September 2023
(Updated Newsletter dated 1st Quarter 2005)
It is well established that in most cases a minority interest in a closely-held entity has a value that is discounted from its pro rata share of the total entity value, for lack of control and lack of marketability. There is some question, however, as to whether or not similar levels of discounts should be applied when valuing a minority interest in a closely-held company that in turn owns another minority interest in a closely-held entity. These second level discounts are often referred to as “layered” or “tiered” discounts.
It is our opinion that layered or tiered discounts can be less than, equal to, or higher than discounts applied at the underlying entity level, depending on the facts and circumstances.
The argument often heard for not applying discounts, or applying lower discounts, at the second entity level is that the discounts are duplicative. Another argument is that the application of discounts at both levels invites abuse by taxpayers by giving them incentives to form multi-level entities in order to avoid taxes. The following is our response to each of these arguments.
The argument that layered or tiered discounts are duplicative seems to make sense on its surface, but fails after careful examination. Take for example ABC company which owns $1 million in real estate. Holdingco’s only asset is a 30% interest in ABC, and we are valuing a 10% interest in Holdingco. Assume that everyone agrees that the appropriate value of Holdingco’s 30% interest in ABC is $180,000, after application of discounts for lack of control and lack of marketability.
Some would argue in the above scenario that any further discounts for lack of control and lack of marketability would be duplicative and the value of the 10% interest in Holdingco is $18,000 ($180,000 x 10%). In our opinion, this argument is simplistic. If appraised correctly, the value of the 30% interest in ABC represents what it would sell for between a willing buyer and a willing seller. It is irrelevant whether or not discounts were applied in getting to that value. It shouldn’t matter how the value of the underlying interest was derived. The focus on whether or not discounts should be applied to the interest in Holdingco is whether or not the facts and circumstances surrounding Holdingco warrant discounts. If the subject 10% interest in Holdingco does not have access to the underlying assets and or earnings of Holdingco (whatever they are), a discount for lack of control is warranted. If the 10% interest in Holdingco suffers from lack of marketability, then a discount for lack of marketability is warranted.
The simple test for whether or not layered discounts should apply is whether or not willing buyers and willing sellers are indifferent as to whether the holding, in this case, of the interest in ABC is direct or through Holdingco. In other words, is the value of a 10% interest in Holdingco identical to a 3% direct holding in ABC? If one would prefer to hold the interest in ABC directly, then discounts must be applied in the valuation of the interest in Holdingco to reflect that preference.
The other argument that the use of layered or tiered discounts invites abuse by taxpayers is unwarranted in the realm of valuation. It is not the appraiser’s duty or right to tailor the valuation to prevent abuse. If the reality of layered discounts invites abuse, it is the purview of the government to prevent it through legislation, not the appraiser to prevent it via an altered valuation.
Conclusion
The use of layered or tiered discounts
depends on the facts and circumstances
of each case, but are generally
applicable. The argument that
these discounts are duplicative is
wrong in that the focus should be each
entity separately. The argument
that these discounts invite abuse by
taxpayers has no bearing on how the
discounts should be applied by appraisers.
Update
Since the publication of this newsletter
in 2005, two court cases were decided
that are relevant to the issue of layered
discounts. The first case is
Jane Z. Astleford v. Commissioner,
T.C. Memo 2008-128, filed May 5,
2008. This case involved estate
tax valuation of minority interests in
a family limited partnership that in
turn held real estate directly and
indirectly via a general
partnership. The Tax Court
allowed layered discounts consisting
of lack of control discounts of
16.17% and 17.47%, for the
two valuation dates and discounts
for lack of marketability as of the
two dates of 21.23% and
22% for the interests in the
family limited partnership. At
the lower tier the Court accepted a
30% combined lack of control
and lack of marketability discount
for the 50% general partnership
interest owned by the family limited
partnership.
The second court case is Estate of Hjersted, 175 P.3d 810, filed February 1, 2008. In this dispute over the value of the elective share of her husband’s estate, the Kansas Supreme Court concluded that applying discounts at both the lower tier and the upper tier was appropriate in valuing the 96% limited partnership interest in a related family limited partnership.
Relevant Court Cases
-
Debra Powell v. John Rasmussen,
U.S. Court of Appeals for the Ninth Circuit,
No. 22-35361,
filed August 31, 2023
-
Wong v. Wong,
Court of Appeal of the State of California
Second Appellate District, B314931,
filed September 5, 2023
Recent Business Valuation Articles
-
“How to Estimate Fair Market Valuation
For Court-Ordered Minority Shareholding
Buybacks,”
by Rupert Macey-Dare,
updated September 10, 2023
-
“Equity Value and Volatility,”
by Moon Hoe Lee,
posted August 31, 2023
Recent Engagements
- Valuation of 100% of the common stock
of a niche service firm on a controlling interest
basis for purchase/sale purposes.
- Valuation of the common stock of an industrial
equipment manufacturer on a minority interest
basis for gift tax reporting purposes.
- Valuation of a limited partnership interest
of a specialized investment partnership
on a closely-held minority interest basis
for charitable donation/income tax
reporting purposes.
- Valuation of 100% of the common stock of a
commercial printing firm on a controlling interest
basis for estate tax reporting purposes.