Discounts in Art: “Starving Artist” Prices?

The 9th Circuit Court of Appeals recently issued a decision (highlighted by Carsten Hoffman’s FMVOpinions) affirming a tiny fractional interest discount applied to a jointly-owned collection of paintings. In Stone vs. U.S. (2009), the district court rejected the opinion of the estate’s expert, who testified in favor of a 44% fractional interest discount, citing the expert’s “total lack of experience with the art market; the dissimilar motives driving purchasers to acquire art, on one hand, and real estate or limited partnership shares, on the other; and the unreasonably low appreciation rate and unreasonably high present-value discount rates Hoffmann used in his cost-of-partition analysis.” The district court refused, on the other hand, to apply no discount, as urged by the government. Instead, the district court settled upon a 5% fractional interest discount, the percentage that was conceded by the IRS. The 9th Circuit affirmed.

On appeal, the estate argued that the lack of data regarding real-world  sales of fractional interests in art justified its use of discounts derived from sales of fractional interests in real estate and limited partnerships. The estate also argued that the district court had erroneously assumed that the estate’s 50% interest in the art collection would be sold together with the other 50% interest. The appellate court dismissed both arguments under an abuse of discretion standard.

In his post-mortem analysis, Carsten Hoffman (who was the estate’s expert in Stone) speculated that fractional interest discounts in art should actually be higher than, not lower than, discounts in real estate and partnerships.

To begin with, empirical data regarding discounts for lack of marketability as it relates to restricted stock, demonstrates that the magnitude of the discount is directly related to the degree of volatility. This is logical, as an investor would rather surrender liquidity for low volatility assets compared to high volatility assets. For example, the FMV Restricted Stock Study shows that the discount for lack of marketability is approximately 300 percent higher for stocks in the top 10 percent, measured by volatility, compared to those in the bottom 10 percent (approximately 45 percent vs. 11 percent). This is significant, as art has provided the least attractive risk and return potential of any asset class as reported by Merrill Lynch. The report also indicates that over a 5-year investment horizon, the risk of loss in art ownership is 70 percent higher than the risk of loss in the S&P 500 Index. Further, the standard deviation (a measure of volatility) for art is 44 percent higher, on average, than for the S&P 500.

Hoffman noted that data did not exist in 1982 when the courts first confronted the challenge of applying a fractional interest discount to real estate and partnership interests. The data that supports such discounts has been developed over the intervening years. Similarly, the scholars will have to compile data for the art market.

Standard of Value dictates Use of Discounts in Divorce Case

The Alabama Court of Appeals recently issued an opinion in Grelier v. Grelier, holding that the parties’ agreement to employ the fair market value standard in a divorce case precluded wife from arguing on appeal that the trial court should not have applied marketability and minority discounts.

In Grelier, the parties appointed a neutral expert to determine the value of the husband’s business, a retail and commercial real estate development company. The husband owed a 25% interest; his father, brother and college roommate owned the other interests. The consent order appointing the expert specified that he would determine the fair market value of the business. Husband and Wife each hired independent experts to offer their opinions of value as well.

The court-appointed expert testified that marketability and minority discounts should not be applied to the husband’s interest in the real estate business, but the opinion does not reveal why. Wife’s expert testified that the court-appointed expert’s valuation was flawed because it relied on out-dated appraisals and verbal statements of value but agreed that discounts should not be applied. Husband’s expert testified that a minority interest discount was appropriate because the wife had not proven that the husband had a right to act independently from the majority stakeholders; and that a marketability discount was standard practice when determining the FMV of close corporations. Husband’s expert suggested a 25% minority discount and 25% marketability discount, but the trial court reduced the combined discounts to 40%.

On appeal, the wife argued that the trial court should have utilized the fair value standard instead of FMV; and that the minority interest and marketability discounts should not have been applied. The Alabama Court of Appeals held that the wife’s argument was waived for failure to raise it in the trial court, where she had consented to a FMV standard in the order appointed the expert. Moreover, the appellate court held that the trial court had not abused its discretion in applying the discounts to arrive at FMV.

Jelke and BIG Tax Liability

Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.

