Estate & Gift Tax Valuations

DISCOUNTING: A NEW CLIMATE

Gone are the days when the only analysis for discounting was the selection of numbers from various market data sources. The answers were often subjective, more qualitative derived than quantitative. Empirical data is still important. However, the new climate is very different in terms of in-depth support now mandated. Why has the landscape changed?

First, the requirements of the Financial Accounting Standards Board (FASB) for valuations and GAAP accounting are much more specific in terms of approaches to value. Second, the IRS has continued to contest discount analyses in Tax Court. Finally, the Court has acceded to the pressure from the IRS to challenge subjective, unsubstantiated valuations. In order to support discounts in the future, a thorough quantitative analysis must be utilized in conjunction with the empirical data.

Lack of Control

The discount for a less than controlling position (minority interest) is based on a synthesis of two methods:

1. Empirical date on control positions (premiums above market). The discount can be the converse of the control premium. In addition, actual trades or sales of minority interests in businesses and real estate limited partnerships are analyzed. We maintain a significant data base of these transactions by our clients and subscribe to proprietary data sources.

2. We also use a financial model for the income generated by the asset or business. This model is either based on capitalized income or discounted cash flows. The greater the cash return, especially when contrasted with the market for similar assets, the less we can quantify the discount. The ultimate answer from this approach is to assess a quantitative analysis.

For real estate, the adjusted balance sheet method is applicable to define market value. This value is compared to RELP’s (Real Estate Limited Partnership data) to determine how the subject asset or investment compares to the RELP investments. The difference in value reflects the amount of discount from a liquid investment (RELP).

Lack of Marketability

There are two approaches used to estimate the discount for lack of marketability. These are the following:

1. The empirical models that utilize capital market transactions similar to the above analysis for the Lack of Control.

2. The second methodology utilizes theoretical models that quantify the discount for lack of marketability through the use of option pricing models and discounted cash flow models. These models attempt to compute the “cost of portfolio protection.” This quantitative result is gauged by the following:

➢ the cost of a put to protect the downside risk: involves the use of the Black-Scholes formula to value a call, from which we can calculate the put value.

➢ LEAPS – similar to put options but are long-term equity anticipation securities. The cost of a LEAP for a maximum of two years is found on the Chicago Board of Trade and is used as a benchmark for the “cost of portfolio protection.”

➢ an income based technique which allows 5 to 7 years of asset growth and discounting the terminal value to present value; the difference between this present value and the current value is the discount. Some courts reject this approach as too sensitive to the discount factor.

➢ as a test to the reasonability of this latter technique is to select a discount factor using other methods and solve the equation for the appropriate holding period to support the discount selected.

IRS Penalties

To add to the contentious nature of the IRS versus appraisers, new Code Section 6695A provides for significant penalties for “substantial” or “gross” over or under valuations. In addition to monetary damages imposed, the new guidelines may prevent appraisers from practicing in income, estate and gift tax cases for up to 5 years. The IRS seems determined to eliminate passive asset-holding family entities from any form of discounting.

Fair Value Issues

Recent Developments in Valuations

For Fair Value Accounting

The fair value accounting disclosures continue to become an important aspect of the financial statements of businesses in the United States. This fair value accounting topic continues to receive a lot of discussion that has caused much valuation controversy. These valuations may include analyses of all different types of assets, real property and business interests. The valuation analyst should understand that these valuations will most likely be subject to thorough evaluation and scrutiny by the client’s auditor. Consequently, the professionals who rely upon fair value valuations should understand current issues relating to this type of work.

1. Banks to “Mark to Market” Financial Instruments - In August 2009, the Financial Accounting Standard Board (“FASB”) proposed that all financial instruments should be marked to market on banking entities financial statements. This fair value disclosure could cause banks to recognize loan losses faster than they did in the past. Under the current requirements, the financial institutions are permitted to elect to disclose eligible items as fair value. The change would require all financial institution’s loans and other receivables to be reported at fair value.

2. What is Fair Value? - In the three years after the issuance of SFAS 157 (ASC 820), the definition of fair value is still not clear to many valuation analysts. The actual definition is “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” However, the valuation industry still seeks guidance for what “orderly transactions” are and who is a “market participant.” In addition, valuation analysts seek guidance with regard to the analysis of “highest and best use.” In real property appraisals, this concept is fairly straightforward. But, there can be questions relating to equity security and intangible assets

3. Need for Disclosure on the Use of Level 3 Valuation Inputs – In August 2009, FASB issued an exposure draft of a proposed Accounting Standard Update. In this exposure draft, the FASB proposes disclosure improvements about fair value measurements and the use of Level 3 unobservable valuation inputs. The proposed disclosure is any significant effect on the fair value measurement if the business has “reasonably possible alternative inputs.” The disclosure would be what the total effect is on the fair value measurement. This is also referred to as the “sensitivity disclosure.” Furthermore, the business would have to disclose the amount of significant transfers and the reason for the transfers in and out of Level 1 and Level 2 fair value measurements.

4. Measuring Liabilities at Fair Value – In August 2009, FASB issued an Update titled “Disclosure – Measuring Liabilities at Fair Value.” The FASB believed that there could be a lack of observable market information to measure the fair value of a liability. Consequently, the update addresses how to measure the fair value of a liability in a hypothetical transaction when restrictions prevent a transfer. The update also clarifies the use of or more valuation technique that uses the quoted price of an identical liability that has been traded, the quoted price of similar liabilities that have traded or an alternative valuation technique such as an income approach that computes the present value of cash flows.

The FASB continues to provide fair value accounting technical guidance. As U.S. GAAP and international GAAP continue to converge, the need for a clear understanding of fair value accounting issues will increase and valuation analysts who practice in this area must keep current.

Case & Engagement Update

AUDIT SUCCESS

As a regular feature in our Valuation Briefs Newsletter, we will discuss the highlights of recent Audit Successes our Clients have had as a result of our real estate appraisal and real estate holding company and discount valuation services.

In a 2006 large Estate in the San Diego (OR Southern California) area, our Client died in January 2006, and at the time of his death, his Trust owned a 99% Limited Liability Company (“LLCs”) Interest in four LLCs and 29.278% LLC interest in a corporation, all of which were real estate holding companies. Each of these companies wholly or partially owned fifty-nine (59) properties, that included forty-nine (49) single family rental residences, Multi-family apartment units, a Wahlgreens and Kohl Store, a large shopping center, and a Motel 6.

This appraisal was conducted for federal estate tax purposes and to assist in the filing of the Form 706 (Federal Estate Tax Return) and it required an appraisal all of the underlying income producing real estate owned by the five (5) entities referred to above, a valuation of undivided fractional Tenant-in Common Interests (“TIC Interests”) held by these five entities in other entities or directly in the Subject Properties, and the valuation of the five entities and the community property interest held in each of the entities.

We opined to two levels of combined discounts for the lack of control and the lack of marketability for the undivided fractional TIC Interests held in the underlying real estate (or other entities) at combined discounts of 28% to 32% and for the 49.5% Community Property Interests held by The Trust in the five Subject Entities at combined discounts of 32% to 36%, depending on the many factors analyzed in order to determine the final discounts, including the all important internal rate of return calculations in support of the discounts.

Our work was accepted without adjustments and without the client incurring any additional expenses under audit.