TAX COURT OPINION

Case: Estate of Webster E. Kelley, Deceased; John R. Louden and Patricia L. Louden, Personal Representativ
Docket Number: 16894-03
Judge: Vasquez
Opinion Type: memo
Filed: 10/11/2005
Pages: 14

T. C: Memo. 2005-235 UNITED STATES TAX COURT JOHN R. LOUDEN AND ESTATE OF WEBSTER E. KELLEY, DECEASEÖ, PATRICIA L. LOUDEN, PERSONAL REPRESENTATIVES, Petitioner v COMMISSIONER OF INTERNAL REVENUE, Respondent .-. Docket No. 16894-03. Filed October M, 2005. Larry W. Gibbs, for petitioner.. Kathryn F. Pati-erson, for respondent. MEMORANDUM FINDINGS OF FACT . AND OPINION VASQUEZ, Judge: Respondent determined a $136, 679 deficiency in the Federal estate tax of -the Estate of Webster E. .Kelley (the estate) . The sole issue for decision is the fair market value of Webster E. Kelley's (decedent) 94.83-percent interest in a family . limited partnership and one-third interest in a limited liability company. SERVED OCT 1 1 2005 _ 4 _ OPINION I. Burden of Proof As a general rule, the notice of deficiency is entitled to a presumption of correctness, and the taxpayer bears the burden of proving the Commissioner's deficiency determinations incorrect. Rule 142(a);³ Welch·v. Helvering, 290 U.S. 111, 115 (1933).4 Section 7491(a), however, provides that if a taxpayer introduces credible evidence and meets certain other·prérequisites, the Commissioner shall bear the burden of proof with respect to factual issues relating to the liability of the taxpayer for a tax imposed under subtitle A or B of the Internal Revenue Code (Code). For the burden to shift, however, the taxpayer must comply with the substantiation and record-keeping requirements as provided in the Code and have cooperated with the Commissioner. See sec. 7491(a)(2). The estate did not claim that section 7491(a) applies. Accordingly, the burden remains on the estate. 3 Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code as in effect at time of decedent's death. the 4 The presumption of correctness does not apply when the Government's determination is a "'naked' assessment without any foundation whatsoever". Unit'ed States v. Janis, 428 U.S. 433, 441 (1976). not be entitled to a presumption of correctness if we conclude that we give some probative value to the ATI report, we conclude that this is not an issue. The estate argues that the notice of deficiency may As the report of its expert, ATI, had no probative value. II. Fair Market Value of Decedent's Interests - 5 - A. Introduction 1. General Principles Property includable in a decedent's gross estate generally is to be valued as of the date of the decedent's death. Sec. 2031. For purposes of the estate tax, property value is determined by finding the price at which the property would (cid:16)042change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. Sec. 20.2031- 1(b), Estate Tax Regs. The willing buyer and willing seller are hypothetical persons. Estate of Newhouse v. Commissioner, 94 T.C. 193, 218 (1990) (citing Estate of Bright v. United States, 658 F.2d 999, 1006 (5th Cir. 1981)). The hypothetical buyer and seller are presumed to be dedicated to achieving the maximum economic advantage. Id. Valuation is a factual determination, and the trier of fact must weigh all relevant evidence of value and draw appropriate inferences. Estate of Deputy v. Commissioner, T.C. Memo. 2003- 176. There are three common approaches to measure the interest in a closely held entity--the income approach, the net asset value (IUa7) approach, and the market approach. Id. Value is determined under the income approach by computing a company's - 6 - income stream. Estate of Jelke v. Commissioner, T.C. Memo. 2005- 131. Value is determined under the NAV approach by computing the aggregate value of the underlying assets as of a fixed point in time. Id. Value is computed under the market approach by comparison with arm's-length transactions involving similar companies. Id. The NÃV approach is often given the greatest weight in valuing interests in an investment company. See Estate of Ford v. Commissioner, T.C. Memo. 1993-580, affd. 53 F.3d 924, 927-928 (8th Cir. 1995) (citing Rev. Rul. 59-60, sec. 5, 1959-1 C.B. 237, 242). After determining the NAV of KLLP and KLBP LLC, it is appropriate to discount decedent's interest in each entity to reflect lack of control and/or lack of marketability. See Peracchio v. Commissioner, T.C. Memo. 2003-280. 2. Expert Opinions a. In General In deciding valuation cases, courts often look to the opinions of expert witnesses. Each party in this case relies on an expert opinion to determine the values of the properties at issue. We evaluate expert opinions in light of all the evidence in the record, and we are not bound by the opinion of any expert witness. Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Shepherd v. Commissioner, 115 T.C. 376 (2000), affd. 283 F.3d 1258 (11th Cir. 2002). We may reject, in whole or in part, - 7 - any expert opinion. Estate of Davis v. Commissioner, 110 T.C. 530, 538 (1998). Because valuation necessarily involves an approximation, the figure at which we arrive need not be directly traceable to specific testimony or a specific expert opinion if it is within the range of values that may be properly derived from consideration of all the evidence. Estate of True v. Commissioner, T.C. Memo. 2001-167 (citing Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-285). b. The Estate's Expert The estate employed ATI in December of 1999 to prepare a valuation report for transfers decedent made at yearend. Decedent's death, however, converted the Federal gift tax valuation study into a Federal estate tax valuation study. The estate's communications regarding the valuation were solely with Ron Lint (Mr. Lint), the founder and president of ATI. Mr. Lint has the designation of accredited senior appraiser from the American Society of Appraisers (ASA). Mr. Lint testified that he assigned the valuation project to Jeff Mills (Mr. Mills), a subordinate at ATI, who also has the designation of accredited senior appraiser from the ASA. The valuation report was prepared and signed by Mr. Mills, but Mr. Lint adopted the report as his own. - 8 - ATI used the NAV approach and the income approach in determining the proper valuation of decedent's interests. ATI gave 80-percent weight to the NAV approach and 20-percent weight to the income approach.s ATI appraised decedent's 94.83-percent limited partnership interest in KLLP at a fair market value of $521,565, applying a 53.5-percent valuation discount to the adjusted NAV of KLLP, and appraised decedent's one-third interest in KLBP LLC at $1,833.33, also applying a 53.5-percent valuation discount. c. Respondent's Expert Respondent submitted an expert report prepared by Raymond F. Widmer (Dr. Widmer). Dr. Widmer has a bachelor of arts degree in economics, a master of business administration degree with a concentration in economics and quantitative methods, and a Ph.D. In economics. Dr. Widmer used the NAV approach and valued the interests using a 25.2-percent valuation discount. Applying this discount, Dr. Widmer determined a value of $869,970 for the 94.83-percent limited partner interest in KLLP and $3,055 for the one-third interest in KLBP LLC. 5 At trial, the estate's expert, Mr. Lint, admitted that the income approach calculation in the.ATI report was incorrect because, among other problems, it did not compound the earnings each year. _ 9 _ B. Fair Market Value Before Discounts As determined supra, the NAV method is generally an appropriate method to apply when computing the value of a nonoperating entity. See Estate of Ford v. Commissioner, supra. While more than one method may be used, giving appropriate weight as necessary, we find that in this case, where the interest to be valued is an interest in a family limited partnership whose (cid:16)042assets consist solely of cash and certificates of deposit, the income approach should not be afforded more than minor weight. The parties agree that the value of KLLP's assets on the valuation date, decedent's date of death, was $1,226,421, consisting of $807,271 cash and $419,150 in certificates of .deposit and no liabilities. Therefore, we use this as the NAV. C. Minority Interest (Lack of Control) Discount 1. Introduction Pursuant to the partnership agreement, a buyer of all or any portion of the transferred interests would have limited control of his investment. A hypothetical willing buyer would account for this lack of control by demanding a reduced price; i.e., a price that is below the NAV of the pro rata share of the interest purchased in KLLP. A minority discount will therefore apply in this case where a partner lacks control. See Estate of Bischoff v. Commissioner, 69 T.C. 32, 49 (1977). - 10 - 2. Determination of the Minority Interest Discount Each expert witness determined a minority interest discount or discount for lack of control by reference to general equity closed-end funds. In a closed-end fund, the assets are brought together for professional management, and the shareholders have no control over the underlying assets. The owner of an interest does not have the ability to sell the underlying assets. The