Court rejects value based on improbable subsequent events

The U.S. Tax Court in Grieve v. Commissioner was required to determine the fair market value of a nonvoting stake in a limited liability company (LLC) for gift tax purposes. Here’s why the court sided with the taxpayer — and why it pays to hire a business valuation professional.

Battling experts

The taxpayer set up an LLC and contributed about $9.1 million worth of publicly traded stock to it. The LLC then distributed 20 voting class A units to the taxpayer’s daughter and 9,980 nonvoting class B units to a grantor retained annuity trust (GRAT).

The daughter was the chief manager of the LLC. Holders of class A units possessed voting powers for all purposes. Class B units couldn’t vote on or participate in any proceedings in which the entity or its members took action. The LLC agreement also contained various provisions that restricted transfers of membership units.

The taxpayer hired an outside valuation expert to value its gift of the class B units. Although the gift represented 99.8% of the LLC’s total units, the expert valued the gift at only $5.9 million, or only 65% of the LLC’s total value, due to lack-of-control and marketability discounts of 13.4% and 25%, respectively.

The IRS disputed the gift’s value. Its expert valued the gift at $9 million or 99% of the LLC’s value. He assumed that any willing seller of the class B units would first look to acquire control of the 0.2% interest held by the class A unit holder to avoid the large discounts that a willing buyer would seek for merely buying the class B units.

Ruling in favor of taxpayer

The IRS’s valuation was contingent on an additional action in the future: the purchase of the class A units. Further, the expert reasoned that the economic stake of the holder of a 99.8% interest of the class B units “dwarfs” that of the holder of the class A units; thus, there shouldn’t be a big discount to the value of the class B units.

The court rejected the IRS’s reasoning. The daughter, the sole owner of the class A units, testified that she had no intention of selling the units and, if she ever sold the units, she would demand a premium much higher than what was estimated in the IRS’s valuation. In addition, if the class B units were ever sold outside the family, the daughter explained that she would require a management fee. The court decided that these facts supported a 35% combined discount for the class B units.

In addition, the court looked at the value of the class B units on the date of the gift — not the value of the class B units based on subsequent events that, while within the realm of possibility, weren’t reasonably probable. The court also wasn’t concerned with the value of the class A units. As a result, the court agreed with the $5.9 million valuation set forth by the taxpayer’s expert.

Expertise is key

In Tax Court, an expert’s written valuation report often serves as his or her direct testimony during trial. So, it’s important to hire a qualified specialist who can explain his or her analysis in a comprehensive manner. Speculative or improbable assumptions that aren’t known or knowable at the time of valuation are unlikely to pass muster. 

Grieve v. Commissioner, TC Memo 2020-28 (March 2, 2020)

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