On June 13, 2016, the U.S. Tax Court rendered its opinion relating to the fair market value of a 41.128 percent limited partnership interest in Giustina Land & Timber Co. Limited Partnership (“Giustina”) held by the estate of Natale B. Giustina at August 13, 2005., The company owned and operated 47,939 acres of timberland near Eugene, Oregon. The timberland was valued at about $143 million, after a 40 percent “absorption” discount for the time delay in selling the acreage. The normalized net income of Giustina at the date of death was $6,120,000.
The case had previously been heard by the Tax Court in 2011 and the court’s opinion (about $27.5 million) was generally unfavorable to the taxpayers whose expert had determined a value of about $13 million. The IRS expert’s opinion had come in at about $33.5 million. The taxpayers appealed to the Ninth Circuit, which reversed the trial court on two key points. First, the Tax Court assumed a 25 percent probability that the willing buyer of the Interest would be in a position to cause liquidation of Giustina. Along with this presumption came the notion that no discounts for minority interest or marketability would be appropriate. Second, in determining the discount rate to be used in the cash flow analysis, the taxpayer’s appraiser included a specific risk premium of 3.75 percent in the overall discount rate of 18 percent. Citing the notion that such a risk can be mitigated by holding a diversified portfolio, the Tax Court reduced the specific risk premium used by the taxpayer’s appraiser to 1.75 percent.
The Ninth Circuit stated that the Tax Court had no reasonable basis for either position. It cannot assume a probability of liquidation without evidence to support this position. Similarly, the Ninth Circuit found that halving the specific risk premium without any visible rationale was erroneous.
The taxpayer’s appraiser also tax affected Giustina’s earnings by applying an effective corporate tax rate of 25 percent. Citing Gross, the Tax Court stated that this was improper. The Ninth Circuit did not find the court’s position to be clearly erroneous. Interestingly, the appeals court cited the estate’s concession that tax affecting was “an unsettled matter of law” as a rationale for not finding the Tax Court in error.
In reconsidering the above in its remand the Tax Court came up with a very different answer. First, it completely disregarded the Liquidation Method and considered only the capitalization method of cash flow method of the Income Approach. Secondly, in so doing, it increased its discount rate to take into account the full specific risk premium. Accordingly, the Tax Court’s valuation changed from $27.5 million to approximately $14 million.
Probability-adjusted Liquidation Method
Abandoning the liquidation method in this situation makes perfect sense. This method should only be used with the valuation of a minority or non-controlling interest when there is actual knowledge of a planned liquidation. A possible exception would be when “break-up” value is calculated for companies in distress or with very low profits (relative to asset value). Such was not the case with Giustina.
The above should not be interpreted to mean that asset rich companies with significant cash flow should only be valued by the Income Approach. Revenue Ruling 59-60 states: “The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type the appraiser should determine the fair market values of the assets of the company… adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.”
It is not clear whether the above passage refers to a controlling or non-controlling interest but it is clear that asset values have an important role to play in the valuation of equity interests in companies holding investments or natural resources. When using the Asset Approach in valuing a non-controlling interest in such companies, discounts for lack of control and lack of marketability always apply. In Giustina, the Tax Court did not apply such discounts since it was (improperly, as it turns out) assuming a probability adjusted liquidation.
Specific Risk Premium
The adoption of the full amount taxpayer’s appraiser’s specific risk premium is an appropriate and welcome development. Despite this, in the most recent decision, the Tax Court’s justification for using the SRP is puzzling. The opinion states:
By the same token, in evaluating the hypothetical buyer’s ability to diversify risk, we should consider only a buyer whose ownership of a limited partner interest is permitted by section 9.3 of the partnership agreement.
This has the effect of turning the willing seller-willing buyer construct on its head. Here only existing partners might be considered as buyers. We see this provision in virtually every limited partnership agreement. We are unaware of any previous Tax Court case which has taken this position.
The following are some reasons that would argue against the logic of the Court’s rationale for the use of the SRP:
- It would seem the restriction (section 9.3 mentioned above) on re-sale is an “applicable restriction” which is more stringent than state law and should be ignored. (The interest still is not marketable and should be accorded a significant discount for lack of marketability.)
- This an Estate valuation where what is valued is what the decedent owned at death—not what the transferee will get.
- If the other partners knew the estate could not sell to anyone else, they could drive a hard bargain—not representative of a fair market value transaction
- The estate could sell the interest anyway. The buyer would be an assignee but still get economic benefits.
The notion that one can eliminate specific risks by diversification has been de-bunked by many academics. It is true that the notion of diversification eliminating non-systematic risks is one of the central theorems of CAPM. However, in back-testing CAPM with this presumption, large errors are found. This is why the SRP (and also size premiums) were invented in the first place—to partially explain the error term in the CAPM equation.
Furthermore, while it is true that a diversified portfolio should have less risk than a non-diversified one, why should a willing buyer give the willing seller the economic benefit of his own diversification strategy? The buyer has invested his own capital in order to hold a diversified portfolio. If the buyer pays the seller the “diversified price”, he is defeating his own strategy from the get-go.
In the remanded opinion, the Court assumes the GPs would never allow a diversified investor to become a limited partner. In reality that is probably true. But, if it is true for Giustina, it is also true for every other family-owned entity.
Fair market value forces us to consider a hypothetical transaction. Some of reality must be suspended in order to make this work. Without doing so, the conclusion may be that interest has no value other the present value of dividends and distributions. Suppose the entity makes no non-tax distributions but has $150 million in timberland. Would the LP just give his interest away because it was without value? Of course not.
Last, the recent opinion seems to conflate the concept of a non-family diversified investor with an investor who would not be interested in buying unless he could force liquidation. This assumption is clearly wrong. There are all types of investors. Certainly, there is a class (or “clientele” as the academics call it) of investors who have a long term view, look for income and appreciation and do not seek an immediate profit. In fact, investors who would be interested in an illiquid investment because of the excess returns which might be earned are typified by their willingness to be patient. Only vultures seek to buy and immediately liquidate.
Related Thought Leadership:
William H. Frazier, ASA is a Managing Director in the Valuation & Financial Opinions Group. He has over 35 years of experience in business valuation and corporate finance. Mr. Frazier can be reached at +1.214.389.3480 or firstname.lastname@example.org.
 Giustina v. Commissioner, 586 Fed. Appx. 417 (9th Cir. December 5, 2014), rev’g, T.C. Memo. 2011-141 (2011).
 The interest was held by a revocable trust but no party considered this to be an issue affecting valuation.
 Gross v. Commissioner, T.C. Memo. 1999-254, 78 T.C.M. (CCH) 201, 209, affd. 272 F.3d 333 (6th Cir. 2001).