closed-end funds typically trade at a discount relative to their share of the NAV, and as the shares enjoy a high degree of marketability, the discounts must be attributable to some extent to a minority shareholder's lack of control over the investment fund. Peracchio v. Commissioner, T.C. Memo. 2003-280. Therefore, it is appropriate to compare the ownership of a partnership interest in KLLP to the ownership of a closed-end fund and apply an appropriate discount for lack of control. Both experts divided the comparable closed-end funds into quartiles by price to NAV ratios. The first quartile represents the funds that are in high demand and therefore trade at premiums or low discounts. The fourth quartile represents the funds that are in low demand and trade at higher discounts. a. The Estate's Expert In computing the minority discount, ATI determined that KLLP would be most comparable to the closed-end funds in the fourth quarti-le with price to NAV discounts of 21.8 percent to 25.5 - 11 - percent. ATI considered several factors in making this determination, including: KLLP is smaller in size than a publicly traded fund; closed-end funds generally have a staff of analysts and professional managers devoted to the full-time management of the fund investments which reduces risk whereas KLLP is not managed in the same manner; closed-end funds offer diversification of the portfolio of investments while KLLP is not (cid:16)042diversified; and KLLP does not have a performance history whereas most closed-end funds have a performance history of 5 to 10 years. Once ATI determined an appropriate discount range of 21.8 percent to 25.5 percent, ATI then further adjusted the discount based on several factors and restrictions inherent in KLLP and using other partnership studies. One such study, published by Partnership Profiles, Inc. (PPI), found that the average discount for 18 publicly registered but nontraded miscellaneous partnerships, when the NAV of such partnerships was compared to the prices at which investors acquired units in them in the secondary market, was 29 percent. ATI also discussed another study published by PPI which compared the NAV of approximately 100 publicly registered but nontraded real estate partnerships with the prices at which investors acquired units in these partnerships in the secondary market. The average discount to NAV was 27 percent for the transactions studied. Therefore, ATI used a 25-percent minority discount for valuing the interests in - 12 - KLLP. b. Respondent's Expert Dr. Widmer calculated a minority discount of 12 percent by calculating an arithmetic mean of the entire data set for closed- end funds, not only the fourth quartile. Dr. Widmer determined that it is essential to use the whole array of closed-end funds as this calculation will remove the marketability element in the discounts or premiums. 3. Conclusion We are not persuaded that ATI's exclusive use of the fourth quartile of closed-end funds is proper. "While we have utilized small samples in other valuation contexts, we have also recognized the basic premise that '[a]s similarity to the company to be valued decreases, the number of required comparables increases'." McCord v. Commissioner, 120 T.C. 358, 384 (2003) (quoting Estate of Heck v. Commissioner, T.C. Memo. 2002-34); see also Lappo v. Commissioner, T.C. Memo. 2003-258. We are also not persuaded by ATI's analyses of PPI's studies regarding minority discounts as ATI admits that these discounts contain some element of discount for lack of marketability, and therefore these studies result in an overstatement of the minority discount. In determining the minority discount for KLLP, we believe a correct analysis would be to take the arithmetic mean of all of - 13 - the closed-end funds, as , shareholders in all closed-end funds lack control. In using only the fourth quartile, ATI combined elements of the lack of mayketability discount with the minority discount because the funds in the. fourth quartile had the lowest demand and therefore the highest marketability discount. As the lack of marketability. will be dealt, with in the discount for lack of marketability, see infra, we agree with respondent that ATI's discount for lack of control is too-high and that it was incorrect to use solely the fourth quartile funds. Although we find neither expert particularly persuasive on this issue, we will apply a 12-percent discount on the grounds that (1) respondent has effectively conceded that a discount factor of up to 12 percent would be appropriate, and (2) petitioner has failed to prove