In the recent unpublished opinion of Estate of Giustina v. Commissioner,1 the Ninth Circuit reversed a Tax Court opinion dealing with the valuation of a 41.128% limited partnership interest. The partnership was in the timber business. As with just about all valuation cases involving a going concern business, the Tax Court looked to different methods of valuation, as well as the different discounts that may be applicable.
In general, the Ninth Circuit held that the Tax Court did not commit reversible error with respect to the various discounts.2 The main issue that the Ninth Circuit reversed and remanded dealt with the Tax Court’s assigning a weighted average to two different valuation methodologies in coming up with its final valuation.3
The Cashflow Method is basically the value of the partnership as a going-concern and assumes that the heirs would continue to operate the partnership as a timber business. The Asset Method assumes that the heirs would sell all the timberland assets of partnership and distribute the proceeds to the partners.
The Tax Court determined that the value of the partnership using the Cashflow Method was $51.7 million and the value using the Asset Method was $150.7 million. Rather than pick one of the methodologies as an appropriate value, the Tax Court looked at the “odds” that the heirs would continue to own the partnership as a going concern versus the “odds” that the heirs would agree to sell the timberland assets and distribute the proceeds.
The Tax Court then detailed the difficulty the heirs who wished to liquidate the partnership would have to achieve that result.4 As explained by the Ninth Circuit:
In order for liquidation to occur, we must assume that (1) a hypothetical buyer would somehow obtain admission as a limited partner from the general partners, who have repeatedly emphasized the importance that they place upon continued operation of the partnership; (2) the buyer would then turn around and seek dissolution of the partnership or removal of the general partners who just approved his admission to the partnership; and (3) the buyer would manage to convince at least two (or possibly more) other limited partners to go along, despite the fact that "no limited partner ever asked or ever discussed the sale of an interest." Alternatively, we must assume that the existing limited partners, or their heirs or assigns, owning two-thirds of the partnership, would seek dissolution.
As a result of the difficulty the heirs would have to dissolve the partnership, the Tax Court concluded that there was a 25% likelihood of liquidation of the partnership. It therefore assigned a 25% weight to the Asset Method valuation and a 75% weight to the valuation of the partnership as a going concern (i.e., the Cashflow Method). This resulted in an overall value $76,447,143 ((75% x $51,702,857) + (25% x $150,680,000)).
In a very brief
opinion, the Ninth Circuit rejected this methodology. It seems
as though the Ninth Circuit did not necessarily have problem with the Tax Court
using a weighted average approach, although it is not clear. As the quote above states, the Ninth Circuit
noted the overall difficulty the heirs would have in forming a 2/3rds voting
bloc that would be necessary to vote to dissolve. Quoting Estate of Simplot v. Commissioner,5 the
Ninth Circuit stated “the Tax Court engaged in ‘imaginary scenarios as to who a purchaser might
be, how long the purchaser would be willing to wait without any return on his investment, and what combinations the purchaser might be able to effect.”
Rather than instructing the Tax Court to reevaluate its 25%/75% approach given the difficulty involved with liquidation and dissolution, the Ninth Circuit simply stated, “We therefore remand to the Tax Court to recalculate the value of the Estate based on the partnership’s value as a going concern.” In effect, the Ninth Circuit determined the Tax Court committed reversible error in assigning ANY probability or weight to an asset sale, despite the fact that the partnership was worth $51.7 million as a going concern and $150.7 million in liquidation/dissolution.
After reading the opinion, I wondered if the Ninth Circuit would have come to the same conclusion if the Tax Court had assigned a 10%/90% weighted average favoring the Cashflow Method. Or, a 15%/85% weighted average favoring the Cashflow Method?6 Further, what if the inheriting heirs only need to convince one other partner to liquidate and assigned a 50%/50% weighted average?
