New Tax Court decision on discounts, embedded capital gains finds taxpayer’s expert more thorough, credible

BVWireIssue #77-2
February 11, 2009

The substantial Litchfield estate—valued at some $26.4 million—consisted primarily of minority stock interests in two closely held, family-owned companies, one that owned Iowa farmland and marketable securities and a second that owned “blue chip” stock and other equity investments. Although the IRS and the estate agreed on the net asset values (NAV) of the estate’s interests, they aggressively disputed the discounts applicable to built-in capital gains taxes, lack of control, and lack of marketability. To value the estate’s 43.1% interest in the first company, for example, the parties’ experts assessed the following:

 

Estate Expert

IRS Expert

NAV

$14.3 million

$14.3 million

Discount for capital gains tax

17.4%

2.0%

Discount for lack of control

14.8%

10.0%

Marketability discount

36.0%

18.0%

Ultimate fair market value

$6.4 million

$10.1 million

Estate expert uses more relevant data. Overall, the U.S. Tax Court (Judge Swift) found the taxpayer’s expert more credible and thorough in his analysis. To calculate the discount for embedded capital gains, for instance, this expert (both are unnamed in the opinion) not only used historic asset sales but also talked directly with management about potential future sales. The IRS expert used only historic data. In addition, he failed to account for the assets’ appreciation during the holding period. Another example: The IRS expert did not weight his average discounts for lack of control, but the taxpayer’s did, to account for one company’s more substantial holdings of farmland as compared to marketable securities.

The taxpayer’s discounts for lack of marketability were too high, however, and the court reduced these without much discussion to 25% for the first company and 20% for the second. A complete abstract of Estate of Litchfield (January 29, 2009)—including the court’s more comprehensive discussion of the expert’s use of restricted stock studies and private placement studies to calculate the marketability discounts—will appear in the next (April 2009) Business Valuation Update™

The opinion will join the more than 100 federal tax decisions posted to the BVLaw™ database, the single-largest compilation of BV-specific case law available to legal researchers, financial analysts, and attorneys. Note: BVWire™ extends special thanks to Owen Fiore for alerting us to the Litchfield case.

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