Tax Court tackles valuation in weird charitable contribution case
In 2014, Tax Court observers were baffled when the court allowed an odd charitable contribution case that centered on the value of a remainder interest in income-producing property to go to trial. The deduction claim relied on a plainly defective appraisal summary. The recent decision, which includes the court’s formula for valuing the contested interest, gives real estate and business valuators much to chew on.
The petitioner in this convoluted tax shelter case was a partnership called RERI Holdings (RERI). During its short life, RERI donated a successor member interest (SMI) whose underlying asset was property that was leased to AT&T. An appraisal valued the property at $47 million as of August 2001. The SMI was to become possessory in January 2021. RERI acquired the SMI for $2.95 million in March 2002 and donated it to a university in August 2003. RERI claimed a $33 million deduction for the gift based on an appraisal that relied on present-value tables promulgated under the Internal Revenue Code’s Section 7520. The appraisal stated an “investment value” for SMI. Section 7520 assures that the values of the present interest and future interest add up to the value of the property underlying the time-divided interests, without discounts. In December 2005, the university sold the SMI for $1.94 million.
In a final partnership administrative adjustment (FPAA), the IRS initially argued the value of the contribution was $3.9 million. In a later amendment, it said RERI had no right to any deduction because the underlying transaction was a sham. Alternatively, the deduction should be limited to $1.94 million, the amount the university obtained when it sold the contributed property. RERI petitioned the Tax Court for review.
The court decided two major procedural issues in favor of the IRS. One, it found that the appraisal summary RERI submitted was deficient, which justified “the full disallowance of its claimed deduction.” Moreover, Section 7520 did not apply because the holder of the SMI did not have adequate protection until the interest became possessory. When the Section 7520 tables cannot be used, the remainder interest had to be valued based on “actual fair market value,” the court explained.
The court’s valuation formula produced an FMV of about $3.5 million for the SMI. Besides disallowing the deduction, the court found the gross valuation misstatement penalty applied.
A digest of RERI Holdings I, LLC v. Commissioner, 2017 U.S. Tax Ct. LEXIS 33 (July 3, 2017), and the court’s opinion, will be available soon at BVLaw.
“The SEC is going to notice this,” says a StreetSweeper blog from 2011 about the financial doings of Miller Energy and its new auditor, KPMG. The SEC sure did notice—and, after investigating it, the matter has been settled, with KPMG paying a $6.2 million fine over alleged audit failures (see prior coverage). KPMG’s engagement partner in charge of the audit also agreed to settle charges against him. Melissa Davis at TheStreetSweeper did the original reporting back in 2011 that revealed a laundry list of financial issues including questionable valuations of oil and gas assets Miller had purchased for $4.5 million but booked at $480 million. In 2015, Miller was charged with accounting fraud and later settled the charges.
In today’s world, when something seems fishy or if a company gets hit with an adverse regulatory action, word spreads faster than ever. Valuation experts should consider this increased exposure or potential exposure of these things going viral. Negative coverage can catch the eye of customers, regulators, and investors. TheStreetSweeper’s masthead reads: “We uncover the dirty little secrets investors need to know.”
The typical DCF valuation assumes that a mature company will survive and grow at a constant rate in perpetuity. Is this a valid assumption? No, because of corporate mortality and the risk of decelerating growth, says Gil Matthews (Sutter Securities) in an article that examines this issue. Not considering these factors may result in an overstated value if you use a constant perpetual growth assumption.
Baked into CSR?BVWire asked Matthews: “Aren’t you double counting because the factors that lead to failure are already in the company-specific risk (CSR) adjustment?” No, not if it’s handled properly, he says. “Corporate mortality (or decline) is not only a company-specific risk. It often stems from factors that are not identifiable at the time of a valuation. If one first adjusts for corporate mortality, then company-specific risk should be limited to other factors.”
Mathews also points out that the courts generally reject CSR as a factor in cost of capital, deeming it to be arbitrary—and even manipulative. Adequate data on corporate mortality do not yet exist, but, once they are compiled, they will be able to be quantified and defended in litigation, in contrast to CSR.
IRS crackdown on nonprofit hospitals yields a casualty
The IRS has been examining nonprofit hospitals over compliance with IRC Section 501(r), which requires them to do a regular community health needs assessment. An unidentified hospital has had its 501(c)(3) tax-exempt status revoked over this issue, according to a Final Adverse Determination Letter just released. It’s a certainty that the IRS is examining other hospitals over this matter, so make sure you ask about it if an engagement involves this type of entity.
Voice-powered personal assistants, self-driving cars, phone apps with behavioral algorithms—will the machines totally take over? Will Siri turn into Talky Tina? Who knows, but, in the meantime, artificial intelligence (AI) needs to be valued. AI is “one of the fastest growing, yet arguably least understood, areas of the tech sector today,” says an article from Marks Paneth that examines the AI valuation challenge. One piece of research the article mentions reveals that the median price paid to AI startups per employee is $2.4 million. Buyers use this metric as a cross-check to avoid overpaying—they don’t use it to value AI startups.
The new edition of Duff & Phelps’ Valuation Insightsdiscusses the genesis of the new Certified in Entity and Intangibles Valuation (CEIV) credential that three of the valuation professional organizations introduced this year to enhance the transparency, quality, and consistency of valuations for financial reporting purposes. The article also discusses the pathway to obtaining the credential and the Mandatory Performance Framework. Other topics covered Include:
BEPS Action 13 and what companies need to know to satisfy the new requirements;
Highlights from the 2017 Global Enforcement Review;
Duff & Phelps' new transfer pricing documentation tool: BEPS Central Tracker; and
Industry market multiples for North America and Europe.
