The U.S. Court of Appeals for the Ninth Circuit recently forced the Tax Court to take another look at an earlier valuation decision in Estate of Giustina v. Commissioner. The Estate owned a 41% interest in a family-owned, limited partnership that owned 47,939 acres of timberland and earned profits from growing trees, cutting them down, and selling the logs. It had continuously operated this business since its formation in 1990. The partnership agreement provided that a limited partner interest could only be transferred to another limited partner if the transfer was approved by the general partners. All current partners were members of the same family.
The Estate valued the 41% interest at $13.0 million while the IRS valued the interest at $33.5 million. At a rate of 40%, the tax on this difference was substantial. The Tax Court, in its first opinion, valued the interest at $27.5 million. They arrived at this figure by reasoning there was a 25% chance that the partnership would liquidate its assets by either convincing two-thirds of the limited partners to vote for a dissolution of the partnership or to replace the two general partners. The value of the partnership’s assets was over $150 million, but the annual earnings of the company were much less. They placed the remaining 75% of the value on the income approach using a discounted future cash flows calculation. They reduced the discount rate used by the estate by 1.75%, arguing that an investor could reduce risk by diversifying its holdings if wealthy enough.
The Ninth Circuit disagreed with the Tax Court’s valuation. It held that a buyer who intended to dissolve the partnership would not be allowed to become a partner by the general partners, who favored the continued operation of the partnership. And the Ninth Circuit found it implausible that the buyer would seek the removal of the general partners who had just granted the buyer admission to the partnership. Therefore, the value must be determined on a “going concern” basis instead of considering a liquidation of the assets.
By the same token, in evaluating the hypothetical buyer’s ability to diversify risk, it should have considered only a buyer whose ownership of a limited partner interest is permitted under the partnership agreement. Since the other seven limited partners were members of the family, it’s doubtful that a multiple-owner investment entity would become a partner, and it’s also doubtful that any current limited partners had enough assets to diversify the risks of ownership. The only remaining disagreement with the Estate’s value of the interest was the tax affecting of the partnership’s income and that’s an argument that we’ll tackle later.
If you have a potential valuation issue or a client considering the succession of a family-owned entity, please contact Mike Stover at (937) 913-2507 or firstname.lastname@example.org. We’d love to have the opportunity to help.