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Contents
Quick Links to SC&H Group, LLC 2009 MSBA Conference We were excited to see everyone at the 2009 Annual MSBA Conference in Ocean City. If you didn't get a chance to meet us in person, please give us a call. We would be happy to discuss any valuation issues that your clients are contemplating. Congratulations to Scott Wilson from Miles & Stockbridge who was the winner of our $100 American Express Gift Certificate drawing. Valuation and Estate Planning in the Current Environment The challenging economic environment has negatively affected many owners of privately-held businesses over the last 12 months. However, it has also created a unique estate planning opportunity for business owners who may be subject to estate taxes in the future. Due to these economic conditions, the values of many privately-held businesses and other assets have declined significantly due to:
As a result of these temporary declines in the value, business owners can use a variety of techniques to pass stock and other income producing assets to their heirs at a fraction of the long term value of those assets. In combination with the observed declines in the value of many assets, the low interest rate environment further contributes to the attractiveness of certain estate planning vehicles such as:
Our experienced valuation and estate planning experts are available to discuss these opportunities with you and guide you through the process of setting up estate plans and properly valuing interests for estate planning purposes. For more information about our Business Valuation practice, email BVLS@SCandH.com or call (410) 403-1500 | (800) 832-3008.
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Valuations Insights, Third Quarter, 2009 Tax Court Decision on Discounts and Embedded Taxes Hinges on Experts Estate of Litchfield v. Comm'r, 2009 WL 211421 (U.S. Tax Court) January 29, 2009 The $26.4 million Litchfield estate consisted primarily of minority stock interests in two family owned companies, Litchfield Realty Co. (LRC) and Litchfield Securities Co. (LSC). The Internal Revenue Service (IRS) and the estate agreed on the net asset values (NAV) of the estate's interests. However, they aggressively disputed the discounts related to built-in capital gains taxes, lack of control, and lack of marketability. Built-in capital gains tax would consume majority of NAV. When Marjorie Litchfield died in 2001, her estateowned a 43.1% interest in LRC, which held primarily Iowa farmland and marketable securities. LRC earned a marginal profit, but the company was not performing up to management expectations or the performance of Midwestern farmland generally. Historically, the company had sold portions of its farm holdings to raise cash. To increase profitability and shareholder returns, LRC converted from a C corporation to an S corporation in January 2000. However, for the 10 years following conversion, if the company sold any of its former C Corp assets then it would incur corporate-level tax on the sale (per IRC Sec. 1374). As of the valuation date, LRC's total NAV of $33.2 million included $28.8 million in built-in capital gains tax liability--or 86.7% of NAV. Just over $19.8 million of the built-in capital gains taxes related to its farm holdings and $9.0 million to its marketable securities. To prepare the estate's tax return in connection with its 43.1% interest in LRC, its expert appraised its share at a fair market value of $6.5 million--after application of discounts for built-in capital gains taxes (17.4%), lack of control (14.8%), and lack of marketability (36%). On audit, the IRS valued the same interest at just over $10 million, applying only a 2% discount for embedded taxes, 10% for lack of control, and 18% for lack of marketability. ; It assessed a deficiency of approximately $3.8 million. The estate's 23% interest in LSC, a C corporation that held primarily "blue chip" marketable securities and partnership investments, had a NAV of $52.824 million. Like LRC, none of the LSC stock had ever been publicly traded and it was subject to substantial restrictions. Its investment strategy focused on continuing to maximize cash dividends to shareholders. In fact, in the late 1990s, the directors became concerned that elderly shareholders in both LRC and LSC would not have adequate reserves to pay for estate taxes and other obligations, and after the death of Mrs. Litchfield, they sold some assets in both entities to raise stock redemptions. As of the valuation date, LSC's NAV included nearly $39 million in built-in capital gains, or 73.8% of its total NAV. Note: The capital gains tax applicable to both companies ranged from 35.5% to 39.1%. The estate's expert discounted its 23% LSC interest by capital gains tax as well as lack of marketability and control, but on