Extra: In a video, Paul Barnes, managing director and global leader of Duff & Phelps' Valuation Advisory Services, discusses the CEIV credential.
Over 770 new private-company transactions have been added to the BIZCOMPS database, bringing the total to almost 14,000. BIZCOMPS focuses on small-company “mom and pop” or sole proprietorship transactions—the majority of transactions are for firms with less than $500,000 in gross revenue.
In terms of the latest data additions, the average selling price for 2017 is $388,000 (excludes inventory). The average annual gross sales for transacted businesses in 2017 are $1.0 million. Companies with annual gross sales greater than $700,000 have a median sale price-to-annual gross sales multiple of 0.33 and of 0.26 for 2017 transactions. This size firm has a median sale price to seller’s discretionary earnings of 1.96 and a median harmonic mean multiple of 1.85.
FTI Consulting Inc. reports a slight increase in 2016 REIT executive compensation levels over the previous year (5% in 2016 versus 3% in 2015), with a tighter range in pay change by executive position (2% to 7% in 2016 versus 1% to 9% in 2015). This is per the firm’s 2017 REIT Executive Compensation Trends study, which focuses on the pay practices at the nation’s largest 150 REITs. One finding of note: Total compensation decreased 0.6% among chairmen, while it increased 7.4% among general counsel, the highest increase among the seven executive categories studied.
Evidence of DLOMs for controlling interests at ASA’s Advanced BV Conference
Do you apply a DLOM to a controlling interest? Even the top BV thought leaders disagree on this one. Shannon Pratt does it—he takes marketability discounts on controlling interests, including 100% ownership. You can’t convert a company into cash in a couple of days, so the DLOM is OK, he says. (That sounds like a discount for lack of liquidity to us, but that’s another story.) At the ASA’s 2017 Advanced BV Conference in Houston (October 7-10), we will definitely be attending this session: Evidence of DLOMs for Controlling Interests, which Ronald DiMattia will present.
If you check out the full agenda for the conference, you’ll notice something: This year’s sessions will stress the practical application of valuation theories. For example, there’s a session on how to forecast balance sheets and cash flow statements for DCF analyses (Joseph Emanuele). There’s also practical ways of using regression analyses in an appraisal (Mark Shirley). FLPs are on the radar of regulators, so there’s a session on using new REIT data to value these entities (Spencer Jeffries and Jim Park). And there’s a lot more.
BVWire will be there—stop by and say hello at the BVR booth!
Call for improved standards for valuing intangibles
A discussion paper, issued by the European Commission, that calls for accounting standards to be improved for the valuation of intangibles (both in corporate and national accounts) could allow companies to more easily assess the value they have in terms of intangibles. A blog by former IVSC executive director Marianne Tissier highlights the lack of a readily identifiable body of business and intangible asset valuation professionals in many European countries and the consequent threat of other bodies creating rules and standards without their input.
A review of empirical evidence from many countries reveals that economic consequences of IFRS adoption significantly differ across jurisdictions, but the impact is reported to be positive in the majority of cases. Although there is some evidence to the contrary, overall the quality of earnings reported under IFRS is superior to that under other local standards, according to the paper, which has references to 56 studies and analyses. The paper is “IFRS Adoption and Financial Reporting Quality: A Review of Evidence in Different Jurisdictions.”
People: PCAOB Chairman James Doty will step down from his position as soon as his successor and new board members are appointed … David Simon, senior vice president of intellectual property at Salesforce, will be the keynote speaker at the Duff & Phelps IP Value Summit October 16-17 at The Ritz-Carlton in Half Moon Bay, Calif. … BDO International Ltd. has named Keith Farlinger as CEO effective November 1, succeeding Martin van Roekel, who will become vice chairman.
Firms: BDO USA LLP and MindBridge™ Analytics Inc. have a new strategic relationship to use the latter firm’s artificial intelligence platform for transactions analysis … Eder, Casella & Co. CPAs has acquired CPA firm Milburn Cain & Co.; the combined firm has 39 employees in three Illinois offices: Gurnee, McHenry, and Barrington … Mountjoy Chilton Medley LLP, an accounting and advisory firm based in Louisville, Ky., has acquired Indianapolis-based K. B. Parrish & Co.; the combined firm will have 380 employees and other offices in Lexington, Ky., Jeffersonville, Ind., and Cincinnati … CPA and advisory firm Albin, Randall & Bennett (Portland, Maine) was named as one of the 2017 Best Places to Work in Maine … Atlanta-based Frazier & Deeter expands into the western U.S. with the opening of a new office in Las Vegas … CohnReznick LLP, based in New York City, ranks No. 3 among companies on WayUp’s first-ever Top 100 list of internship programs … Jaynes, Reitmeier, Boyd & Therrell PC will combine with fellow Waco, Texas, firm Coker Wommack & Co. PC; the combined firm will be known as JRBT and will employ 106 professionals … Seattle-based Moss Adams LLP deepens its presence in key western markets by combining with Hein & Associates LLP effective November 1. Hein’s offices are in Denver, Houston, Dallas, and Orange County, Calif. This is one of the biggest accounting firm M&A deals so far this year, and the combined firm will have nearly 2,900 employees in 26 locations.
Key considerations when valuing an automotive dealership will be discussed, including franchise, location, real estate, management, and more. Also, you’ll get an update on private equity and family office activity in the industry.
A detailed case study on estimating the FMV of a 100% controlling, marketable interest in a nonfood franchisee that will provide real-time insight into the thought process for evaluating a business model, historical financials, projections, and guideline private transactions.
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