Credibility is King in War of the Experts

The typical “war of experts” was presented in Bussa v. Bussa, 2008 WL 2117138 (Mich.App.), a 2008 unpublished decision of the Michigan Court of Appeals. In this case, the business owner’s expert gave an opinion of value based upon the asset approach. The subject company (actually, companies) was a petroleum sub-jobber comprised of a gas station operator, a real estate holding company owning the gas stations, and a trucking company delivering fuel to the gas stations. The business owner’s expert relied on an net asset value approach and excluded the income approach because the company was involved in a highly volatile industry.

The wife’s expert considered all three approaches, including discounted cash flow, market comparables, and net asset value. In valuing the operating company, she relied primarily upon the market approach. For the trucking company, she considered all three approaches; and for the real estate holding company, the net asset approach was deemed most reliable.

The trial court rejected the opinion of the husband’s expert and slightly modified the value suggested by the wife’s expert, applying a 5% discount for lack of control (the business owner’s brother owned half of the stock) and a 10% key man discount. The opinion of the husband’s expert was rejected because of significant computational errors, an inability to cite data to support his views, and an impression of advocacy for his client.

On appeal, the Michigan court affirmed, finding that it was mostly an issue of credibility, which is best left to the trial courts to decide. It is perhaps notable that the business owner on appeal seemed to contradict his own expert, arguing that his businesses should be valued at their liquidation value (contrary to his expert’s testimony) and criticizing the discounts that were applied to the value rendered by wife’s expert (which were the discounts to which husband’s own expert testified).

Astleford has valuation professionals FLiP’n

Last month the U.S. Tax Court released its memorandum opinion in Astleford v. Com. (TC Memo 2008-128), a case dealing with the minority and marketability discounts applicable to family limited partnerships. In Astleford, the widow of a Minnesota real estate tycoon contributed her interests in real estate (which included real estate partnerships and trusts) to a family limited partnership (FLP) for the benefit of the parties’ children.

In valuing the interests gifted to the children for the donor’s IRS Form 709s, the taxpayer’s valuation expert took a 41.3% absorption discount against the value of the real estate. The taxpayer’s expert opined that the parcel of farmland was so much larger than the average comparable sales that it would flood the market, warranting a discount. The IRS, predictably, rejected the absorption discount.

On appeal, the Tax Court reduced the absorption discount considerably, to approximately 20%. In doing so, the Tax Court examined the specific data on which the taxpayer’s expert relied and reached its own conclusion from that data by excluding certain datapoints and determining its own weighting.

The taxpayer’s expert also discounted the value of the partnership donated to the FLP and the FLP interests conveyed to her children for lack of control and lack of marketability, relying on market data from sales of registered real estate limited partnerships (RELPs). Deriving a range of 22% to 46%, the donor’s expert settled on a 40% combined discount against the value of the partnership. The IRS did not discount at the partnership level, arguing the discounts should be applied only at the FLP level.

The taxpayer’s expert applied “tiered discounts” by discounting the partnership interests that were donated to the FLP and the FLP interests that were transferred to children. In other words, the value was discounted once at the partnership level and again at the FLP level. The Tax Court noted that tiered discounts were disallowed where minority interests comprised most of the assets of the FLP entity being valued, but since the partnerships were just 16% of the FLP’s value, the tiered discounts would be allowed. The TAx Court arrived at a 30% combined discount at the partnership level.

The IRS in calculating discounts at the FLP level applied data from REIT sales, which the Tax Court deemed more reliable than RELP data. Because of the data source, the IRS expert had to adjust his minority interest discount to account for the unusual liquidity of REITs. By eliminating the liquidity premium from the observed discount, the IRS arrived at a minority interest discount of 7-8%, which the Tax Court deemed too low. The Tax Court instead calculated a minority interest discount of 16-17%.

The Tax Court accepted the IRS’s marketability discount of 22% (which was slightly higher than the marketability component of the taxpayer’s combined discount).

