Summer 2001 Newsletter
Quantifying the Discount for Lack of Marketability Due to Imbedded Capital Gains
Deducting Built-In Capital Gains Tax
By D. B. Gray, CPA/ABV, MBA, eRA, ASA SE Biz Val, LLC
This article discusses the background and increase in the discount for lack of marketability due to built-in capital gains taxes. In the following we will answer three basic questions:
• Do we deduct for built-in capital gains taxes when valuing a Post-1986 C-Corporation?
• Where do we deduct the taxes?
• How much of the tax is deducted?
The Nature of Built-In Capital Gains
Subsequent to the repeal of the General Utilities doctrine in 1986, C-Corporations that liquidate must now pay capital gains taxes at the corporate level as well as at the shareholder level on any additional gains they may have. This corporate level tax is what we will refer to in this section as the "built-in capital gains tax."
Deducting Built-In Capital Gains Tax
In deciding whether to adjust for built-in capital gains tax we can approach the question from two perspectives - the hypothetical willing buyer's and seller's, and the courts' perspective. We will start with the hypothetical willing buyer and seller.
The bedrock of valuation theory rests in the definition of fair market value, the standard of value used in estate valuations, as follows:
...the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical willing buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market.
Rev. Rul. 59-60, 1959-1 C.B. 237
The argument for making an adjustment for built-in capital gains tax is based on. what a willing buyer would pay for any particular investment. Assuming that valuation theory considers any theoretical buyer, one must assume that, based on rational thinking
• Any buy decision is made to have' the highest economic results inure to the buyer.
• Under the economic principles of anticipation and substitution, a willing buyer would want to pay a lower price to acquire an interest in a real estate holding company organized as a C-Corporation with a built-in capital gains tax liability than for the same interest in an identical entity that was organized differently.
• If the taxes imbedded in a transaction (property) cannot reasonably be expected to be avoided, a willing buyer would assess the potential cost and take this into account by lowering his offer.
• Any willing seller (within the context of fair market value) would be expected to have taxes taken into account. When we looked at the business valuation literature, we found several relevant articles:
Shannon Pratt, FASA, CFP, DBA, known as the most widely respected business appraiser of our times, in the February 2, 1996 issue of his Business Valuation Update stated:
In most (if not all) cases, I believe that the liability for trapped-in gains taxes should be reflected in the value of the stock or partnership that owns the assets.
Consensus is building among appraisers that the built-in capital gains tax should be recognized one way or another, either in the form of a balance sheet adjustment or some type of discount.
In the June 1999 issue of Business Valuation Review, David M. Bishop, ASA, FillA, BVAL, MCBA argued that it was time for business valuation experts to explore more the considerations of built-in capital gains taxes when they were relevant. Even though this article was written subsequent to the Davis and Eisenberg Tax Court cases discussed below, he argued:
the pure marketplace view seems to be that the hypothetical buyer acting without compulsion under the fair market standard would have the alternative of selecting other comparable property with the same or very similar market value which does not have imbedded gains. This is consistent with the underlined portion of the Circuit Court's position in Eisenberg.
In his treatise "Imbedded Capital Gains in Post-l 986 C-Corporation Asset Holding Companies," published in the -November/December, 1998 issue of Valuation Strategies, the likewise acclaimed founder of Mercer Capital, Z. Chris Mercer, ASA, CFA argued for taking adjustments in appraisals to reflect built-in capital gains taxes. His article included 5 examples (scenarios) dealing with such taxes. His conclusions were:
A rational willing buyer will pay no more than a price· for shares of a C corporation asset holding entity that recognizes 100% of the imbedded gain tax liability in that C corporation. A rational seller will sell for no less than this amount because of the ability to liquidate and achieve this result. Rational negotiations between hypothetical willing buyers and sellers should lead to a full recognition of imbedded capital gains tax liabilities in the determination of the price to be paid for the C corporation's share (absent any compulsion on the part of the buyer or the seller).
