On April 8, 2013, the Tax Court (and, specifically, Judge Morrison) opined on the following two issues in the Estate of John F. Koons, III (the “Estate”) v. Commissioner:
- Whether or not the Estate is entitled to a deduction of approximately $71.4 million of claimed interest expense on a $10.75 million loan from Central Investment LLC (the “LLC”) to the John F. Koons III Revocable Trust (the “Trust”).
- The estimated fair market value (FMV) of the Trust’s interest in the LLC (the “Subject Interest”) on the date of death. The dispute over the FMV of the Subject Interest revolved primarily around the selection of an appropriate discount for lack of marketability (DLOM) for the Subject Interest.
Judge Morrison (the “Court”) ruled that (1) the Estate was not permitted to deduct the $71.4 million of interest expense from the value of the gross estate and (2) the value of the Subject Interest was calculated based on the IRS expert’s estimated 7.5 percent DLOM and not the taxpayer expert’s estimated 31.7 percent DLOM.
This discussion focuses on the FMV of the Subject Interest, and the DLOM in particular. For a more complete view of this case, readers are encouraged to review the entire opinion.
The Subject Ownership Interest
Both of the Court’s decisions were influenced by the amount of control inherent in the Subject Interest.
The analysis performed by the taxpayer expert and IRS expert assumed that the Subject Interest had the rights of an approximate 50 percent owner and 71 percent owner, respectively.
The IRS expert gets from 50 percent to 71 percent by assuming that stock redemptions that were planned but not completed as of the valuation date would eventually occur. This would give a hypothetical owner of the Subject Interest substantial control over the LLC, including the ability to distribute most of the LLC assets.
The Court agreed with the IRS expert because (1) the redemption agreements were signed prior to the date of death, (2) the redemption price could be easily ascertained (most of the LLC assets were cash), (3) the LLC could have successfully sued the other stockholders for breach of contract if they reneged on the redemption, (4) the stockholders had expressed interest in selling their interests in the LLC, (5) the LLC manager wanted the stockholders removed from the LLC, and (6) a 71 percent ownership of the LLC would enable to owner to make certain amendments to the LLC agreement and change the board of directors (and cause the LLC to distribute most of its assets). The Court also considered the motivations of a hypothetical willing buyer of the LLC stock.
The Interest Deduction
The Court opined that interest expense on the $10.75 million loan was not a deductible expense of the Estate because the loan was not necessary to the administration of the Estate. This was because the Trust had (1) sufficient liquid assets combined with (2) an ability to force distributions of additional cash from the LLC (based on a 71 percent ownership interest).
Both experts relied on restricted stock studies and their professional judgment to adjust the results of the studies to their concluded DLOM. The Court opined that the IRS expert’s 7.5 percent DLOM was the appropriate DLOM for the Subject Interest.
The Court sided with the IRS expert because it determined that the regression analysis that was relied on by the petitioner’s expert was flawed. The Court also largely ignored the transfer restrictions in the LLC operating agreement because (1) the Subject Interest had the ability to distribute most of the LLC assets and (2) the company was—and was projected to remain—a cash-rich company.
Based on the decision in this case, if a post-valuation-date event is likely to occur (in this case, stock redemptions), it generally should be considered in the valuation analysis. Examples of post-valuation-date events that analysts may want to consider could relate to merger or acquisition transactions, distributions, capital projects, partnership amendments, or other uses of cash. Whether or not the foreseen event actually happens is another important point for the analyst to consider.
There are also lessons in the Court’s selected DLOM of 7.5 percent. For example, the Court viewed the ability to get to the subject company’s assets as one of the most important DLOM factors (and more important than the transfer restrictions placed on the company’s stock). And, the Court ultimately sided with a more subjective DLOM estimate than a scientific one.
However, this decision should not significantly change the way analysts estimate the DLOM on a day-to-day basis. This is because the Court’s decision was impaired by the paucity of relevant DLOM data that was presented before it. Even though the Court viewed the Subject Interest as having substantial control over the LLC, the Court was forced to select a DLOM based on data that was derived from, and appropriate for, noncontrolling ownership interests.
That being said, the concluded 7.5 percent DLOM is within a reasonable range of DLOMs for controlling ownership interests in cash-rich companies. DLOMs for controlling ownership interests generally range from around 5 percent to 20 percent. In this case, it is possible that the IRS expert and the Court had a concluded DLOM in mind, and both parties needed to fit the data around that answer. In spite of this Court decision, I would not recommend following the guidance outlined in the Koons case to estimate the DLOM for a controlling ownership interest.
Aaron is a manager in our firm’s Portland office. His practice includes valuations for litigation support purposes such as shareholder disputes and other commercial litigation matters, and for taxation planning and compliance purposes such as gift tax, estate tax, and ad valorem property tax. Aaron can be reached at 503-243-7522 or at firstname.lastname@example.org.