IRS's New Discount Approach Yet Again Reducing Taxpayer's Discounts
9/3/2003

IRS's New Discount Approach Yet Again Reducing Taxpayer's Discounts

By David M. Eckstein, CFA

“In quantifying that liquidity premium, however, we hesitate to rely on a single academic study—particularly one that [the IRS's expert] did not participate in and could not elaborate upon first hand.” Lappo v. Commissioner—T.C. Memo. 2003-258 (September 3, 2003)

On September 3rd, Judge Thornton's opinion in Lappo gave significant weight to the IRS's new approach to marketability discounts—the same approach the IRS successfully used in McCord four months earlier. Furthermore, the Lappo case confirms that detailed data and sound reasoning trump third party studies and unsupported deviations from averages every time. The ultimate cost of ignoring these lessons (and not understanding the IRS's new approach to marketability discounts) will be born by the taxpayer.

The Lappo case involved the valuation of limited partnership interests in Lappo Family Limited Partnership (Lappo FLP), which was formed under Georgia law on October 20, 1995, by Clarissa Lappo and her daughter, Clarajane Middlecamp. On April 19, 1996, assets were contributed to the partnership and Ms. Lappo made gifts on the same date. She made additional gifts on July 2, 1996. Lappo FLP's assets were just under 60 percent real estate (commercial property subject to long-term leases) and a bit over 40 percent marketable securities (mostly municipal bonds). Prior to the gifts, Ms. Lappo held a 1.0-percent general partnership interest and a 98.7-percent limited partnership interest, and Ms. Middlecamp held a 0.2-percent general partnership interest and a 0.1-percent limited partnership interest. The first round of gifts consisted of a 66.80917-percent limited partnership interest transferred to an irrevocable trust and a 0.6680917-percent limited partnership interest transferred to each of Ms. Lappo's four grandchildren. In the second round of gifts, Ms Lappo gave all of her remaining 29.2194632-percent limited partnership interest to Ms. Middlecamp, so that she retained only a 1.0-percent general partnership interest.

The IRS issued a deficiency notice for a net tax due of $821,243. The parties agreed that the values of the gifts should be determined by reference to the net asset value of Lappo FLP's assets minus “minority interest and marketability discounts.” They disagreed about the size of the discounts.

The taxpayer's expert applied a 7.5-percent discount for lack of control to the marketable securities held by Lappo FLP. He applied a 35-percent discount for lack of control to the partnership's real estate holdings as of the April 1996 gifts, and a 30-percent discount as of the July 1996 gift. He also applied a 35-percent discount for lack of marketability to all assets. Because the discounts are applied sequentially, the taxpayer's expert concluded that the appropriate combined discount was 50.4 percent as of April 1996 and 48.2 percent as of July 1996.

The IRS's expert applied an 8.5-percent discount for lack of control and an 8.3-percent discount for lack of marketability to all assets. Thus, the combined discount of the IRS's expert was 15.9 percent.

The court ultimately selected an 8.5-percent discount for lack of control to apply to the marketable securities, a 19.0-percent discount for lack of control to apply to the real estate, and a 24.0-percent discount for lack of marketability to apply to all assets. The court's overall discount was 35.4 percent as of both valuation dates. Throughout, the court tended to favor the data and methods used by the IRS's expert, and ended up only slightly closer to the taxpayer's value than to the IRS's.

The court had no trouble selecting a discount for lack of control for the marketable securities because the two sides agreed their opinions were not materially different. The court's opinion does not state the methodologies used by the experts to determine these discounts, but they both probably used closed end mutual funds, which are the most common data source to determine discounts for lack of control for marketable securities in a partnership.

With regard to the discount for lack of control for the real estate, the court first rejected the valuation analysis of the taxpayer's expert. The expert considered over 400 publicly traded real estate investment trusts (REITs) and real estate companies, and selected seven. Of these, three were REITs and four were real estate companies. The court rejected the four real estate companies. All were taxable entities, unlike Lappo FLP. Furthermore, two were highly leveraged and the other two were financially troubled, while Lappo FLP was neither of these. With regard to the analysis of the taxpayer's expert, the court concluded, “We are not persuaded that [the expert's] guideline group is sufficiently large or made up of companies sufficiently comparable to the partnership.”

The taxpayer's expert attempted to confirm his 35- and 30-percent discounts for lack of control by mentioning he had also examined 14 publicly registered, non-publicly traded real estate limited partnerships and found an average discount from net asset value of 36 percent. The court rejected this because the details of the study were not submitted into evidence, and because the real estate limited partnerships, as non-publicly traded entities, have very limited trading volume, so their discounts incorporate not only lack of control, but also significant illiquidity.

After rejecting the limited data and poorly founded conclusions of the taxpayer's expert, the court turned to the analysis of the IRS's expert. He looked at 62 real estate companies followed by an investment research firm and eliminated 10 that were not REITs or were otherwise not comparable. The remaining 52 REITs traded at a 4.8-percent premium over the net asset value estimated by the investment firm. The IRS's expert noted certain characteristics that made Lappo FLP less attractive than the REITs and consequently looked to the 15th percentile of the data, which was a 0.8-percent discount as of March 25, 1996, and a 1.48-percent premium as of June 25, 1996.

