Tax court determines valuation discounts.

• Author: O'Driscoll, David

A decedent (L) and his predeceased wife (P) had organized a Texas limited partnership (LP). After L's death, the estate employed an appraisal company (A) to prepare a valuation of L's interests in closely held entities. A concluded that a 53.5% valuation discount applied. The IRS issued a deficiency notice, determining that the discounts claimed by the estate were too high.

Minority Discount

Pursuant to the LP agreement, a buyer of all or any portion of transferred interests would have limited control of his or her investment. A hypothetical willing buyer would account for this lack of control by demanding a reduced price (i.e., a price below the net asset value (NAV) of the pro-rata share). Thus, the court applied a minority discount in this case.

Each expert witness determined a minority interest or lack-of-control discount by reference to general equity closed-end funds. The experts divided the comparable closed-end funds into quartiles by price-to-NAV ratios. In computing the minority discount, A determined that LP would be most comparable to the closed-end funds in the fourth quartile, with price-to-NAV discounts of 21.8%-25.5%. A then further adjusted the discount based on several factors and restrictions inherent in LP and by using other partnership studies.

According to the court, A's exclusive use of the fourth quartile of closed-end funds was improper. "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, 120 TC 358, 384 (2003) (quoting Est. of Heck, TC Memo 2002-34); see also Lappo, TC Memo 2003-258). A's analyses of studies on minority discounts contain some element of discount for lack of marketability, and these studies result in an overstatement of the minority discount.

The court believed a correct analysis would be to take the arithmetic mean of all of the closed-end funds, as shareholders in all closed-end funds lack control. In using only the fourth quartile, A combined elements of the lack-of-marketability discount with the minority discount, because the funds in the fourth quartile had the lowest demand and, thus, the highest marketability discount. As a result, A's discount for lack of control was too high, and was incorrect to use solely the fourth-quartile funds.

The court applied a 12% discount on the grounds that (1) the IRS had effectively...