Eight Landmines to Watch Out for in Divorce Valuations

Whether attacking or defending your expert’s business valuation in a divorce trial, it is important to know and avoid the eight landmines that can blow up your case:

  • Reasonable Owner’s Compensation – A business valuation usually requires the expert to make adjustments to the subject company’s income statement. This process is called “normalization.” Normalizing the company’s financial statements permits the valuation expert to compare the subject company to other businesses in the same geographic area and industry. One of the most common normalization adjustments is the owner’s compensation, which may be increased or decreased to reflect market levels. The valuator is not a vocational expert, so how can he/she give an opinion of what the business owner should be earning? Business valuation experts usually rely on published sources of survey data for the industry in which the subject business is engaged. This is one reason why it is essential to interview or depose the business owner to learn about his/her skills, duties, working hours, compensation, and perquisites. If the survey data on which the valuator relied does not match the characteristics of this particular owner, then this landmine could explode his/her opinion of value!
  • Adjusting Asset Values to Market – Another common normalization adjustment is “adjustment to book.” Tangible assets like real estate, inventories, and equipment must be adjusted to their market value if a “book value” or “excess earnings” approach is used. Again, most business experts are not appraisers, so it may be helpful to engage real estate appraisers or equipment appraisers to provide their opinions. Many business experts rely on the business owner’s opinion, which can be hazardous. Review the limiting conditions in the valuation report to see if the expert is tiptoeing between the landmines.
  • Adjusting Rent to Market – If the company pays rent to owners or other insiders, the amount of rent may be greater or lesser than market. The safest route is to hire a real estate appraiser to give an esimate of fair rental value. If the business expert relied on the owner’s opinion of market rent, it should be disclosed in the limiting conditions.
  • Specific Company Risk – Perhaps the most common method of choosing the capitalization rate in a business valuation is called the “Ibbotson build-up” method. Valuation professionals rely on the data published annually by Ibbotson Associates to calculate the risk associated with a particular business. There are generally four elements of risk which are added together (thus, a “build up”). The first three elements — the risk-free rate, equity risk premium, and size premium — are pretty cut-and-dried. The real subjectivity comes into play when an expert adds a specific company risk premium. Before going to trial, it is vitally important for the lawyer to understand specific company risk and talk to the expert about his opinion and how it was derived.
  • Rate Matching – Most lawyers don’t know that the capitalization rate is calculated differently to match various types of benefit streams: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. When preparing for trial, don’t forget to ask the expert to explain how the capitalization rate matches the benefit stream.
  • Taxes and Transaction Costs – Most divorce courts have not addressed the issue of whether to “tax-affect” the earnings of a Subchapter “S” corporation. Another issue is whether to deduct taxes and transaction costs from the hypothetical proceeds that a business owner might receive upon the sale of the company. This would require the expert to allocate the sales price and perhaps even give an opinion about broker’s fees. It’s uncharted territory, so don’t forget to bring your metal detector when crossing this minefield!
  • DLOM/DLOC – Many business experts apply discounts for lack of marketability (DLOM) to their valuations of closely-held companies. They may also apply discounts for lack of control (DLOC) to minority interests (less than 50%) of a business. In recent years, the U.S. Tax Courts have aggressively challenged business valuation experts who apply discounts for estate and gift tax purposes. Intuitively, it makes sense that investors would pay less for businesses they cannot liquidate as easily as publicly-traded stocks; and the disadvantages of owning a minority interest in a company are obvious. The evidence to quantify these discounts, however, is much less obvious and bears close scrutiny.
  • Identifying Non-operating Assets – Some companies maintain investment portfolios or own property that is not used in the operation of the business. On the other hand, some businesses require capital reserve to replace costly equipment or inventory, to secure bonding or financing, or for other reasons. Non-operating assets generally increase the value of a business because the business expert will isolate those assets and add them to the capitalized earnings of the remaining assets.

Comparing Apples to Apples when Measuring Increase in Value

In Haentjens, a 2004 decision of the Pennsylvania Superior Court, the husband inherited a minority interest in a family business around the mid-point of his 20 year marriage. The family business was subequently sold prior to the parties’ separation.

In the equitable distribution proceeding, the wife’s expert measured the increase in value of the husband’s non-marital business interest by subtracting the discounted value of the husband’s minority interest at the time of his inheritance from the sales proceeds that the husband actually received when the entire company was sold. Husband objected because a minority discount was applied to his acquisition value but not to his sales proceeds.

Husband’s expert, by contrast, urged the court to discount the sales proceeds by subtracting the book value of Husband’s interest.

The trial court, rejecting both these approaches, instead valued Husband’s acquisition on a pretax basis without a minority discount, thereby placing that value on the same footing as the undiscounted sales proceeds. This value was subtracted from Husband’s pretax sales proceeds to measure the increase in value.

The Superior Court affirmed the trial court’s hybrid valuation technique, finding that the technique urged by the wife’s expert was fundamentally flawed and artificially inflated the appreciation in value.