted stock of publicly traded companies.¹ Subsequently, numerous small studies have been performed typically listing the average discount found in the limited study.  These averages have become known as the Benchmark Average.  The following table is an example of the Benchmark Average Method that is often seen in appraisal reports.²

To date, the Benchmark Average Method has been the primary method utilized by valuation experts to determine the discount for lack of marketability.

Recently, however, the Benchmark Average Method has been losing in Court.  In Peracchio,³ the Court criticized the use of the Benchmark Average Method saying, "While restricted stock studies certainly have some probative value in the context of marketability discount analysis... [the expert] makes no attempt whatsoever to analyze the data from those studies as they relate to the transferred interests. Rather, he simply lists the average discounts observed in several such studies, effectively asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests."

This criticism was echoed in the 2006 Temple Court decision which rejected the Benchmark Average Method saying, "Rather than taking restricted stock sale data and explaining its relation to the gifted interests, [the Taxpayer's expert] simply listed the studies and picked a discount based on the range of numbers in the studies."⁴

Pre-IPO Approach

In the mid-1980's, an appraiser from Wisconsin, John Emory, began to examine stock transfers of companies that subsequently went public.  This appraiser reasoned that the difference between the pre-public stock transfer price (when the company was still private) and the post-initial public offering (IPO) price, represented the discount for lack of marketability.  Many appraisers felt the Pre-IPO discount studies overcame the weakness of the Benchmark Average Method in that (a) there were more transactions with which to do a comparative analysis, and (b) because restricted stock has more liquidity than a private company interest, the higher Pre-IPO discounts were more appropriate for private equity.

In 2003, however, the entire Tax Court took a look at the Pre-IPO Approach, and rejected it.⁵  The en banc McCord Court stated "[The IRS's Expert] offers a compelling criticism of [the various Pre-IPO studies]. ... [The IRS's Expert] has convinced us to reject as unreliable [the Taxpayer's Expert's] opinion to the extent it is based on the IPO approach."

While McCord was subsequently overturned on a technicality, the Fifth Circuit specifically noted, "...in arguing at trial that some of the discounts employed by the Taxpayers' expert in valuing the interests were erroneous or inapplicable, the Commissioner specifically opposed a discount grounded in [the Taxpayer's expert's] contention that the Taxpayers had transferred less than full limited partners interests.  The Commissioner does not, however, advance such a contention on appeal; so it too is waived, and we do not address that issue.  Our failure to address it should not, however, be viewed as either agreeing or disagreeing with the Majority's determination on this point.  Rather, as shall be shown, we have no need to reach it."⁶  Despite McCord's reversal, the McCord Tax Court decision still represents the best evidence of how the entire Tax Court views the use of the Pre-IPO Approach.

QMDM

In the mid-90's, the valuation firm, Mercer Capital, expended great sums to market and promote an alternative discount methodology called the Quantitative Marketability Discount Model (QMDM).⁷  According to the Weinberg Court, "The QMDM is an economic model that attempts to relate the present value of the future returns of an investment in the form of distributions and capital appreciation to the amount an investor is willing to pay for the investment.  The QMDM incorporates various factors, including: The expected distribution yield (i.e., the expected annual return through distributions), the expected growth rate of value (i.e., the expected growth in the underlying asset value), the required holding period return (i.e., the rate of return on similar investments), and the assumed holding period.  The QMDM consists of various summary tables in which implied marketability discounts are enumerated for each set of the above four factors."⁸  In one example, possible discounts ranged from 1.7 percent to 92 percent⁸.⁹ 

While many appraisers favored the QMDM because of its ease of use and flexibility, the Courts did not.  In Weinberg, the Court singled out the QMDM for criticism saying, "We disagree with the discount computed by [the IRS's expert] on the basis of the QMDM model because slight variations in the assumptions used in the model produce dramatic differences in the results. ... Because the assumptions are not based on hard data and the range of data may be reasonable, we did not find the QMDM helpful...."  Weinberg was soon followed by Janda which stated, "We have grave doubts about the reliability of the QMDM model to produce reasonable discounts...."¹⁰

One component that lends itself to the flexibility of the QMDM to arrive at different discounts is the choice of holding period.  And, the selection of the holding period is a mandatory requirement of the QMDM.  However, because "slight variations" in the holding period "produce dramatic differences in results" the 2006 Temple Court effectively banned the use of the QMDM stating, "...the Court finds it is inappropriate to assume a particular holding period for the hypothetical willing buyer."

