When valuing a non-controlling, minority interest in an entity for tax purposes, both the government and taxpayers generally agree that discounts must apply and then argue over the magnitude of the discounts. But what if the non-controlling interest being valued isn’t a minority interest? In limited partnership and limited liability companies, the majority interest (for example, 75% of the entity) can easily be divorced from control by making the minority the general partner or managing member.
But what if the interest being valued is an extremely large majority, to the point where it constitutes almost the entirety of the economic interest in the entity? What then? This was the main topic handled by Judge Kerrigan in the recent case of Grieve v. Commissioner (TCM 2020-28, March 2, 2020). In the appraisals submitted with the original gift tax return, lack of control discounts for the two entities were determined to be 13.4% and 12.7%, and the same 25% lack of marketability discount was applied to both entities.
In these circumstances, most analysts would still agree, discounts should still apply to the subject interest, but should they be lower than in more “normal” circumstances?
Consider the facts in Grieve:
- The subject interests (in two entities with marketable securities; the net asset values (NAV) were $9 million and $32 million, respectively) were 99.8% in both cases.
- For each of the subject entity, the controlling owner was entitled to no more than 0.2% of the entities.
- There’s no evidence in the text indicating that the controlling owner was taking non-pro rata rewards from the entities of any kind. In fact, she was not even taking a management fee, even though she was spending at least some time managing the investments.
- Could not a hypothetical willing buyer of the subject 99.8% interest simply purchase the interest of the controlling owner?
- Assuming nothing about the identity of the controlling owner other than that this person was interested in maximizing her wealth, is there not some price at which she would be persuaded to sell?
- What if she was offered five times the pro-rata value of her ownership stake? How about 10 times? Maybe 50 times her value? What would any reasonable investor do in such a situation? What would you do?
The Perfect Method
This is, essentially, the gist of the Internal Revenue Service’s argument in Grieve, as well as hat of the government’s appraiser. This isn’t a new argument. Most appraisers have seen the IRS raise this issue before and often with much larger controlling slices than 0.2%. The IRS often calls this approach “The Perfected Method.”
The name implies that the government views such a lopsided ownership structure, where the controlling owner has almost no “skin in the game,” as one in which the controlling owner should have very little incentive to cling onto her interest. Conversely, it views the holder of the non-controlling interest as holding an interest in its pro-rata share of the NAV that’s only temporarily “clouded” by the lack of control created by the presence of the controlling owner. The only logical thing to do, then, is to “Perfect” this interest by buying out the other party.
Logic, But No Evidence
The IRS has logic on its side. What it doesn’t have is evidence.
As the Tax Court points out in Grieve:
- The government’s appraiser submitted no “evidence to show support for his valuations.”
- “His reports did not include empirical data which back up his calculation of the […] premium to purchase the […] units of either entity.”
- “He provided no evidence showing that his methodology was subject to peer review”; and
- “Respondent cited no case law in support of [its appraiser’s] methodology.”
The Court also, however, notes that the government’s appraiser claimed that “there was no empirical data on the sale of a 99.8% non-controlling interest.” The Court simply lets this statement stand without comment. But it’s obviously true: there’s no discount data for such large non-controlling interests. What appraisers do instead is use data from smaller block sales and hope it’s accepted for larger interests too. Grieve provides hope that this will continue to be the case.
It didn’t help the government’s case that the sole owner of the controlling interests in this case testified in court and stated that she had no intention of selling. And even if she did sell, she claimed that she would have demanded a higher premium than the IRS’ appraiser determined. But does that not implicitly admit that there’s some premium at which she would sell?
Premium Applied by IRS Appraiser
So, what premium did the IRS appraiser apply? First, he had estimated reasonable sounding but generic discounts for a minority interest in each entity. Then, he determined that 5% of the theoretical dollar amount of each discount would be a reasonable premium to pay the controlling owner to, basically, take a hike. What does this work out to?
In the case of one entity, the 5% “purchase premium” applied was $130,000. This compares with a pro-rata NAV of $18,134 for the controlling owner’s interest. For the other entity, the purchase premium was $450,000, which compared with a pro-rata NAV of $63,941. In other words, in both cases, the total amount offered to the controlling owner to sell was approximately seven times her NAV. According to the controlling interest owner on the stand, this would have been insufficient. The Court believed her. Would another court, in another set of circumstances? We may not have seen the end of the government’s Perfected Method quite yet.
Court Adopts Taypayer’s Approach
In the end, the Tax Court rejected the opinions of both appraisers. The taxpayer’s appraiser took positions on the NAV that were counter to the positions taken by the taxpayer on the original return, which the Court views as an admission, and applied an income approach to the valuation, while the Court held the market approach used in the taxpayer’s original appraisals for the tax return to be appropriate method. The Court found no reason to object to the discounts in the taxpayer’s original appraisals and adopted them.