While there are many cases that use weighted averages of different valuation methods, my colleague, Kate Adcock, and I found it difficult to locate cases where the courts have assigned weighted averages to the Asset method versus the Cashflow Method. To do so, a court would necessarily have to create “imaginary scenarios” especially where the heirs are still operating the business as a going concern – as the heirs in the Estate of Giustina case were doing. And, when assigning weights to these two methods, it is necessary for a court to basically “predict the likelihood” that the heirs would sell the assets rather than keep the business as a going concern. The case of Estate of Dunn v. Commissioner7 is similar to the Estate of Giustina case. In the Dunn case, the decedent owned a 62.96% interest in a corporation that owned and rented out heavy equipment. Despite the 62.9% ownership interest, under Texas law, the decedent (and heirs) lacked the power to compel a liquidation, a sale of all or substantially all of its assets, or a merger or consolidation as each action would require a “super-majority” equal to 66.67% or greater. The Tax Court concluded that the likelihood of liquidation was slight. Despite this conclusion, the Tax Court used a weighted average approach assigning a weight of 65% to the Asset Method and 35% to the Cashflow Method.
The Fifth Circuit seemed incredulous at this result. After reiterating the Tax Court’s conclusion that the possibility of an asset sale or liquidation was minimal, the Fifth Circuit stated:
Given the stipulated or agreed facts, the additional facts found by the Tax Court, and the correct determination by that court that the likelihood of liquidation was minimal, our expectation would be that if the court elected to assign unequal weight to the two approaches, it would accord a minority (or even a nominal) weight to the asset-based value of the Corporation, and a majority (or even a super-majority) weight to the net cash flow or earnings-based value. Without explanation, however, the Tax Court baldly—and, to us, astonishingly—did just the opposite, assigning a substantial majority of the weight to the asset-based value. The court allocated almost two-thirds of the weight (65%) to the results of the asset-based approach and only slightly more than one-third (35%) to the results of the earnings-based approach. We view this as a legal, logical, and economic non sequitur, inconsistent with all findings and expressions of the court leading up to its announcement of this step in its methodology.
As you read the Estate of Dunn case, it almost seems inevitable that the Fifth Circuit would have assigned no weight to the Asset Method, just like the Ninth Circuit in Estate of Giustina. However, the Fifth Circuit decided to come up with its own weights, and, in doing so stated:
Tempting as it is to follow the implication of the Tax Court's rhetorical question and disregard the asset-based value altogether, we remain cognizant of the venerable Cohan rule, which counsels against assigning a zero value or probability to anything under any circumstances, and therefore resist that temptation. Recognizing the impossibility of ever making an absolutely precise and universally accepted determination of weighting percentages, we nevertheless hold that the proper method of valuing the stock of Dunn Equipment, under all the relevant circumstances and discrete facts of this case (not the least of which is the "unlikelihood" of liquidation of its assets), requires assigning a weight to its earnings-based value somewhere between 75% and 90%, and to its asset-based value somewhere between 10% and 25%. Within these ranges we select 85% for the earnings-based weight and 15% for the asset-based weight, producing a 85:15 weighting ratio. [citations omitted]
As the Ninth Circuit stated in Estate of Giustina, whenever a court is faced with choosing between the Asset Method and the Cashflow Method in valuing a business interest in an estate, it will necessarily have to employ “imaginary scenarios” in trying to determining the relative likelihood that the heirs of a deceased would continue to operate a business as a going concern versus an asset sale and liquidation. Would the Ninth Circuit argue that doing so would render any Asset Method versus Cashflow Method weighted average approach undoable?
While it is true that a court must determine the value as of the date of death, one would think that if the heirs chose to sell the assets of the company it would have done so (or attempted to do so) long before the court is asked to decide the matter.8 And, if the heirs did look to sell the assets and liquidate the company, it is unlikely that such a case would ever be litigated as the heirs would hardly be in a position to argue for the Cashflow Method. And, while it’s unclear whether the Estate of Giustina court would ever allow for a Asset Method versus Cashflow Method weighted average approach, perhaps courts should take the Estate of Giustina approach and choose one or the other.
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