It is interesting to note the taxpayer's expert criticized the other expert's use of the investment firm's REIT data, suggesting that the investment firm's method of estimating the net asset value of the REITs was not comparable to the appraisal methods used for Lappo FLP's real estate. While the court rejected the criticism of the taxpayer's expert, the fact that both experts agreed there should be a discount for lack of control, but the vast majority of the REITs (roughly 85 percent) traded at premiums to their supposed net asset values, suggests strongly that the REITs are in some way not comparable to Lappo FLP.

It is also interesting to note that the IRS's expert in McCord selected a percentile for the REIT data that produced essentially a zero discount, although in that case the percentile was the 25th.

At this point, the analysis of the IRS's expert took a very interesting turn. Just as in McCord, the IRS's expert claimed the REIT discount (or premium) reflected two components: not just a discount for lack of control, but also a premium for liquidity. The premium is based on the fact that publicly traded stock is more marketable than directly owned real estate. While the fact is indisputably true, it is meaningless to the overall analysis.

To explain why, let's begin with the traditional methodology. Publicly traded interests in a REIT or other real estate company are traditionally considered to represent a “marketable minority interest.” The difference between this level of value and the “controlling interest” level of value (equivalent to owning 100 percent of the equity, or directly holding the assets and liabilities) is traditionally called a discount for lack of control. A second discount, traditionally called a discount for lack of marketability, reduces the marketable minority interest value to the non-marketable minority interest level. Admittedly, the traditional discount for lack of control also reflects some difference in marketability. Nevertheless, it brings the value down to a level at which we can apply the traditional discount for lack of marketability, which measures the difference between publicly traded stock and non-traded stock. In other words, even if the terminology is not precise, the logic is consistent and arrives at a correct result.

In comparison, the IRS's experts in McCord and Lappo attempt to isolate the pure discount for lack of control and bring the controlling interest value down to the theoretical level of a minority interest that is exactly as marketable as the underlying assets themselves. Leaving aside the difficulty of doing this, there is no reason for wishing to do so, because the following step would be to determine a pure marketability discount that measures the difference in value associated with the marketability differential between direct ownership of the underlying asset and ownership of a minority interest in a non-traded entity. This is not what restricted stock discounts measure. They measure the difference between publicly traded and non-traded stock, which is what is called for by the traditional methodology. Thus, decomposition of the traditional discount for lack of control is an exercise in futility. This is confirmed by the fact that in both McCord and Lappo, the IRS's expert started with a traditional discount for lack of control essentially equal to zero, then adjusted for the liquidity premium—based on the 7.2-percent discount for illiquidity—to reach a discount roughly equal to 7.2 percent (8.34 percent in McCord and 8.5 percent in Lappo). Subsequently, the IRS's expert takes an illiquidity discount that is also roughly equal to 7.2 percent (7.0 percent in McCord and 8.3 percent in Lappo), so the total discount is roughly equal to two times the illiquidity discount.

Nevertheless, the court accepted the methodology of the IRS's expert, if not his conclusions. In particular, the court stated, “In quantifying that liquidity premium, however, we hesitate to rely on a single academic study—particularly one that [the IRS's expert] did not participate in and could not elaborate upon first hand.” (Emphasis added.) Instead, the court rejected the concept of breaking the restricted stock discounts into three parts and using only the illiquidity component, and instead used the overall average of the study, as well as other restricted stock studies, to calculate an average liquidity premium of 17.6 percent. Combining this with the 0.8-percent REIT discount as of April 1996 and rounding up, the court selected a 19.0-percent discount for lack of control as of both valuation dates.

Because the liquidity premium and the discount for lack of marketability are based on the same data, the court arrived at a similar figure for the discount for lack of marketability. First, however, the court rejected the data and conclusions of the taxpayer's expert. Thirteen of the 39 restricted stock transactions used by the taxpayer's expert were rejected because they involved technology companies, which were considered much riskier and therefore not comparable (and it was noted that they had the highest discounts). The remaining 26 transactions had a median discount of 19.45 percent.

The court favored the data of the IRS's expert because it was more extensive—88 transactions. However, as mentioned above, the court took the overall discount—22.21 percent—and averaged it with another study to get a 21-percent benchmark discount for lack of marketability. The Court noted that this figure was similar to the 19.45-percent discount derived from the data of the taxpayer's expert after removing the technology companies. The court then added three percentage points for certain factors, to conclude at a marketability discount of 24 percent.

Overall, the court looked first at the data used by both experts and favored the more extensive data. Then the court considered the arguments made by both experts and deviated from the averages of the studies only where the argument was well reasoned and supported by the data. While the data of the IRS's expert was favored, neither expert's arguments were well received, so the court stayed close to the averages. In particular, the court rejected the novel argument of the IRS's expert that marketability discounts for family partnerships should be only seven to eight percent.

The lessons appraisers and those who hire them should learn from Lappo, if they haven't already learned them from McCord and other prior cases, are that (1) detailed data developed first hand by the testifying expert, as opposed to medians cited from studies performed by others, are required to sustain discount opinions, and (2) the courts recognize there are reasons to go above or below the medians, but they will do so only when presented with soundly reasoned and empirically supported arguments. Moreover, as the IRS is increasingly having success with its new approach to marketability discounts, appraisers and those who hire them run a significant risk of harming their clients' cases should these lessons go unheeded.

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