Our Position Based on Hypothetical Buyers and Sellers
After studying the literature and using common sense regarding the definition of fair market value, we concluded that an adjustment for imbedded capital gains taxes should be taken into account when valuing a C-Corporation. Additionally there is nothing indicating that a hypothetical willing buyer would take less than the full amount of the taxes into account on a present value weighted basis in buying the asset.
The courts recently have issued two landmark cases regarding the recognition of a discount for trapped in capital gains taxes, Estate of Davis v. Commissioner, and Eisenberg v. Commissioner. Both support the call for an increase in the discount for lack of marketability when a C-Corporation holding assets with built in capital gains is valued.
Estate of Davis v. Commissioner, 10 T.C. 35 (1998)
This case involved the estate of Artemis D. Davis who made two gifts of ADDI&C, Inc. stock in 1992, both gifts reflecting a 15 point increase to the discount for lack of marketability due to the built-in capital gains taxes. in the final outcome the court sided (for the most part) with the estate's expert, Dr. Shannon Pratt. The court did not however allow the full amount of the taxes to be deducted. It indicated that the full reduction of the taxes would be allowed only if there was a planned liquidation. The court stated:
Although Dr. Pratt recognized in his expert report that as of the valuation date it would have been possible for ADDI&C to convert to an S corporation, he did not consider conversion to S corporation status to be likely...such an assumption would have impermissibly limited the hypothetical willing buyer of each of the two blocks of stock at issue to certain individuals and entities who were permitted as of the valuation date to be shareholders of an S corporation, see sec. 136(b)(1)(B) and (C), thereby improperly excluding as a hypothetical willing buyer of each such block, for example, a C corporation...
. ..we agree that as of the valuation date it was unlikely that ADDI&C would have converted to an S corporation. Based on the record before us, we reject respondent's unwarranted assumptions that ADDI&C could have avoided all of ADDI&C's built-in capital gains tax by having it elect S corporation status and by not permitting it to sell any of its assets for 10 years thereafter, and the record does not establish that there was any other way as of the valuation date by which ADDI&C could have avoided all of such tax.
We are convinced on the record in this case, and we find, that, even though no liquidation of ADDI&C or sale of its assets was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of ADDI&C's built-in capital gains tax. We are also persuaded on that record, and we find, that such a willing seller and such a willing buyer of each of the two blocks of ADDI&C stock at issue would have agreed on a price on the valuation date at which each such block would have changed hands that was less than the price that they would have agreed upon if there had been 'no ADDI&C's built-in capital gains taxes of that date.
Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir.1998)
This case involved gifts made by Irene Eisenberg for taxable years 1991, 1992, and 1993 for which the IRS determined deficiencies of $20,158, $38,257, and $3,320 respectively. The Tax Court found that 'a discount for built-in capital gains taxes does apply. Ms. Eisenberg appealed the case to the United States Court of Appeals for the Second Circuit, and a decision was handed down on August 18, 1998.
In its decision, the court remanded the case to the Tax Court to determine the gift tax liability consistent with the opinion. The, opinion reflected:
In the past, the denial of reduction for potential capital gains tax liability was based, in part, on the possibility that the taxes could be avoided by liquidating the corporation...
These tax-favorable options ended with the enactment of the Tax Reform act of 1986....
Many courts also base their decision (prior to TRA 86 not allowing the deduction for built-in capital gain) on the ability of the corporation to avoid corporate taxes altogether (upon liquidation).
Courts may not permit the positing of transactions which are unlikely and plainly contrary to the interest of a willing buyer. ... We believe. it is common business practice and not mere speculation to conclude a hypothetical willing buyer, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains on the sole asset of the Corporation at issue in making a sound valuation of the property.
We disagree with the Commissioner's reasoning that the critical point in this case is that there was no indication a liquidation was imminent or that a "hypothetical willing buyer would desire to purchase the stock with the view toward liquidating the corporation or selling the assets, such that the potential tax liability would be of material and significant concern." Eisenberg v. Commissioner, 74 T.C.M. (CCH) 1046, 1048-49 (1997). The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying. while prior to the TRA any buyer of a corporation's stock would avoid potential built-in capital gains tax, there is simply no evidence to dispute the fact that a hypothetical willing buyer today would likely pay less for the shares of a corporation because of the buyer's inability to eliminate the contingent tax liability.
