Practical Considerations of Valuation Discounts and Principles for Real Estate Attorneys

Keith Schiller, Esq.¹

While estate tax attorneys exploit use valuation discounts to reduce estate and gift tax for the valuation of fractional interests in real property or minority ownership of business entities. However the legal and valuation principles applied to create these discounts present significant implications, and surprising results for real estate and transaction attorneys. Apart from all tax considerations, valuation determinations can directly affect the purchase and sale price for property and the price paid for an undivided interest in real property or a partial interest in a business organization. Are valuation discounts intended or desirable a business setting?

Consider the following example from a buy-sell agreement among three equal co-owners of Blackacre, which has an agreed fair market value for the property as a whole of $1.2 million and which is subject to $300,000 deed of trust:

“In the event of an event of Transfer, the Non-Transferring Co-Owners shall have the option to purchase the interest of the Transferring Co-Owner at its fair market value.”

Is the value of the transferor's one-third interest $300,000 ($1.2 million less debt of $300,000 divided by three), or is the fair market value discounted to reflect the fact that the transferor owned only a partial interest?

Attorneys need to discuss with their client the effect of valuation adjustments and the impact of a given formula in order to avoid the client being disgruntled at time of redemption or buy-out. Practitioners may also wish to consider more precise guidance to the appraiser than simply referencing words, such as “market value” or “fair market value”

The author notes that CEB text materials are not consistent in the treatment of discounts. In the corporate context, CEB's Business Buy-Sell Agreements, §3.60 recommends a formula that value the entity as a whole and then apply a proportionate value to each share without adjustment for control premiums or discounts. On the other hand, CEB's Advising California Partnerships, §19.49 (on the purchase of a defaulting general partner's interest) and Forming and Operating California Limited Liability Companies, §9.72 (valuation of the interest of the transferring member for purpose of the purchase option) direct that the valuation be that of the interest being transferred or determined. The cited partnership/LLC text forms will apply applicable market value principles, including entity-level valuation methods and premiums and discounts based for controlling or minority interests.

Fair Market Value Principles Discount Partial Interests in Real Property

For estate tax and gift tax purposes, the measure of value of property is its fair market value at “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Treas. Reg. §§ 20.2031-1(b) and §25.2512-1. These regulations direct that “all relevant facts and elements of value as of the applicable valuation date shall be considered in every case.” The fair market value test considers the perspective of both the buyer and seller. The regulation also instructs, “The value of property ... is not to be determined by a forced sale price.”

The definition of “market value” adopted by the Appraisal Institute closely follows the definition of value used for estate tax and gift tax purposes. See, the Dictionary of Real Estate Appraisal, published by the Appraisal Institute. As a consequence, the price payable to the transferor based upon the meaning of words such as “fair market value” or “market value” without further elaboration or direction in an agreement, would be determined after considering adjustments (discounts or premiums) applicable to the transferring interest. Moreover, in the case of the a minority ownership in an entity, the discounting of the price payable may arise not only from discounts but also from different methodology used when valuing an entity on a minority ownership basis.

Fractional Interest Discounts Reduce the Value of the Co-Owned Interest

Limitations of ownership attendant to a fractional interest reduce the value of the co-owned interest to an amount below the pro-rata net value of the property as a whole. See, cases infra. This discount arises from the inability to exclude other co-owners from occupancy or use; inability to borrow with the collateral limited to the debtor's fractional interest, and inability to manage the property without the cooperation of the other owners. This reduction in fair market arises from the valuation principles applied by appraisers.

The fair market value determination entails a factual analysis unless sales of comparable assets exist in reasonably close time to the valuation date. The appraisal industry recognizes the difficulties establishing market value for partial interests in real property, which is evident from the increasing levels of sophistication presented in peer-reviewed articles and the frustration with the lack of a systematic measure to determine the amount of these discounts in tax or business settings. Healy, Valuation of Partial Interests, The Appraisal Journal, July, 1988, p. 193; Simmons, A Survey of Appraisers Regarding Factors in Discounting Partial Interests, The Appraisal Journal, October, 1993, p. 600; Humphrey and Humphrey, Unsyndicated Partial Interest Discounting, The Appraisal Journal, July, 1997, p. 267; Webb, Bridging the Gap: Marketability Discounts for Real Estate Interests, The Appraisal Journal, January, 2001, p.95 and, Wiggins, Revisiting Valuation of Real Estate Partial Interests: Recent Case Studies, The Appraisal Journal, October, 2001, p. 404.