that a figure greater than 12 percent would be appropriate. See Peracchio v. Commissioner, supra (using a 2-percent minority discount factor for the "cash and money market funds" asset category of a family limited partnership) . D. Marketability Discount 1. Introduction A discount for lack of market*ability is appropriate in valuing the interests in KLLP as there is not a ready market for partnership interests in, a closely held partnership. Estate of Newhouse v. Commissioner, 94 T.C. at 249. Although both experts I . - 18 - study is not entirely accurate. The Bäjaj study states that the 14.09-percent discount,. which Dr. Widmer focused on, is not solely a reflection of marketability discount but is also influenced by additional factors which have to be accounted for. Bajaj et al., suprä at 107. These factors depénd on the 'fraction of total shares of'fe(cid:0)576ëdin the plàcement, business risk, . financial distress of the firm, and t tal proceeds from the placement. Id. at .107-109. As we find the partiies' . assumptions and analyses concerning the marketability discount only minimally helpful, we use our own analysis and judgment, relying on the partiés' experts' assistance where appropriate. Helvering v. Nátl. Grocery Co., 304 U.S. at 295. In McCord v. Commissioner;: 120 T.C. at 394-395, we focused on the Bajaj study and found that a 20-percent marketability discount was appropriate for interests in a family limited partnership classified as an investment company. Dr. Bajaj divided the private placements into three groups according to the level of discounts--the 29 loUest discounts, the middle 29 discounts, and the 30 highest discounts. Id. at 394. The low discount group, with a discount of 2.21 percent, is dominated by registered private placements whïâh did not suffer from. impaired marketability. Id. The high discount group, with a. discöunt of 43.33 percent, is dominatéd by unregistered private placements which, unlike the sale of an interest in an investment company, have relatively high assessment and monitoring costs. Id. As - 19 - these characteristics do not reflect the characteristics of an investment company, we concluded in McCord, as we do here, that the partnership is in the middle discount group, and a discount of 20 percent (rounded from 20.36 percent) is applicable. Id. In McCord, we did not refine the 20-percent discount any further to incorporate specific characteristics of the partnership at issue as we were not persuaded that we could refine the figure. Id. at 395. In Lappo v. Commissioner, T.C. Memo. 2003-258, we found that a 21-percent initial discount was appropriate for an interest in a family limited partnership consisting of marketable securities and real estate subject to a long-term lease. We then made a further upward adjustment of 3 percent to the marketability discount accounting for characteristics specific to the partnership, including: The partnership was closely held with no real prospect of becoming publicly held; the partnership was relatively small and not well known; there did not exist a present market for the partnership interests; and the partnership had a right of first refusal to purchase the interests. _I_d_,_ As these characteristics are similar to the characteristics in KLLP, we find that a 3-percent upward adjustment is applicable. - 20 - Therefore, we hold that a 20-percent initial marketability discount · is appropriate. We further f ind that an upward adjustment of 3 percent . is proper to incorporate characteristics specific to the partnership. E. Conclusion on the basis of all the evidence and using our best judgment, we conclude that a 12-percent minority discount and a 23-percent marketability discount are appropriate in valuing the interests in KLLP. The fair market value of the 94.83-percent limited partnership interest is $788,059 computed as follows: Total NAV as of 12/8/99 94 . 83 percent of NAV Less: 12-percent minority interest discount Less: FMV of 94 . 83-percent 23-percent marketability discount interest $1, 226, 421 1, 163, 015 (139,562) 1, 023, 453 (235,394) 788, 059 We conclude that the fair market value of the 33.33-percent interest in KLBP LLC, the sole asset of KLBP LLC being a 1- percent general partnership interest in KLLP, is $2, 770 computed as follows: Total NAV as of 12/8/99 33 . 33 percent of 1 percent of NAV Less: 12-percent minority interest discount Less: FMV of 33.33 percent of 1-percent 23-percent marketability discount interest $1,226,421 4 , 088 (491) 3, 597 (827) 2,770 To reflect the foregoing, Decision will be entered under Rule 155.