IRS continues attack on FLPs as ‘indirect gifts’

For the second time in recent months, the U.S. Tax Court has considered an IRS challenge to a family limited partnership (FLP) under IRC Sec. 2511 as an indirect gift.  This new case, Gross v. Commissioner (Sept. 29, 2008), comes with a few interesting twists, however. First, the IRS stipulated to a combined minority and lack of marketability discount of 35%—if the taxpayer could show that the eleven days between the founder’s transfer of funds to the FLP and the creation of limited partnership interests was not an indirect gift.  The IRS must have thought its odds were good, because the partners did not execute a limited partnership agreement, creating the LP interests, until after the transfer was complete.  Six months before, the FLP had complied with all other filing and notice requirements under applicable New York law, but the IRS claimed that it didn’t formally exist until execution of the agreement, thus telescoping all critical events—formation, funding, distribution of interests—into a single day.   

In a last wrinkle, the same judge who heard the Gross case (Judge Halpern) also decided Holman v. Commissioner (May 2008), in which the Tax Court found that six days between funding the FLP to distribution of the LP interests was sufficient to disqualify the transfer as an indirect gift, and also take it out of the “step transaction doctrine” (treating a series of intertwined events as one).  “We reach the same conclusion here,” the Gross court said, where eleven days passed between funding and formation and where (as in Holman), the assets were common shares of well-known public companies.  Key to its finding: Even though the parties may not have created a limited partnership until after the asset transfer, by filing the certificate and agreeing to essential terms, they had created a general partnership.  The taxpayer “won,” and the court adopted the 35% stipulated discount. 

Curiously, the IRS did not raise a Sec. 2703 argument in this case, as it did in Holman—claiming the court should ignore the severe transfer restrictions that the FLP imposed on the limited partners’ interests.  Given these restrictions and the substantial control that the founder/general partners retained over the assets in both cases—watch for the IRS to attack these FLPs when their founders die, attempting to bring the full undiscounted value of the LP interests back into the estate under Sec. 2036.  Presumably, the Holmans and the widow Gross are still in good health—and could use the advice of a qualified business appraiser and tax advisor.  Copies of both cases are available at BVLaw, and an abstract of Gross will be in the next (November 2008) Business Valuation Update™. 

How to use the guideline transaction databases—the right way

Many questions arise when using the guideline transaction method (aka the merged and acquired method).  As this method developed and grew over time, private company transaction databases like Pratt’s Stats®, BIZCOMPS®, Factset Mergerstat Global Mergers and Acquisitions Information and Done Deals® were created to help the BV profession gain access to details on private acquisitions. 

These databases allow BV professionals to relate the price paid in other transactions to their subject company’s underlying financial data—ultimately creating and applying valuation multiples.  But just exactly how is this done, and what differences do you need to know about the various private company transaction databases?  

The authors of The Comprehensive Guide to the Use and Application of the Transaction Databases, Nancy J. Fannon, ASA, MCBA, CPA, ABV, BVAL and Heidi Walker, ASA, CPA, ABV (both of Fannon Valuation Group, Portland, ME), will be presenting a special teleconference on October 23rd that will offer information on how to use these transaction databases (register here). This is your opportunity to learn, in detail, about the transaction databases and to get your questions answered.  Also be sure to see the introductory chapter of The Comprehensive Guide to the Use and Application of the Transaction Databases and the article How to Use Transactional Databases for M&A: 2008 Update, both available on our Free Downloads page.

Letter to the Editor: Will market volatility increase the risk of double counting?

In response to last week’s article entitled, “Reduced liquidity may lead to larger marketability discounts in the current economy,” (BVWire, Issue 73-1), Ronald M. Seaman, FASA (Southland Business Group, Tampa, FL) offers the following comments in a letter to the editor regarding Lance Hall’s contention that during periods of increased volatility, investors desire an increased ability to sell, so “it makes sense that cash flows might decrease in an analysis, and discounts might also increase,”: “I suspect that Lance Hall is correct.  However, the question can be answered easily by an analysis of the costs of LEAPS Put Options. The costs of LEAPS put options are an excellent proxy for the discount for lack of marketability because the costs of LEAPS include most of the Mandelbaum factors and are obviously market-based.  Because LEAPS are valuation-date specific and industry specific, the question about reduced liquidity can easily be answered by a study of their costs on whatever beginning and ending dates one chooses and for whatever industries or companies one chooses.”

New data on the average holding period for non-marketable minority interests

Our latest online survey garnered 35 responses and a number of interesting insights on the average holding period for non-marketable minority interest. By the way: the online survey is still open, and taking responses; you can weigh in here.

The numbers broke out as follows:

  • When asked “What do you consider to be the average holding period for a minority interest in privately owned PROFITABLE COMPANY with $10 million in revenue?,” the majority of respondents (28.6%) answered “9-10 years,” followed by 15+ years (the time frame offered by 25.7% of respondents), and “5-6 years,” a response offered by 22.9% of the BV professionals who completed our survey.
  • Respondents also weighed in the following question: “What do you consider to be the average holding period for a minority interest in a privately owned NON-PROFITABLE COMPANY with $10 million in revenue?” To this query, 31.4% of analysts answered “9-10 years,” 25.7% said “5-6 years,” and 14.3% of those who completed the survey told us that the average holding period in such instances was “7-8 years.” Brian Pearson president of Valuation Advisors LLC, who spoke at our recent teleconference on Discounts for Lack of Marketability and Related Discount Issues notes that it’s odd that the holding period results are similar for a profitable and non-profitable company.  There may be a few reasons for this, he adds: the sample size is small or simply that people didn’t think about the differences too much.
  • We also inquired about the average amount of time spent arriving at DLOM conclusions for a company with $10 million in revenue. The top response (6-10%) was cited by 45.7% of respondents, followed by 11-15%—an answer offered by 25.7% of those who completed our survey.  

Equally compelling were the written comments offered by respondents. A few which caught our attention: “I have worked with closely-held companies for 25 years. Many of the companies and owners are the same as they were 25 years ago. These are controlling and non-controlling interests. There has been some transition to other family members primarily through gifting over is time [but] any of the newer generation have held their interests for 10 years or so and still hold the interests,” wrote one respondent.

Another more outspoken respondent offered more controversial comments: “Expected holding period has nothing to do with a discount for lack of liquidity/marketability. Nothing, zero, nada. Liquidity and marketability are related to the time it takes to convert an asset to cash once consideration is made TO SELL…Liquidity and marketability are not related to expected holding period. Securities traders may be concerned about liquidity and marketability when they look at their expected holding period, but investors are not traders. Bottom line: expected holding period has NOTHING to do with liquidity and marketability.”

Pearson disagrees with this respondent’s take: “Is it easier to sell a better performing investment?  Does it attract more interest?  Obviously yes, thus your theoretical holding period is less, and your presumed marketability is higher.”


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