We are convinced on the record in this case, and we find, that, even though no liquidation of [the corporation) or sale of its assets was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of [the corporation's) built-in capital gains tax. We are also persuaded on that record, and we find, that such a willing seller and such a willing buyer of each of the two blocks of [the corporation's] stock at issue would have agreed on a price on the valuation date at which each such block would have changed hands that was le~s than the price that they would have agreed upon if there had been no built-in capital gains tax as of that date We have found nothing in the...cases on which respondent relies that requires us, as a matter of law, to alter our view....
We were advised that on remand, Eisenberg was settled at a discount for trapped in gain approximately equal to the percentage in Davis which was 13.2% applied to the net asset value of $80.14 million after a reduction of 15% for a minority interest discount and a 27.9% marketability discount. In Eisenberg, the dollar amount $9 million represents 36% of the estimated tax of $25.4 million due to the imbedded capital gain or 11.2% of the net asset value of the stock.
Our Position Based on Economic Rationality and the Perspective of the Courts
Based on both sound economic theory and the relevant court cases, we conclude that it is appropriate to adjust our valuation to fully reflect the built-in capital gains taxes on a present value weighted basis.
Where to Deduct Taxes
We agree with courts (Davis and Eisenberg) that the deduction for built-in capital gains taxes should be reflected as an adjustment to the discount for lack of marketability. We feel that the portion of the discount for lack of marketability due to built in capital gains is an issue for both control and minority stockholders, accordingly it would be inappropriate to reflect the liability to the net asset value of an asset which by definition is a control value.
By placing the adjustment in the discount for lack of marketability it rests purely with marketability and not with percentage of control.
How Much to Deduct
The amount (%) of built-in capital gains to be reflected as an increment to the discount for lack of marketability continues to be argued. The IRS would like it to be zero unless a sale is imminent. Others like Shannon Pratt have settled for an amount equal to 15% of the minority marketable value. The courts indicate 11%-13% of net asset value. When interviewed by D. B. Gray, CPAIABV, MBA, CBA, ASA of SE Biz Val, LLC, Dr. Pratt indicated that his finding in Davis represents more of a gut feel of what the IRS would accept than any pure economic model. We feel there are 2 models that should be considered in determining how much of the total built-in capital gains tax should be included in the discount for lack .of marketability. First, a 50/50 split of the tax liability between buyer and seller, or second, recognize 100% of the tax liability on a present value weighted basis as a reflection in the discount for lack of marketability.
Some would argue that the hypothetical willing buyer and seller would "split the baby" and agree to Y2 of built-in capital gains taxes to reduce the selling price. The buyer would pay more, and the seller get less, but at least each would accomplish their objective.
We would reject this notion because under the theory of fair market value, the buyer can buy any asset of equal risk in .any ownership form he wishes, and would not buy an asset whose entity form causes it to be less valuable.
Recognize 100% of the Tax
By definition, fair market value implies that a sale will take place. Since neither the buyer nor the seller is compelled to deal with each other, we must assume that they will deal with the facts and circumstances in a prudent· manner. Assuming there are many investment opportunities to the buyer, there is no reason why the seller of a C-Corporation with built-in capital gain could expect the· buyer to share in that liability. Hence, we would conclude that by definition, the seller would be expected to absorb all of the built-in capital gains taxes.
Based on the definition of fair market value, we conclude that the SELLER would expect and accept that the full amount of built-in capital gains taxes on the sale of his C-Corporation stock would be reflected in the price to be paid for the stock. We do not feel however, that the taxes should be directly subtracted from the net asset value, but rather determined after the adjustment for lack of marketability for reasons other than taxes. In addition, we realize that the built-in capital gain tax liability may not be payable at once, but is contingent upon the timing of the liquidation of the corporation's assets. Hence, there is a "time value of money" factor that would be rationally considered by both a knowledgeable seller and a knowledgeable buyer of the subject interest in the Company.
