Has the Tax Court become too valuation-savvy?

BVWireIssue #106-3
July 27, 2011

An estate reported its 41.1% limited partnership (LP) interest in a family owned, timberland holding company at just over $12.6 million; the IRS said it was worth closer to $36 million. In finding that the “correct” value of the LP interest was roughly $27.5 million, the U.S. Tax Court (J. Morrison) held:

  • The discounted cash flow (DCF) analysis by the taxpayer’s BV expert was better overall, because he extrapolated cash flows from the five prior years instead of the most recent and he pointed out the internal inconsistencies in the IRS expert’s DCF. But he also tax-affected the projected cash flows while also using a pre-tax rate of return to discount them to present value, an inconsistency the court found “problematic.”
  • Three out of the four components that the taxpayer’s expert used to build a discount rate were good (risk-free rate, beta-adjusted ERP, small stock ERP), but his partnership-specific risk premium was too high, given standard portfolio investment theory, resulting in a “correct” rate of 16.25%, the court said. This nearly equaled the 16.22% rate posited by the IRS expert, but the court expressly rejected his method (risk-free rate plus small stock ERP).
  • Since the taxpayer’s expert failed to rebut the IRS expert’s contention that pre-IPO studies overstated the discount, the court accepted the latter’s 25% DLOM (versus 35% for the taxpayer).
  • Yet, even though the experts differed by only 10% on weighting the cash flow method (30% for the taxpayer vs. 20% for IRS), the court more than doubled the weighting to 75%, based on a 75% probability that the partnership would have kept going rather than liquidating. The only cited authority: a 1995 law review article that states “the entire valuation process is a boundless subjective inquiry,” requiring the court to make numerous “guesses or assumptions about the future.”

The court also rejected the guideline public company method used by both experts (for poor comparables) and three hybrid methods used by the taxpayer’s expert, giving only their net asset values (NAV) the remaining 25% weight. Read the entire digest of Estate of Giustina v. Commissioner, T.C. Memo. 2011-141 (June 22, 2011) in the September BVUpdate; the Tax Court’s opinion will be posted soon at BVLaw.

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