T.C. Memo. 2005-235
UNITED STATES TAX COURT
ESTATE OF WEBSTER E. KELLEY, DECEASED, JOHN R. LOUDEN AND
PATRICIA L. LOUDEN, PERSONAL REPRESENTATIVES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16894-03. Filed October 11, 2005.
Larry W. Gibbs, for petitioner.
Kathryn F. Patterson, 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.
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
John R. Louden and Patricia L. Louden (the Loudens), personal
representatives of the estate, resided in Plano, Texas, at the
time the petition was filed. Decedent resided in Plano, Texas,
at the time of his death.
Decedent and his predeceased wife had one child, Patricia L.
Louden. Patricia L. Louden is married to John R. Louden, and
they have four children.
On April 6, 1999, decedent, Patricia L. Louden, and John R.
Louden organized Kelley-Louden Business Properties, LLC (KLBP
LLC), and Kelley-Louden, Ltd., a Texas limited partnership
(KLLP). Between June 6 and September 11, 1999, decedent
contributed $1,101,475 cash and certificates of deposit to KLLP.
On September 13, 1999, the Loudens contributed $50,000 cash to
KLLP.
At the time of decedent’s death, December 8, 1999, decedent
owned the following interests, the values of which are at issue
in this case:
KLBP LLC 33.33 percent
KLLP 94.83 percent
The Loudens owned the remaining two-thirds interest in KLBP LLC.
The Loudens also owned a 4.17-percent interest in KLLP. KLBP LLC
owned the remaining 1-percent interest of KLLP which is the only
asset of KLBP LLC. Therefore, we are valuing decedent’s
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interests of 94.83 percent in KLLP and of 33.33 percent in KLBP
LLC.
On decedent’s date of death, KLLP held assets totaling
$1,226,421, which consisted of $807,271 cash and $419,150 in
certificates of deposit, and had no liabilities.
In December 1999, the estate employed Appraisal
Technologies, Inc. (ATI), to prepare a valuation of decedent’s
interests in these closely held entities. ATI concluded that a
53.5-percent valuation discount was applicable.1
On September 1, 2000, the estate filed a Form 706, United
States Estate (and Generation-Skipping Transfer) Tax Return,
reporting decedent’s 94.83-percent interest in KLLP at a value of
$521,565 and his interest in KLBP LLC at a value of $1,833.33.
Respondent issued a notice of deficiency determining that
the discounts claimed by the estate were too high and lower
discounts were appropriate.2 Respondent contends that the estate
is entitled to a 25.2-percent discount.
1
The estate states several times on brief that ATI used a
55.15-percent discount; however, in calculating the discounts
applied by the estate, we find that ATI used a 53.5-percent
discount.
2
The statutory notice of deficiency sets forth numerous
alternative arguments including arguments based on secs. 2035,
2036, 2038, and 2703. At trial, respondent conceded all the
alternative arguments.
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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 prerequisites, 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 the
time of decedent’s death.
4
The presumption of correctness does not apply when the
Government’s determination is a “‘naked’ assessment without any
foundation whatsoever”. United States v. Janis, 428 U.S. 433,
441 (1976). The estate argues that the notice of deficiency may
not be entitled to a presumption of correctness if we conclude
that the report of its expert, ATI, had no probative value. As
we give some probative value to the ATI report, we conclude that
this is not an issue.
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II. Fair Market Value of Decedent’s Interests
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
change 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
(NAV) approach, and the market approach. Id. Value is
determined under the income approach by computing a company’s
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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 NAV 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,
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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.
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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.5
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.
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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
assets 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).
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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
quartile with price to NAV discounts of 21.8 percent to 25.5
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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
diversified; 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
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used a 25-percent minority discount for valuing the interests in
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
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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 marketability 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 marketability 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
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agree that a lack of marketability discount should be applied to
the partnership’s NAV (after applying the minority interest
discount), they disagree on the magnitude of that discount. See
Peracchio v. Commissioner, T.C. Memo. 2003-280; see also Estate
of Bailey v. Commissioner, T.C. Memo. 2002-152 (indicating that
the application of a minority discount and a discount for lack of
marketability is multiplicative rather than additive).
2. Determination of the Marketability Discount
There are several ways to determine a marketability
discount. Two of the most common include the initial public
offering (IPO) approach and the restricted stock approach.
McCord v. Commissioner, supra at 387. IPO studies compare the
private-market price of shares sold before a company goes public
with the public-market prices obtained in the IPO of the shares
or shortly thereafter. See id. Restricted stock studies compare
private-market prices of unregistered (restricted) shares in
public companies with the public-market prices of unrestricted
but otherwise identical shares in the same corporations. See id.
A variant of the restricted stock approach, the private placement
approach, attempts to isolate the effect that impaired
marketability has on the discount determined under the restricted
stock approach. See id. at 388, 392.