The remainder of this article addresses the magnitude of the appropriate discount for lack of marketability attributable to the built-in capital gains tax liability through LEC, a hypothetical real estate holding company. We will first consider the built-in gains tax as if LEC were to liquidate all of its real estate immediately. We will then assess the value of the built-in tax liability by taking the present value of those taxes over a more reasonable period of liquidation. Subsequently we will measure the potential total cash returns to LEC assuming on-going earnings, capital appreciation and liquidation over a period of ten years, the difference in pres...ent value compared to net asset value being the total marketability discount. Finally we will review the reasonability of our conclusions compared to certain market measures.
Value of the Marketability Discount for Taxes if LEC Liquidated Immediately
We begin our analysis by assessing the full value of the built-in capital gains tax liability as if all of LEC's real estate portfolio was to be liquidated as of the valuation date. The table below provides those calculations:
Hence, we observe above that if LEC were to recognize all of the built-in capital gains tax liability as of the date of liquidation, the total amount would be $505,631 or 24.9% of net asset value. We calculate this tax after taking into consideration a 27.5% discount for lack of marketability due to factors other than taxes.
We consider the approximate $500,000 built-in gains tax liability assessed here to be the upper limit of what a willing buyer/seller would negotiate. In this example we assume the following:
LEC would be unable to sell its real estate portfolio in less than six years without unduly depressing the local real estate market;
(1) A reasonable buyer of the 63% restricted control interest in LEC might choose to liquidate the real estate portfolio over a longer period of time, either reinvesting in higher returning assets or distributing the proceeds to shareholders (with other shareholder approval); and
(2) Based upon a reasonable liquidation time horizon, a rational investor would view the potential $500,000 built-in capital gains tax liability as being worth something less due to the "time value of money."
Hence, under this method we might set an upper limit as to what the built-in gains tax liability might be worth. Our conclusion of fair market value for the subject interest under appraisal is $610,000, which we view as the lower limit of its value. Under the next two methods~ we explicitly address the "time value of money" issue in regards to this important component of the marketability discount.
Value of the Marketability Discount for Taxes if LEC Liquidated Over 6 Years
We feel the discount for lack of marketability is a function of how long it would take to find a buyer who wanted to buy 54 pieces of property and the most likely discount the buyer would require. From that we develop our discount for lack of marketability due to taxes on imbedded capital gains.
Time to Sell
Due to the nature of the assets, we are concerned with how long it would take a buyer to buy, fix up and market the assets within LEC. This time is similar to the calculation considered in blockage discounts. However, since blockage discounts generally apply to large blocks of listed stocks, we do not feel it appropriate to develop our discount strictly along that model.
We interview several real estate professionals to estimate the length of time for a buyer to "get his money out" of LEe. The owner feels it would take 5-10 years to liquidate LEe without saturating the market. Mr. Appraiser appraised the net asset value of each parcel of real estate on a STAND-ALONE basis and did not adjust for saturation of the market. He felt that the time frame for any piece of real estate to sell would be 2 years.
We also discuss selling LEC's assets with a realtor with prior experience with LEC assets who currently has several properties listed. Her estimate is that about 25% of the real estate could be sold in the first year, and then 15% per year thereafter over the next 5 years. We use this estimate in our calculation. To develop our discount rate, we determine that in cases in which the income approach was used, the weighted average discount rate of 10.85% was used to indicate value. Thus, we are persuaded that this is a reasonable required rate of return or "discount rate" with which we calculate our assessment of the "present value weighted" built-in capital gains tax liability.
The basis of the properties in LEC is $139,000. We assume that since LEC has had few profits in the past the only taxable income the company would have would be from property sales and (we determined the estimated tax to be paid on that income. We assume that basis would be allocated pro rata 139,000/1,831,850 or 7.6% of the sale price. By adjusting the results for time we determine that the most taxes LEe would pay in present dollars would be $319,849 as shown in the schedule on the opposite page.
Based on this valuation methodology, we therefore conclude that the value of a 630/0 non marketable equity interest in LEe is $720,000, calculated as follows:
Value of Average Discount if LEC Liquidated Each of Next 10 Years
Another perspective to review is to answer the question "What would a reasonable investor expect to realize in actual cash returns on his investment in a 63% restricted control interest in LEC?"