Common to all of these appraisal articles is the recognition that fractional interests discounts exist with real estate and that valuation adjustments (discounts or premiums) apply with the ownership of partial interests in an entity.

In California, the co-ownership of real property may be unwound through a partition proceeding, unless the procedure is waived by the parties. See, California Code of Civil Procedure § 872.010, et. seq. Partition proceedings generally result in the sale of the real property unless its physical division is feasible.

The state courts are not bound to follow federal valuation procedures This article is not premised on the fact that federal approaches apply in all instances of state-law valuation. For example, in the area of corporate liquidations and buy-out options and valuation under Corporations Code §2000, et seq., the Court does not want to see a discounted value apply to a minority interest. Brown v. Allied Corrugated Box Co. (1979) 95 CA3d 477, 485; 154 CR 170. However, even in the corporate liquidation context a different measure of valuation may be applied depending upon whether or not the corporation can be sold as a going concern. Compare, Ronald v. 4-C's Electronic Packaging, Inc. (1985)168 Cal.App.3d 290, 214 Cal.Rptr. 225 (which determined that the five valuation approaches in combination stated in Revenue Procedure 59-60, 1959-1 Cumulative Bulletin 237,established the value of a minority interest in a closely held corporation”) with Trahan v. Trahan (2002) 99 CA 4th 62 (which rejected the Ronald approach because the investment value approach that underlies the revenue procedure's methodology should not apply when it is not possible to sell a going concern. However, this statutory approach does not avoid the effects, for better of worse, of the valuation formula established by the parties by contract, the meaning of words, or the principles and practices employed by appraisers. Survey of Recent Tax Court Decisions Applying Fractional Interest Discounts

The following is a summary of other significant tax cases addressing fractional interest discounts: Estate of Stevens v. Comr. T.C. Memo. 2000-53 (25% discount for undivided 50% interest in commercial property); Estate of Busch v. Comr. T.C. Memo. 2000-3 (10% discount with raw land); Brocato v. Comr. T.C. Memo. 1999-424 (20% fractional interest discount with valuation of 50% interest in two apartment house and two flats in the Marina District of San Francisco litigated by the author); Estate of Williams v. Comr. T.C. Memo 1998-59 (20% lack of marketability discount plus a 30% discount for lack of control (which totaled a 44% discount) with an undivided 50% interest in timberland); Estate of Wineman v. Comr. T.C. Memo. 2000-193 (15% discount based upon comparable sales method for Santa Barbara County properties); Estate of S. LeFrak v. Comr. TC Memo 1993-526 (30% combined discount-- 20% minority interest and 10% lack of marketability for gift of fractional interest (6-7.5%) in real property; Estate of Forbes v. Comr. TC Memo 2001-72 (30% discount on the valuation of a 42% interest in timber and orchard property); Estate of Barge v. Comr. TCM 1997-188 (26% discount using partition and present value analysis to determine fractional interest discount); Baird Est. v. Comr. T.C. Memo 2001-258 (60% fractional interest discount with timberland. See also, Van Loben Sels v. Comr. TC Memo 1986-501). See, Schiller, Piercing the Partition Fiction for Fractional Interest Valuation, Trusts & Estates, July, 2000.

The Entity as a Whole May Be Valued Differently Depending Upon Whether or not a Controlling Interest or Minority Interest Is Being Valued

When real property is owned by an entity (partnership, LLC or corporation), the owners hold stock, rights or interests, not the real estate itself. As a result, the determination of an owner's interest in the entity involves a two-step process: (1) valuation of the entity; and, (2) valuation of the owner's interest in the entity.

