I am looking at a case involving valuations.
The concept starts easily enough:
· Let’s
say that your family owns a business.
· You
personally own 20% of the business.
· The
business has shown average profits of $1 million per year for years.
· Altria
is paying dividends of over 7%, which is generous in today’s market. You round
that off to 8%, considering that rate fair to both you and me.
· The
multiple would therefore be 100% divided by 8% = 12.5.
· You propose a sales price of $1,000,000 times 12.5 times 20% = $2.5 million.
Would I pay you that?
Doubt it.
Why?
Let’s consider a few things.
· It
depends whether 8 percent is a fair discount rate. Considering that I could buy Altria and still
collect over 7%, I might decide that a skinny extra 1% just isn’t worth the potential
headache.
· I
can sell Altria at any time. I cannot sell your stock at any time, as it is not
publicly-traded. I may as well buy a timeshare.
· I
am reasonably confident that Altria will pay me quarterly dividends, because
they have done so for decades. Has your company ever paid dividends? If so, has
it paid dividends reliably? If so, how will the family feel about continuing
that dividend policy when a non-family member shows up at the meetings? If the family
members work there, they might decide to increase their salaries, stop the dividends
(as their bumped-up salaries would replace the lost dividends) and just starve
me out.
· Let’s
say that the family in fact wants me gone. What recourse do I – as a 20% owner –
have? Not much, truthfully. Own 20% of Apple and you rule the world. Own 20% of
a closely-held that wants you gone and you might wish you had never become
involved.
This is the thought process that goes into valuations.
What are valuations used for?
A ton of stuff:
· To
buy or sell a company
· To
determine the taxable consequence of nonqualified deferred compensation
· To
determine the amount of certain gifts
· To
value certain assets in an estate
What creates the tension in valuation work is
determining what owning a piece of something is worth – especially if that
piece does not represent control and cannot be easily sold. Word: reasonable people
can reasonably disagree on this number.
Let’s look at the Estate of Miriam M. Warne.
Ms Warne (and hence the estate) owned 100% of Royal
Gardens, a mobile home park. Royal Gardens was valued – get this - at $25.6
million on the estate tax return.
Let’s take a moment:
Q: Would our discussion of discounts (that is, the sum
of the parts is less than the whole) apply here?
A: No, as the estate owned 100% - that is, it owned the
whole.
The estate in turn made two charitable donations of Royal
Gardens.
The estate took a charitable deduction of $25.6 million
for the two donations.
The IRS said: nay, nay.
Why?
The sum of the parts is less than the whole.
One donation was 75% of Royal Gardens.
You might say: 50% is enough to control. What is the
discount for?
Here’s one reason: how easy would it be to sell less-than-100%
of a mobile home park?
The other donation was 25%.
Yea, that one has it all: lack of control, lack of
marketability and so on.
The attorneys messed up.
They brought an asset into the estate at $25.6
million.
The estate then gave it away.
But it got a deduction of only $21.4 million.
Seems to me the attorneys stranded $4.2 million in the
estate.
Our case this time was the Estate of Miriam M.
Warne, T.C. Memo 2021-17.
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