We attempt to answer this question by analyzing the net realizable cash available to LEC upon liquidation for each· of the next ten years. We then take the present value of each of those liquidation scenarios and finally average them together to assess what the average expected present value would be for those net cash returns.
The average net present value of these liquidation proceeds would therefore equal the fair market value of 100% of LEC. The difference between this fair market value and LEC's net asset value would constitute the total discount for lack of marketability.
Fundamental Liquidation Assumptions
If we assume that in each of the following 10 years, LEe liquidates its total portfolio and distributes the proceeds to shareholders, we need to make some basic assumptions regarding retained earnings, capital appreciation, tax rates, built-in gains tax rate, basis of the built-in gain tax liability, marketability discount due to other than tax issues, and what the appropriate discount rate should be. The schedule below presents these assumptions:
Firstly, we needed to generate assumptions as to the earnings and capital appreciation capacity of LEC's investment portfolio. This is because a fundamental assumption of this particular methodology is that the liquidation proceeds realized in year five, for example, would be based upon the original net asset value of the portfolio increased by retained earnings and capital appreciation from previous years. As can be observed above, we assume that LEC's portfolio of investments, on a net asset value basis, would generate an average annual 10.98% return (composed of 6.69% current and 4.29% capital appreciation). Given the composition of LEC's investments and our previous analysis of the Company's earning capacity, we believe these assumptions are, if anything, aggressive but reasonable. We also assume that the tax rate on retained earnings would be 30%.
In addition to earnings and capital appreciation factors, we also make the same assumptions as we did in the previous methodology employed regarding the tax rate on the imbedded capital gains tax liability (38% with a basis of $139,000), the marketability discount not attributable to tax issues (27.5%) and the discount rate employed (10.85%).
Calculation of the Average Net Proceeds Available on a Present Value Basis
Given the basic assumptions above, we then ,generate a schedule which (1) calculates the net cash proceeds available after liquidation for each of the next 10 years, (2) we then "discount" those values to present value, and (3) then average them to determine the average fair market value of a 100% interest in LEe (see Figure4).
We observe above that the net asset value, and therefore the net realizable cash proceeds, increase over time as LEe's portfolio of investments increases in value due to retained earnings and capital appreciation. We also note that the built-in capital gains tax liability remains constant at $505,631. Finally we can observe that the net present value for each of the years calculated is fairly stable, averaging $1,083,846 or 53.5% of net asset value.
Given the above analysis, we conclude that the fair market value of the subject block of stock representing a 63% restricted control ownership interest LEe is as follows:
Our conclusion of value represents a total discount for lack of marketability of 46.5%, of which 27.5% is attributable to factors other than tax issues and 19.0% is attributable to the imbedded built-in gains tax liability. Finally we note that the implied marketability discount due to the built-in capital gains tax liability at $385,761 represents 76.3% of the full imbedded tax of $505,631 due to the ''time value of money." Therefore, under this particular appraisal methodology, we determine that the fair market value of the subject block of stock representing a 63% restricted control ownership interest in LEe is worth $680,000.
Reconciliation of Valuation Conclusions
We have viewed the fair market value of the subject block of stock under appraisal from three different valuation perspectives:
(1) FMV in immediate liquidation: $610,000
(2) FMV contemplating a six-year orderly liquidation: $720,000
(3) FMV using average PV of liquidation proceeds in each of the next 10 years: $680,000
As discussed previously, we view the results of method #1 as setting a lower limit as to the fair market value of the subject block of stock. However, both methods 2 and 3 have taken into account the "time value of money" and provide a reasonable estimate of fair market value for the subject securities. Hence, we determine that the best estimate of the fair market value is $700,000.
Final Conclusion of Fair Market Value (Figure 6)
As indicated in the schedule above, our final conclusion of fair market value represents a total discount for lack of marketability of 45.1 0/0, of which 27.50/0 is attributable to factors other than tax issues and 17.60/0 is attributable to the imbedded built-in gains tax liability. The implied marketability discount due to the built-in capital gains tax liability at $357,214 represents 70.6% of the fully imbedded tax of $505,631 due to the "time value of money."