The Restricted Stock Comparative Analysis Approach

With the Courts rejections of the Benchmark Average Method, the Pre-IPO Approach and the QMDM, appraisers need to find a different method to determine discounts for lack of marketability.  Luckily, the Courts have provided just such a method - The Restricted Stock Comparative Analysis.  In Temple, the Court rejected both the Benchmark Average Method and the QMDM.  However, the Court viewed the Restricted Stock Comparative Analysis with great favor saying, "As for the lack of marketability discount, the Court finds [the IRS's expert's] methodology to be correct. ...The Court finds reliability in the fact that [the IRS's expert] endeavored to understand and incorporate the market dynamics of restricted stock sales."  And, "The better method is to analyze the data from the restricted stock studies and relate it to the gifted interests in some manner, as [the IRS's expert] did."¹¹

Instead of listing the average discounts arrived at in various restricted stock studies¹² as the Benchmark Average Method does, the Restricted Stock Comparative Analysis Approach attempts to analyze the underlying restricted stock transaction data in comparison with the subject interest.  The largest of all published  restricted stock studies, and the one with the most information allowing for quite broad comparisons, is The FMV Restricted Stock Study.¹³ 

From The FMV Study, consider the following:

The above table takes the data from The FMV Study and divides the transaction discounts into quintiles from the lowest discount to the highest discount.  It then examines the various characteristics of the companies found within each quintile.  As is clearly indicated by the table, discounts for lack of marketability vary based upon size of Market Value, Total Assets, Revenues, and the undiscounted public Price per Share.  Moreover, the discount is also related to the price Volatility of the underlying public stock.  Instead of utilizing the restricted stock average (as represented by the 3rd quintile discount), the appraiser can compare the subject company characteristics with that of the restricted stock transaction company characteristics.

This comparison, however, is just the first step.  Because of the "dribble-out" provisions of Rule 144, restricted stock has varying degrees of illiquidity based upon the percentage block of the interest.  For example, under Rule 144 a one percent block in fictional company ABC is held for one-year and then can be sold immediately in the first quarter.  However, a 24 percent block in the same company will take seven years to dribble-out under Rule 144.  Accordingly, the larger block is significantly more illiquid than the smaller block and should command a higher discount.  This is exactly what The FMV Study indicates (see below).

On average, in transactions involving companies that are generally similar in terms of Market Value and Volatility (two of the most important determinants of the restricted stock discount), on average the discounts are 20 percentage points higher for large blocks (over 30%) versus small blocks (less than 20%).  In other words, the larger discounts associated with large blocks of restricted stock reflect the greater illiquidity of the larger blocks.

Please note, while a small block of restricted stock will have a different discount than a large block because of differences in liquidity, this is not the case for a private company interest.  For a private company interest, it is most likely that the small block and large block will have similar discounts as their illiquidity is identical.

Accordingly, for a privately held equity interest, a comparative discount process would first determine an "as if" restricted stock discount.  However, because private equity is more illiquid than the restricted stock in the restricted stock studies, an increment can be added to the "as if" restricted stock discount based on the differential between the more liquid small blocks and the less liquid large blocks of restricted stock.  This is appropriate because the illiquidity of private equity is more similar to that of the large restricted stock blocks than the small blocks.

At the end of the day, it is important for the appraiser to not rely on the Benchmark Average Method, the Pre-IPO Approach or the QMDM as the primary determinant of the discount for lack of marketability. On the other hand, a Restricted Stock Comparative Analysis should be the center point for the discount for lack of marketability determination.  In order to "analyze the data from the restricted stock studies and relate it to the gifted interests in some manner,"¹⁴ appraisers should consider such discount determinants as Market Value, Revenue, and Total Assets.  Volatility for a private company can either be estimated, or the Market-to-Book Value ratio can be used as a surrogate for Volatility.  This is because a company with greater intangible assets (a high Market-to-Book ratio) is likely to have greater Volatility than a company that is comprised primarily of tangible assets (a low Market-to-Book ratio.  Such comparisons are more likely to find favor with the Courts than the use of the Benchmark Average Method, the Pre-IPO Approach of the QMDM.