Valuation Discount Case and a "Novel Valuation Approach" used by the IRS Valuation Expert
PIERSON M. GRIEVE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
T.C. Memo. 2020-28
Filed March 2, 2020.
In a case that had many valuation issues, the tax court found that two 99.8% class B, non-voting interests in two asset holding companies, owning primarily cash, marketable securities and private investment assets, were entitled to significant discounts for lack of control and lack of marketability.
The IRS’s expert presented a “novel valuation approach” that took the form of a game theory exercise and was rejected by the court.
Pierson Grieve, a successful businessman and chairman of Ecolab, a publicly traded company, established two LLCs and a family limited partnership after the death of his wife, Florene Grieve, in 2012 as part of an updated estate plan.
Prior to forming the two LLCs, Pierson established the Grieve Family Limited Partnership and Pierson M. Grieve Management Corp. (“PMG”) with Margaret Grieve, the daughter of Pierson and Florence, purchasing PMG from Pierson in 2008.
Both Rabbit 1, LLC (“Rabbit”) and Angus MacDonald, LLC (“Angus”) were formed in 2013 with PMG owning a 0.2% interest (class A voting interest) in both entities and the Grieve Revocable Trust and Pierson Grieve owning 99.8% interests (class B non-voting interests) in both entities, respectively.
Both 99.8% class B non-voting interests were subsequently transferred: the Rabbit interest to a GRAT and the Angus interest to an irrevocable trust. At issue is the value of the interests transferred.
Valuation experts were retained by the taxpayer and determined that under the member agreements that the chief manager of both LLCs, Margaret Grieve, was appointed for life and the agreements indicated she could be removed only for cause, but also provided her with the right to appoint a successor chief manager of both LLCs.
As indicated above, the class A interests held all the voting powers for all purposes and the holders of the class B interests had no voting power. In addition, consent was required by the class A interest holder(s) for a transfer of interests.
The taxpayer hired two valuation experts, the first of which found the discount for lack of control for Rabbit, which held shares in Ecolab and cash valued at $9.1M, at 13.4%, using closed-end mutual funds to benchmark the adjustment and a 25% discount for lack of marketability using various studies including restricted stock studies. For Angus, the first expert determined the discounts were 12.7% and 25% respectively.
Tiered Entity Discount?
The taxpayer also hired another appraiser who adjusted the indicated value of certain private investments (Palladium Investments) and venture capital funds (Grossman Investments) held by Angus for lack of control and lack of marketability, 15% and 20%, respectively, for each asset prior to any adjustments for lack of control or marketability for the class B interests.
The IRS objected to what it considered to be tiered discounts, where discounts are taken at the asset level (the Palladium and Grossman investments) and at the investment level (the entities owning the assets – Rabbit and Angus), which would be akin to “double-dipping” or duplicating the discounts according the IRS in their objection.
While the court did not accept the discounts proffered by this expert for reasons unrelated to the discount determination, it does raise an important question – Can tiered discounts exist in situations where the investments held by an asset holding company be adjusted for both lack of control and lack of marketability?
The answer is, it depends. In a presentation by Will Frazier titled, “Its Turtles All the Way Down” at the 23rd Annual Advanced Business Valuation Conference in 2004, Frazier cites a number of factors that would influence the existence of such discounts and the magnitude of potential adjustments for lack of control and lack of marketability for investments held by holding companies.
For example, in determining a discount for lack of control for a holding company with underlying investments in marketable securities, an appraiser would typically use closed-end funds to benchmark the magnitude of the adjustment for lack of control. For real estate holding companies, real estate partnerships traded in secondary markets would typically be used to benchmark the potential adjustment for lack of control.
It is important to recognize that the average discounts observed for closed-end funds is 12% for example and for undeveloped real estate partnerships the observed discounts could exceed 30%. The types of assets held make a difference as the risk characteristics differ.
Therefore, one of the first factors is what type of assets are being held by the holding company. A second factor would be an assessment of investment performance and an assessment of the actions of management for these assets. It would include, for example, rate of return, level of distributions, and diversification within asset classes.
Finally, a third factor would consider the relative lack of control, for example, of a minority holder in a publicly traded closed-end fund versus a class B interest holder in Rabbit or Angus. Closed-end fund holders would have limited influence over decisions made by management whereas the class B holders in Rabbit and Angus would have no influence over management.
All these factors could influence the existence and magnitude of any adjustments to value for the investments held by the holding company as well. The investments in Palladium and Grossman investments were minority in nature and suffered from a lack of liquidity. Both investments should have been adjusted for these discounts. As indicated above, the court decided that the lower values for these assets were not accepted.
For more information on tiered discounts see: Astleford v. Commissioner, TC Memo 2008-128, May 5, 2008.
A Novel Valuation Approach
The Commissioner also retained a valuation expert to perform the valuation of both 99.8% interests. This is where it gets interesting: the expert’s valuations were conducted under the assumption that a “reasonable buyer of a 99.8% interest could be expected to seek to maximize his or her economic interest by consolidating ownership through the purchase of the 0.2% interest”.
Hypothesizing that the willing seller of the class B interest would first seek to purchase the class A interest at a premium, the result would be to consolidate control of the entity and reduce the discount that would be applied to the 99.8% interest by a hypothetical willing buyer. It also presumes that the holder of the class A interest would be willing to sell, a point that the court makes very clear in its decision.
The difference in value determinations for Rabbit is summarized below:
IRS value $893.68 per unit
Taxpayer value $591.56 per unit
The difference in value determinations for Angus is summarized below:
IRS value $3,151.98 per unit
Taxpayer value $2,093.28 per unit
The court in examining the “valuation approach” considered that “…we are valuing the class B units on the date of the gifts (or transfer) and not the value of the class B units on the basis of subsequent events, that while in the realm of possibilities, are not reasonably probable…”.
Additionally, the court used the “speculative” continuum discussed by the Court of Appeals for the Fifth Circuit in the McCord v. Commissioner decision, where it identified three types of speculative conditions “(1) a future event that is absolutely certain to occur, (2) a future event “that not absolutely certain to occur, but nevertheless may be a ‘more…certain prophecy’”, and (3) “a possible, but low-odds, future event” which is “undeniably a ‘less…certain prophecy’”.
Finally, the Court concluded that “the facts do not show that it is reasonably probable that a willing seller or 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”.
Minority Premium Model
It is interesting to note that the IRS expert asserted an approach not unlike that presented by Neil Mills-Mazer of the IRS in 2007 at the Second National IRS Symposium. The Minority Premium Model was introduced as a guide to acceptable discounts for tenant-in-common (“TIC”) interests. The model was a response to large discounts for majority holder’s interest in real estate that is held as TIC.
The model posits the same question posed by the appraiser in this case above – why would a hypothetical seller facing a substantial discount not consider buying out the minority interest holder (only in this instance a TIC)?
There are, however, significant differences. TIC interests have unique characteristics that make a comparison much more difficult. Holders of TIC interests have “equal” rights, for example, to request a partition, participate in management and agree on any financing arrangements, among many other differences. As we see above, the class B holders have very limited rights and privileges.
More importantly, the Minority Premium Model has significant issues, including an assumption that a majority owner would always pay a premium, the development of an arbitrary range of maximum discount, and does not meet the requirements of the fair market value definition by making assumption and speculating on the actions of either the willing buyer or the willing seller.
This case was a victory for the taxpayer, as the first valuation expert’s opinions of value were accepted. This is one of the first cases involving the valuation of majority interests in LLCs that resulted in significant adjustments to value for lack of control and lack of marketability. There are some parallels to this case involving limited partner interests and their valuation.