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.