Two Tales of Recent Valuation Tangles with the IRS

What is your goal when you send a valuation report to the Internal Revenue Service for a gift or estate tax matter? My goal has always been one of quiet acceptance. I hope that the report will be viewed as heavy, as well written, as logical and good, and that the Internal Revenue Service will say, “Ho hum, another pass,” and move on. And that’s been the case with literally thousands of Mercer Capital reports.

Today’s valuation video is a tale of two Tax Court situations. Two totally different situations. In the first situation. I did the original appraisal for an estate. The subject interests were four small minority interests in four New York City LLCs holding very attractive underlying real estate.

So we sent the report in. The report had a minority interest discount of 5% and the marketability discount of 50%. Now before you go, ”Whoa!”, let’s talk just a little bit more. The Internal Revenue Service reviewed my report and issued a separate report. Their report basically said the minority interest discount should be 10%. I didn’t argue with that — and that the discount for lack of marketability should be 15%. My total discounts were 52.5% and theirs were 23.5% So this is a classic dispute over, really, the marketability discount.

So what were the issues? Well, the managing member of the LLC was a bad actor. He was literally trying to steal minority interests from lots of minority owners of these very attractive underlying real estate properties. There was ongoing litigation and the minority shareholders had been litigating for quite some time. The shares that were the subject interests were in a trust to participate in the litigation. There were substantial accrued legal fees, but their total amount was not yet known. But the fees were known as a percentage of the ultimate settlement. There are lawyers and attorneys that could be legally fighting the charge against you, so hiring one would be a good idea.

The discount for lack of marketability was a real issue. There was an uncertain holding period there was ongoing litigation. It was not settled. There was high risk, very high risk in this situation for any holder coming in to buy the stock and there were negative distributions. In other words they were either paying tax distributions only in a couple of them, and not even tax distributions in the other two. So those were the issues.

In terms of the Internal Revenue Service, there was absolutely a complete and utter failure to distinguish between the attractiveness of the underlying real estate and the unattractiveness of the subject interests. So I wrote a report that criticized the IRS report. The attorney for the estate used that report as a basis for discussion and it must have been a pretty good valuation report and a pretty good rebuttal report because they settled at a net discount for 49.65%.

The client was happy and I was certainly happy. It wasn’t quiet acceptance, but it was basically a virtual acceptance of our report. The second case. I was not the original appraiser in this matter, but there were four S Corp auto dealerships. They’d been valued a couple of years, ago a few years ago, and the original appraiser was simply not available. So the counsel for the estate for the taxpayer, who had made a substantial gift, called us. And we valued the companies.

We valued a hundred percent of the equity at $24.6 million. The Internal Revenue Service issued a report by an Internal Revenue Service appraiser at $29.7 million. My discount for lack of marketability — there were four — so the blended marketability discount was 33%. Their’s was 25% across the board. We had a non-marketable minority value $16.5 million versus their $22.3 million.

This was not your basic dispute over a marketability discount. This was basically a blocking and tackling valuation situation. I call it valuation blocking and tackling. Their valuation report was not very good.. We both used total Capital as a vehicle to capitalize and get enterprise values, subtracting debt and adding cash. Well, they used debt from the wrong balance sheet date. It’s just wrong. They used non-operating assets from the wrong balance sheet date.

It was just wrong they had forecasts that were simply unsupported, and when graphed them out, they bore no resemblance whatsoever to history, So. they had that problem as well. And then of course the discount for lack of marketability — because there was no differentiation between the four S corps and there were clear differentiation between them.

Our marketability discounts ranged from 30% to 40%. And the most attractive and biggest company had a 30% marketability discount. In any event, what happened? We sent this report to Tax Court, and we were scheduled to go to Tax Court. I was sitting in my office on a Thursday afternoon, planning to go Sunday evening to Tax Court down in some city somewhere. And the attorney called. He said “Hang it up. It has settled.” Well, where did it settle? It settled — after our rebuttal report. Because the attorney had used that rebuttal report to discuss with the Internal Revenue Service. It settled at $17.7 million, or about 20% of the difference — of the nearly $6 million dollar difference. It settled because I don’t think the Internal Revenue Service wanted to go to court with their report.

So in today’s valuation video, we have a tale of two valuation disputes with the Internal Revenue Service. In the first, an original appraisal. We sought quiet acceptance and didn’t get it, but we ultimately got acceptance.

In the second dispute, we were called to help take the case to Tax Court. We didn’t get quiet acceptance, but we got pretty much acceptance. The client was happy. Everybody was happy. What is your goal when you send a report to the Internal Revenue Service for gift or estate tax purposes? My goal is to have the best possible valuation report and to earn the quiet acceptance of the Internal Revenue Service.

This is Chris Mercer with one more valuation video. I look forward to talking to you again in the future.

Please note: I reserve the right to delete comments that are offensive or off-topic.

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