The value of an entity as a whole may vary greatly depending upon whether the entity is valued on a controlling interest or minority interest basis. Recent Tax Court decisions, applying basic valuation principles, reflect the increased utilization of the discounted cash flow method or other references to net income and distribution capacity of valuation when a minority interest is being valued. On the other hand, the ownership of the controlling interest may create a higher valuation because greater weight is placed upon the underlying value of the assets, particularly real estate or other holding company situations. As a result, the valuation of the same entity may differ when the ownership of a minority versus majority owner are considered. This dichotomy underlies the tension in Ronald, supra, and Trahan, supra in the context of corporate liquidations.

Estate of Dunn v. Comr. T.C. Memo 2000-12, rev'd and rem'd 2 USTC ¶60,446 reflects the reduced valuation result at the entity level, when a minority as opposed to a majority interest. The Tax Court weighted the valuation of 65:35 ratio of earnings to underlying assets of an equipment company and allowed only a 5% built-in gain discount (rejecting the taxpayer's argument for a 34% discount). The Fifth Circuit reversed and directed that the entity be valued at the greatly more favorable 85:15 ratio favoring earnings and granted the full 34% discount for built-in gain discount. In Weinberg Estate v. Comr. T.C. Memo. 2000-53, the Court valued a minority interest in a partnership and concluded that the underlying value of the real estate would be weighted 75% based on capitalization of income and 25% underlying asset value. This substantially reduced the value of the entity from that which would have applied had the real estate been valued solely for its underlying asset value. This reduction applied before the Court awarded a further 20% discount for lack of marketability of the decedent's interest. In Furman v. Comr.75 T.C.M. 2206 (1998) the Court applied EBIDTA to valuation and allowed 40% discounts for minority shareholder. See also, Barnes v. Comr. 1998-413 and Rodgers Estate v. Comr. T.C. Memo. 1999-129.

Apart from methodology differences in the valuation of the entity, a discount for built-in gain may also be appropriate. C Corporations may have income taxable gain on sale by the difference between the fair market value and the adjusted basis for its assets (so-called “built-in gain”). The buyer of the business would consider it a liability upon the purchase of the business. The amount of the reduction to value for the built-in gain remains an issue.

The Dunn decision, supra, allowed a full reduction for the built-in gain. Tax Court cases since 1998 have not been as consistent in determining the amount of the discount. Some cases apply a present-value approach to the discount while others use it to increase the lack of marketability discount for the stock ownership in the C Corporation. See, Davis v. Comr. 110 T.C. 530 (1998); Eisenberg v. Comr. 74 T.C.M. 1046 (1997), rev'd 98-2 U.S.T.C. ¶60,322 (2nd Cir. 1998); acq'd I.R.B. 1999-4; Estate of Desmond v. Comr. 77 T.C.M. 1529 (1999); Estate of Welch v. Comr. TC Memo 1998-167 (rejecting deduction with real estate corporation), rev'd 2000-1 USTC ¶60,372 (6th Cir.). The application of a deemed built-in gain for S Corporations was rejected in Estate of Gross v. Comr. 1999-254, aff'd 88 AFTR ¶ 2001-5553 (6th Cir. 2001) and Estate of Adams v. Comr. TC Memo 2002-80. Before 1998, the Tax Court did not allow a built-in gain discount unless the corporation was in liquidation or such event was foreseeable. See, Estate of Gray v. Comr. T.C. Memo. 1997-67 as an example.

Discounts May Be Larger or Premiums May Apply to the Ownership of Entity Interests

Apart from entity-level distinctions, the minority interest in an entity may be subject to a discount for lack of marketability or for being a minority interest. The controlling interest in the entity may be receive the benefit of a control premium, which reflects the value added as a result of holding voting control.