Given all of the analysis performed, our final conclusions regarding the fair market value of the subject securities appear to be reasonable and economically rational.
The combined discount for lack of control and lack of marketability was determined to be 45.1 %. Since this determination involved a great many qualitative assumptions about the factors, their applicability and impacts, it is important to independently assess the reasonability of the conclusion.
Partnership Spectrum, published by Partnership Profiles of Dallas, Texas annually surveys sale prices of real estate limited partnership interests compared to their appraised net asset values (control values). This directly measures the combined discount for lack of control and lack of marketability, most of which is for marketability. This comparison is apt for the Company's shares because the secondary market for closely held interests is a brokered market, which is relatively thin and inefficient, there being limited buyers for any potential sales transaction. As a result, there are few and infrequent transactions and limited data available.
The markets for private real estate companies and publicly traded real estate .limited partnerships are both relatively limited. However, the market for LEC's stock likely would not enjoy the same degree of exposure to the market and therefore would be much less marketable than shares in listed partnerships. In addition, these limited partnership interests, because of the nature of their pass-through tax status, do not have any imbedded capital .gains tax issues.
By contrast, the exchange-based market for securities of publicly traded real estate investment trusts (REITs) is not comparable to the market for small private real estate partnerships. The REIT market is far larger and deeper. .Institutional investors dominate it. The typical REIT has a market capitalization far in excess of that of the typical limited partnership. According to a recent Goldman Sachs report, capital inflows into and the pace of merger activity in the industry have reached record levels. REITs differ fundamentally in numerous ways' from limited partnerships: They are less risky because they are more diversified, they have larger investment-quality properties, more stable tenant mixes, are geographically more diverse, have deeper management and enjoy greater access to financing. Because' the REIT market is liquid, discounts observed on REIT stocks relative to net fair market asset values reflect only lack of control and not lack of marketability. These discounts are therefore not suitable for comparison to the 45.1% combined discount for lack of both control and marketability developed above.
Regarding the discount data found in Partnership Spectrum, about fifteen independent finns make secondary markets in publicly traded limited partnerships. Three, of which the largest is the Chicago Partnership Board, account for sixty percent of trading activity. The average transaction size is less than $8,000, with 81 percent of all trades averaging less than $10,000. According to a study by Robert Stranger & Co., a leading real estate finn, sales of public real estate limited partnerships have declined from a peak of $8.5 billion in 1986 (the year in which significantly restrictive tax reforms were enacted) to $350 million in 1995, the latest date for which data were available prior to the valuation date of March 18, 1996.
Therefore our final analysis is a review of the reports in Partnership Spectrum, May/June 1996 (Exhibit 3) which indicates that non distributing equity partnerships had an average discount to Net Asset Value of 56%. These values are based upon a hypothetical sale of the partnership property at appraisal values, and the distribution of the resulting net proceeds (less estimated selling costs) together with any other net assets. We note that the 56% cited in Partnership Spectrum is comparable to the 45.1% discount we developed for LEe. Since the Partnership Spectrum data reflects taking taxes into effect, no adjustment to that data is needed.
Hence, based upon all of the analyses performed for this appraisal, we conclude that LEe would expect to be sold at a 45.10/0 discount from the NAV if a willing buyer and willing seller were to negotiate a deal based upon reasonable and rational economic expectations.
In arriving at our final opinion of fair market value of a 63% restricted control interest with limited marketability in LEe; we considered all relevant factors based upon information known or susceptible of being known as of the effective valuation date. We therefore determine that the fair market value of the subject block of stock is as follows:
D. B. Gray, CPA/ABV, MBA, CBA, ASA, of Virginia Beach, teaches intrinsic valuation of goodwill for the MCLE Board of the Virginia State Bar. He is the only person in Virginia to be recognized as an accredited appraiser by the American Institute of CPAs, the American Society of Appraisers, and the Institute of Business Appraisers. He can be reached at 1-800-766-9056, or SEBizVal@aol.com.