Tiered Discounts for Estate and Gifts

The application of tiered discounts is a thorny issue for valuation analysts.  The issue arises when we perform a valuation, typically of an FLP that owns interest in another LP which owns interest in another LP, and so forth.  Most agree that applying discounts for lack of marketability and lack of control depends on circumstances unique to each situation.  However, in order to apply discounts at multiple levels (ie., tiers), there must be substance to the legal structure of the entities that goes beyond taking multiple discounts on essentially the same interest.

To successfully defend tiered discounts, the following components should be considered:

(a) Asset class: expected returns.

(b) Financial risk: degree of leverage, earnings history, risks specific to each legal entity.

(c) Governance risk: type of interest, composition of investors, control term of the life of the entity, liquidity.

(d) Distributions: full, partial, or no payout, consistency of payment.


In general, valuation analysts agree that discounts beyond the intitial tier will generally be lower.  With respect to the four components, the more consistent the downstream entities are, the lower the downstream discounts should be.  As with most cases, better planning results in better fact patterns, which leads to better outcomes. 

Astleford v. Commissioner (T.C. Memo 2008-128) is a case where the tax court upheld tiered discounting.

Built-In Gains Tax Victory for Taxpayer (Estate of Jensen v. Commissioner)

In T.C. Memo 2010-182, the U.S. Tax Court found in favor of the taxpayer with regard to a valuation reduction for the estimated built-in long-term capital gains tax (LTCG tax).  Decedent Jensen owned a controlling interest in a closely-held C-Corporation that held a parcel of real estate with improvements that had appreciated significantly.  Wa-Klo Corporation ran a summer camp for girls on the parcel in question.  In valuing Wa-Klo, the Estate's expert relied on the Asset Approach and reduced the value of the net assets by 40% for the combined federal and state LTCG tax.  The Court accepted this reduction while rejecting the analysis performed by the IRS's expert. 

The IRS's expert used discounts from net asset values on closed-end funds which primarily held real estate investments.  The Court held that such discounts derive from a multitude of factors, which may or may not include the liability for LTCG tax.  Further, the Court found that the real estate held by the selected closed-end funds were not similar to Wa-Klo's holding.

The full text of T.C. Memo. 2010-182 can be found at the following link.

www.ustaxcourt.gov/InOpHistoric/estatejensen.TCM.WPD.pdf

Goodwill Hunting in Divorce

In general terms, goodwill is the value in excess of the net tangible worth of a business enterprise.  Within the context of closely-held business, there has evolved the distinction of professional (or personal) goodwill and enterprise (or corporate) goodwill.  Professional goodwill is that portion of goodwill that is dependent on the presence, skills, expertise, network, and performance of a key individual.  Enterprise goodwill is the portion of goodwill that flows from the enterprise primarily based on name recognition, location, and workforce in place.

Case law regarding the inclusion of goodwill in assets subject to division for divorce varies wildly from state to state.  Mississippi takes an extreme position in excluding all goodwill from division.  Other states include all goodwill in assets subject to division.  Currently, most states exclude professional goodwill from division.  In recent months, three rulings have been made at the state appellate level related to the division of goodwill for purposes of divorce.  All three cases involve dental practices and the implication of covenants not to compete on the value of the practice included in the division of assets.

Chronologically, the first case is McReath v. McReath, which was heard by the Wisconsin Court of Appeals.  The husband had purchased his dental practice and admitted that as much as 95% of the price was for professional goodwill, as evidenced by a covenant not to compete (“CNTC”).  The Court found that the goodwill supported by the CNTC was salable goodwill.  The Court ruled that salable goodwill should be divided.

On the heels of McReath, the Tennessee Court of Appeals ruled on McKee v. McKee.  In McKee, the Court ruled that a CNTC supported the existence of professional goodwill.  At its core, a CNTC is protecting an enterprise by restricting an individual from exercising his personal talents and abilities.  As such, the Court treated the goodwill as professional, excluding it from division.

Most recently, the Ohio Court of Appeals decided Banchefsky v. Banchefsky.  In this case, the husband, a cosmetic dentist, sold his practice during the divorce proceedings.  The purchase agreement specifically allocated $15,000 (total sales price $580,000) to a CNTC and $416,000 to goodwill.  Based on the Multi-attribute Utility Model (“MUM”), the husband’s valuation expert argued that the professional goodwill was $215,000.  Despite acknowledging the value of using MUM to calculate professional goodwill, the Court found it to be unnecessary since there was a recent arm’s length transaction to support the $15,000.  As a result, the Court accepted the amount allocated by the purchase agreement to the CNTC as separate property.

Courts will continue to wrangle over goodwill in divorce cases.  The primary caveat remains avoidance of the double dip, which can occur when alimony is awarded.  If the alimony is based on total earnings which support the goodwill, whether professional or enterprise, then division of the goodwill is redundant.  Business valuation analysts and attorneys need to weigh and assess the interaction of maintenance payments and division of goodwill to avoid such a double dip.

Business Ethics Assignment

The other day, my freshman son at Millsaps interviewed me in connection with a paper that he had to write on ethics.  I rarely encounter ethical situations in which I do not have at least an idea of the right course to take.  I think the overwhelming majority would agree with me on that.  Ethics are simple until you bring money into the equation.  The Association of Certified Fraud Examiners has published an exhaustive survey on worldwide fraud entitled, "Report to the Nations."  See following link for access to the survey.2010 Report to the Nations.   It is estimated that a shocking 5% of top line revenue is lost annually to fraud ($2.9 trillion worldwide).  Now that is an ethical problem.

In the 1950s, criminologist Donald Cressey developed the "Fraud Triangle."  Cressey argued that three components are present in any fraud:  (1) opportunity, (2) pressure, and (3) rationalization.  Obviously, a perpetrator must have the opportunity or access to the asset to steal it.  Pressure can be as simple as, "Baby needs a new pair of shoes," or a loss of prestige after being passed over for a promotion.  Rationalization is what let's the perpetrator live with himself - e.g. it's only a loan, or I'm entitled to it based on years of faithful service.  These components are present in every fraud, from stealing from the cash register to the misstatement of WorldCom's financial statements.

Over the years, I have seen the gamut from large financial statement frauds to small cash lapping schemes.  The big frauds are generally motivated by the need to meet targets to pay out compensation or to preserve a loan facility.  Thefts of cash generally begin with a base need such as a medical bill or a car repair.  Although schemes may start small, they tend to grow over time if the perpetrator perceives that no one has noticed.

I consult with small businesses.  Small business frauds typically do not garner the headlines, even on the business pages.  However, due to their small accounting / bookkeeping staffs, these businesses are especially vulnerable because they cannot implement adequate checks and balances.  I give small business owners two pieces of advice to reduce their fraud risk - (1) receive and open your bank statement directly.  Make sure that the scanned checks that cleared make sense with respect to payee, amount, and timing.  (2) take out employee dishonesty insurance on your staff.  I know you think your staff is trustworthy; but unfettered opportunity will eventually run into pressure, and rationalization is not far away.  As Ronald Reagan would say, "Trust but verify."