audit, the IRS determined a deficiency of over $3.0 million. The Tax Court considered each of the experts’ discounts in turn. 1. Built-in capital gains taxes. The estate's expert reviewed historic asset sales for both entities along with board meetings and management plans for future sales. He estimated a 5-year holding period for LRC and 8 years for LSC to reach discounts of 17.4% and 23.6%, respectively. By contrast, the IRS expert used turnover rates based solely on historical asset sales, projecting a holding period of 53 years for LRC and 29 years for LSC to derive his discounts of 2% and 8%, respectively. Given the "highly appreciating non-operating investment assets" that both companies held, the Tax Court considered it likely that a hypothetical buyer and seller would negotiate "substantial" discounts for the embedded tax liability. Further, the estate's expert based his asset turnover on more accurate data, in particular his conversations with management and review of current sales. By contrast, the IRS expert looked only at historic data and did not account for appreciation. The court adopted the estate's discounts for built-in capital gains tax, without adjustment. 2. Lack of control. To determine the discount for lack of control (DLOC) for LRC securities and farm holdings, the estate's expert reviewed data from closed-end funds as well as real estate investment trusts) and limited partnerships. He then reviewed entity-specific factors, weighted for the combined asset classes, to calculate a 14.8% DLOC. He performed a similar exercise using closed-end funds to calculate an 11.9% DLOC for the estates interest in LSC. The IRS expert claimed that because LRC's assets were performing well, a buyer would not expect a large DLOC. Without breaking down his analysis by asset class, he reviewed closed end funds, trimming the average, to calculate a 5% DLOC for LSC's marketable securities. For its farm holdings, the IRS expert reviewed a variety of public sales data to posit a range of 17% to 20% DLOC. Because discounts for public takeovers are generally higher than those for "normal" sales activity, he said, LRC's farming assets merited a lower DLOC of 15%. Even though the farmland comprised the bulk of the firm's NAV, he averaged the two findings (5% and 15%) to conclude an overall DLOC for the estate's interest in LRC of 10%. For LSC, the IRS expert used the "trimmed mean" from the closed-end funds. Because the estate's 22.96% interest was the single largest block of stock, its returns were good, and a purchaser would not want to change operations, a hypothetical buyer "would place no value on control," he believed, and a "nominal" DLOC of 5% was appropriate for LSC. The court noted that both experts calculated similar DLOCs for LRC's farming assets (15.7% vs. 15%); and both used lower-than-average discounts for its securities. But only the taxpayer's expert used a weighted (instead of a straight) average to account for LRC's more significant holdings of farm property, and the court adopted his 14.8% DLOC. Similarly, the IRS expert failed to account for the taxpayer's smaller holdings in LSC, and the court adopted the 11.9% DLOC by the estate's expert. 3. Marketability discount. The estate's expert used data from restricted stock studies as well as weighted values for entity-specific factors to calculate a discount for lack of marketability (DLOM) for LRC of 36%. He used the same restricted stock studies for the LSC interest, and after accounting for entity-specific factors and different asset classes, he applied a 29.7% DLOM. The IRS expert looked at restricted stock studies, including three from the 1990s that the estate's expert did not consider, and private placement studies. He then adjusted for entity-specific factors, such as LRC's dividend-paying policy, the estate's sizeable interest, and stock transfer restrictions, to apply an 18% DLOM. He reviewed the same studies with reference to LSC, and because its assets were more readily ascertainable and saleable, its earning history was consistent and its management competent, he assigned it a lower than average discount of 10%. This time, the court believed the estate's expert's DLOMs were too high, particularly when combined with his discounts for lack of control. In addition, some of his restricted stock data was aged, and, more notably, the estate's expert had determined "significantly lower" discounts for the same entities in connection with an earlier gift tax return. As a result, and without further discussion, the court concluded DLOM for the estate's respective interests in LRC and LSC of 25% and 20%. Overall, the court found that the fair market value of the estate's 43.1% interest in LRC was $7.546 million, and its 22.96% interest in LSC was worth $6.530 million. |
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