This Court has concluded that the private placement approach
is appropriate where the interest to be valued was part of an
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investment company as the assessment and monitoring costs would
be relatively low in the case of a sale of an interest in that
company. Id. at 394; Lappo v. Commissioner, supra. KLLP is an
investment company as 100 percent of its assets consist of cash
and certificates of deposit. See McCord v. Commissioner, supra.
a. The Estate’s Expert
In determining the marketability discount, ATI used the
restricted stock approach by drawing an analogy between
partnership interests in KLLP and the common stock of a private,
closely held corporation. In doing so, ATI considered several
restricted stock studies and their findings.
ATI also listed as barriers to marketability of a limited
partnership interest in KLLP the following: (1) Once admitted as
a limited partner, one must continue as a limited partner until
all partners unanimously consent to the admission of a substitute
limited partner and to the withdrawal of the transferring
partner, and the limited partner must execute legal documents as
required by the general partner, who must receive and approve the
documents in writing; (2) a limited partner can assign, transfer,
encumber, or pledge all or part of his partnership interest only
if such assignment is fully executed by assignor and assignee,
such assignment is received by the partnership and recorded on
the books, and the transfer is approved by unanimous vote of all
the partners; (3) no partner has a property right in any of the
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partnership property, regardless of whether specific property was
contributed to the partnership by a given partner; (4) limited
partnership interests are fully paid and nonassessable, and
limited partners do not have the right to withdraw or reduce
their capital contributions to the partnership; (5) limited
partners could be asked to lend additional money to the
partnership or increase their capital contributions and may have
their partnership interests diluted if they do not increase their
contribution and other partners do make additional contributions;
(6) general partners are not liable personally for the return of
capital contributions to the partnership, and limited partners
have no recourse against general partners should their claims to
assets remaining after liquidation and discharge of debts and
obligations not be satisfied; (7) the general partner has sole
discretion to determine whether to make distributions of any
type; and (8) upon the dissolution of the partnership, the
general partner acts as liquidator and has a reasonable amount of
time to wind up the partnership assets, and therefore the limited
partner may not obtain the final proceeds from an investment for
6 months or longer.
After considering all of these factors and the results of
the restricted stock studies, ATI determined that a 38-percent
marketability discount is appropriate for an interest in KLLP.
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b. Respondent’s Expert
Using the private placement approach, Dr. Widmer determined
a 15-percent discount for lack of marketability on the basis of a
study by Dr. Mukesh Bajaj, Bajaj, et al., “Firm Value and
Marketability Discounts”, 27 J. Corp. L. 89 (2001), which found
that the private placement of unregistered shares has an average
discount of about 14.09 percent higher than the average discount
on registered placements. Dr. Widmer also based this discount on
the low risk of the partnership’s portfolio.
3. Conclusion
We are not persuaded by ATI’s recommendation of a 38-percent
marketability discount as the restricted stock studies referred
to in ATI’s expert report examine mostly operating companies, and
there are fundamental differences between an investment company
holding easily valued and liquid assets (cash and certificates of
deposit), such as KLLP, and operating companies. See Peracchio
v. Commissioner, supra. Moreover, ATI did not analyze the data
from these studies as they related to the transferred interests
herein, and therefore we cannot accept the premise that this
average discount is appropriate. See id.
We are also not persuaded by Dr. Widmer’s recommendation of
a 15-percent marketability discount. While we agree that the
Bajaj study is an appropriate tool in determining the lack of
marketability discount, Dr. Widmer’s conclusion based on the
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study is not entirely accurate. The Bajaj 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., supra at 107. These factors depend on the fraction
of total shares offered in the placement, business risk,
financial distress of the firm, and total proceeds from the
placement. Id. at 107-109.
As we find the parties’ assumptions and analyses concerning
the marketability discount only minimally helpful, we use our own
analysis and judgment, relying on the parties’ experts’
assistance where appropriate. Helvering v. Natl. 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 lowest 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 which did not suffer from impaired
marketability. Id. The high discount group, with a discount of
43.33 percent, is dominated by unregistered private placements
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which, unlike the sale of an interest in an investment company,
have relatively high assessment and monitoring costs. Id. As
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. Id. As
these characteristics are similar to the characteristics in KLLP,
we find that a 3-percent upward adjustment is applicable.
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Therefore, we hold that a 20-percent initial marketability
discount is appropriate. We further find 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 $1,226,421
94.83 percent of NAV 1,163,015
Less: 12-percent minority interest discount (139,562)
1,023,453
Less: 23-percent marketability discount (235,394)
FMV of 94.83-percent interest 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 $1,226,421
33.33 percent of 1 percent of NAV 4,088
Less: 12-percent minority interest discount (491)
3,597
Less: 23-percent marketability discount (827)
FMV of 33.33 percent of 1-percent interest 2,770
To reflect the foregoing,
Decision will be entered
under Rule 155.