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.

Can the Court Award Legal Fees in a Child Suppot Modification Proceeding?

An interesting, and perhaps unanswered, question which may arise in a child support modification proceeding is, “Can the court award legal fees to the prevailing party?” Since 1997, there has been statutory authority for awarding legal fees in a child support case. Previously, no statutory authority existed.

23 Pa.C.S. 4351 authorizes an award of legal fees where “an obligee prevails in a proceeding to establish paternity or to obtain a support order.” Soon after the enactment of this law, it was tested in the Pennsylvania Supreme Court by a lawyer who advocated an automatic award of legal fees to all support recipients, based on a simple disparity in their net incomes.

The Supreme Court rejected that notion in Bowser v. Blom, a case that established several criteria for determining whether a support recipient should receive reimbursement of legal fees.

Factors which the court may consider include: (1) whether the obligor’s unreasonable or obstreperous conduct impeded the determination of an appropriate support order; (2) whether the obligor mounted a fair and reasonable defense in a child support order; (3) whether the obligor’s failure to fulfill his moral and financial obligation to support his children required legal action to force him to accept his responsibilities; and (4) whether the financial positions and financial needs of the parties are disparate.

Subsequently, the Superior Court was asked to determine, in Krebs v. Krebs, whether the trial court should have forced a father to reimburse the mother’s legal fees, in a case where child support was modified retroactively for several years because the father had concealed an increase in his income. The Superior Court vacated and remanded the case, instructing the trial court to consider whether the mother’s claim for legal fees was appropriate under 23 Pa.C.S. 4351 or 42 Pa.C.S. 2503 (a different statute authorizing an award of legal fees as a sanction for dilatory, obdurate or vexatious conduct by a litigant).

More recently, in Sirio v. Sirio, the Superior Court was again asked to decide whether the mother should have been awarded legal fees in a child support modification proceeding. Once again, the Superior Court vacated and remanded the trial court’s decision not to award fees, instructing the trial court to consider 23 Pa.C.S. 4351 as well as 42 Pa.C.S. 2503. The Sirio Court alluded to Krebs, suggesting that it answered the question of whether fees could be awarded in a modification proceeding (despite statutory language that refers to “establishing” paternity or “obtaining” a support order).

I think both Krebs and Sirio have asked the question, but I have yet to see an authoritative decision (or, for that matter, a strong policy argument).

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.

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).

Innocent Spouse Relief Granted

TaxProf Blog reports on a Tax Court decision in which the former wife of an accountant won equitable relief from joint and several liability under section 6015(f) of the Internal Revenue Code. The former wife credibly testified that she relied on her husband’s expertise in preparing joint tax returns throughout the marriage. She did not review the returns or even fill in the date next to her signature. Years later, when the parties were in marital counseling with a clergyman, the husband confessed that he had filed fraudulent joint tax returns but failed to mail the confession that he told them he would send to the IRS. The Tax Court credited the former wife’s testimony and overruled the Commissioner’s refusal to grant innocent spouse relief.

Locked-Out Spouse Finds No Sympathy at IRS

The TaxProf Blog reported an interesting story about a husband who failed to report his share of passthrough income from the medical billing company that he and his estranged wife owned together. The Tax Court was not impressed with the husband’s explanation that his wife had locked him out of the home where the business was located, raided their business and personal bank accounts, and ran up more than $50,000 in credit card bills. In its decision, the Tax Court affirmed the deficiency assessed by the IRS.

S Corporations: A Taxing Question (Part I)

A hot topic confronting the valuation community these days is whether to discount the earnings or cash flows of a Subchapter “S” corporation by subtracting the shareholder-level income taxes before capitalizing those earnings or cash flows in a business valuation. Intuitively, it stands to reason that an S corporation is not intrinsically more valuable than a C corporation that would generate the same net income or cash flow if it did not have to pay corporate-level income taxes. Perhaps this is why the valuation community has endorsed the practice of “tax-affecting” the earnings of S corporations – until recent court decisions have called into question that practice.

In several recent decisions, “tax-affecting” S corp earnings has been disapproved by the Tax Court. Most recently, in Dallas v. Commissioner, the Tax Court rejected several arguments frequently cited by valuation experts as reasons for “tax-affecting” S corps:

(1) The Tax Court rejected the argument that the company (a family-owned chemical-processing business) might lose its Subchapter “S” status. There was no evidence of record to suggest that the stock transfers which prompted the experts to value the business for estate and gift tax purposes would result in a loss of Subchapter “S” status.

(2) The Tax Court rejected the argument that “tax-affecting” S corp earnings is the standard method among NACVA-certified experts and is taught in NACVA courses for valuation professionals. The expert who had advocated “tax-affecting” in this case testified about an informal poll he took at a cocktail party during a NACVA convention. Not surprisingly, the judge did not regard his poll as scientifically valid. Similarly, the Court dismissed testimony that most bankers and business brokers usually tax-affect S corporation earnings.

(3) The Tax Court rejected the rationale set forth by the Delaware Court of Chancery in its opinion published in Delaware Open MRI Radiology Assoc. v. Kessler. The Tax Court held that the “fair value” standard employed in shareholder dissent cases like Kessler is not necessarily the same as “fair market value” in estate and gift tax cases.

Some of the leading commentators in the business valuation field have been following these cases closely. Those commentators seem to agree that whether “tax-affecting” is appropriate is fact-dependent. In Part Two of this post, I will describe some of the theories that these commentators have developed and how they might apply in a divorce context.