The value of an interest in an LLC or partnership can differ depending upon whether or not a voting rights or merely an economic interest is the subject of the appraisal. This valuation differences resulting from the determination of whether a partnership/LLC interest or an economic interest is being valued is reflected in Adams v. U.S. 83 AFTR2d 99-1887 (N.D. Tax 1999), rev'd 2000 USTC ¶ 60,379 (5th Cir.), r'tried 2001-2 USTC ¶ 60,418. Although the case applied Texas law, Cal. Corp. Code §16,701(b) provide for similar assignee treatment, including on death, for a dissociated partner's interest. The initial Adams decision concluded that general partnership interest was transferred on the death of a partner and allowed only a 5% discount. On retrial after remand on instruction to value an assignee/economic interest, the Court granted a 54% combined discount (a 20% minority interest discount, a 10% portfolio discount, and a 35% lack of marketability discount). See also, Estate of Nowell v. Comr. T.C. Memo 1999-15.

Other cases reflective of the much greater discount for minority partnership interests as compared to fractional interests in real property include Moore v. Comr. T.C. Memo 1991-546 (35% minority interest discount); Weinberg Estate v. Comr., supra (20% discount to minority interest on top of reduced entity-level valuation); Estate of Barudin v. Comr. 1996-395 (19% minority interest discount plus a 26% marketability discount); Estate of Dailey v. Comr. TC Memo 2001-263 (40% discount allowed with partnership with substantial liquid assets); McCormick Est. v. Comr. TC Memo 1995-371 (minority discounts of 18-32% plus marketability discounts of 20-22% in valuing minority interests in partnerships).

In the arena of marketability discounts at the corporate level, Mandelbaum v. Comr. 1995-255; aff'd 96-2 U.S.T.C. ¶ 60,240 (3rd 1996) allowed a 30% discount and noted that studies of restricted stock and IPOs cited average discounts of 35-45%. This gift tax case references 10 factors to consider in measuring the lack of marketability discount.

The lack of marketability discount is not limited to minority interests in the entity. Even a controlling interest in the partnership or other business entity may be subject to this discount when the underlying assets are difficult to sell, including real property. Estate of Dougherty v. Comr. 59 TCM 772 (1990) (35% discount yet 100% of stock in real estate corporation was in estate); Estate of Andrews 79 TC 938 (1982); Estate of Bennett TC Memo - CCH 1993-34 (15% lack of marketability discount on 100% of stock in real estate corporation with a strip center development); Borgatello Estate v. Comr. T.C. Memo 2000-264 (33% discount for lack of marketability for 82.76% interest in real estate holding company); Estate of Folks v. Comr.(1982) 43 TCM 427 (40% discount in value of real estate investment company owned by a 62% shareholder); Pillsbury v. Comr. 64 TCM 284 (1992) (15% discount was allowed on a 77% interest in residential real estate and on a 50% interest in rental real estate). When the underlying assets of the entity are liquid, however, there will likely be no lack of marketability discount for the valuation of a controlling interest. Estate of Cloutier T.C. Memo. 1996-48; Estate of Jephson v. Comr., 87 T.C. 297 (1986).

Review and Evaluate the Effect of Valuation Formulas and Terms Used in Agreements

Valuation determinations underscore the business deal. The standards for valuation adopted by attorneys will change, for better or worse, the ultimate valuation conclusion and how much money is paid in the buy-out. No one form meets all needs. If attorneys desire to have a valuation result that avoids or minimizes the valuation discounts or adjustments, special attention will need to given in the co-ownership or entity-level agreement to that object. The selection of the method to value a business as a whole, and for valuation adjustments for premiums and discounts, are not reserved for the domain of estate planning. Real estate and transaction attorneys need to understand and apply these principles in order to achieve the intended result for their clients.

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¹This information footnote was updated 1/04. Keith Schiller is a Certified Specialist in Taxation Law and Estate Planning, Probate and Trust Law by the State Bar of California. He is a shareholder with the Schiller Law Group, a Professional Law Corporation of Orinda, California, and a frequent lecturer and author for the California CPA Education Foundation, which granted Mr. Schiller the Award for Outstanding Course Materials in 2000. Tel: (925) 934-3600. Email: Kschiller@Slg4Law.com. Web Site: www.cpas411.com © Keith Schiller. 11/2002.