This recent estate tax case is rife with valuation issues. And it is one of the few that the issues are clearly defined and resolved.
The United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) remanded the case to the Tax Court to reconsider its decision on the valuation of the Estate’s interest in the Giustina Land and Timber Company Limited Partnership (the “Partnership”).
On January 1, 1990, the Partnership was formed to operate a sustained yield timber harvesting company. (A sustained-yield timber harvesting company looks to harvest timber and replace it with new plantings at a rate that will allow it to continue into the foreseeable future). The partnership agreement stated the Partnership would continue in business until December 31, 2040, 50 years after it was formed.
The partnership agreement placed all control of the partnership into the hands of the two general partners. This control included the ability to sell off the land and harvested products. The agreement stated a general partner could only be approved or replaced by limited partners owning at least two-thirds of the limited partnership (“LP”) interest. (Note the two GP’s were family members operating through corporate structures. The decedent was not a GP. All limited partners were either family members or trusts for the benefit of family members). To dissolve the partnership, the backing of the same two-thirds ownership of LP interests would be required.
Natale Giustina passed away on August 13, 2005 holding a 41.128% LP interest. The Estate’s valuation expert and the IRS’ valuation expert opined widely divergent values, primarily from the IRS expert’s reliance on a net asset method and from very different results from the guideline company method.
The Tax Court primarily agreed with the IRS. The Court ultimately derived a value based on the net asset method and the cash flow method. The Estate appealed.
The net asset method, in my view, is associated with liquidation, not with a going concern. Under a net asset method, the value derives from the analyst’s belief of what the assets sell would for and liabilities be settled for in an orderly sale. At the date of death, this Partnership had been in successful operation for almost 15 years. Predecessor companies existed, dating back to the early 20th century. The GPs had never expressed any intent to cease operations or sell off major assets. This Partnership definitely qualifies as a going concern. The Ninth Circuit apparently agrees.
In its initial decision, the Tax Court weighted the net asset method 25%. It presumed there was a one-in-four chance a limited partner could either replace the two general partners or force a partnership dissolution. As the Ninth Circuit pointed out, not only would this require the backing of limited partners holding two-thirds of the total LP interests, it would mean a new limited partner would turn against the GPs who just admitted him or her to the partnership. (Alternatively, a transfer could occur to an existing limited partner without GP approval). In such a cohesive family partnership, turning other family members against the GPs appears more hopeful than possible. And, as I stated above, the GPs never expressed any intent to sell assets. The fact the entity and its predecessors had been in operation for decades was significant evidence the Partnership was a going concern.
On remand, the Tax Court weighted the cash flow method 100%.
The Tax Court took issue with a component of the company-specific premium the Estate’s expert included. All income-generating assets were timberland in Oregon, significant revenue and geographic dependencies. The Estate expert added a 3.5% risk factor. The Tax Court halved it under the presumption a buyer could force diversification. The Ninth Circuit stated the Tax Court did not provide support for cutting this premium in half. The Tax Court rescinded it.
The Estate expert applied a 35% lack of marketability discount. The IRS expert applied a 25% discount. The Tax Court, in its initial decision, applied a 25% discount, but only to the cash flow result. The Ninth Circuit did not question the Tax Court’s use of a 25% discount. It pointed to the Estate expert’s statement that these discounts can range from 25% to 35%. This supports the standard that all factors used needs to be thoroughly supported. Support for discounting is among the most difficult parts of a valuation. It’s one of the many reasons why a valuation is an opinion.