The Sum Of The Parts Is Less Than The Whole

 

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.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.

A Rough Rider’s Eagle And The Estate Tax

What is the value of something that you cannot sell?

Someone walked face-first into this issue with the IRS.

We are talking about Ileana Sonnabend, an avid art collector and a very wealthy woman. She died in 2007, leaving an art collection that included works by Andy Warhol, Jasper Johns and Robert Rauschenberg. Her estate was in the billion-dollar range, prompting her executors to sell pieces from the collection to pay federal and New York estate taxes. Those taxes approached $500 million.

There was a troublesome piece in the collection – Rauschenberg’s “Canyon.” Rauschenberg was a post – World War II American artist, and some of his work is described as “combine.” This means that the work includes different materials, such as Picasso mixing sand into his paints. The issue with “Canyon” is that it includes a stuffed bald eagle.

There are federal laws – the 1918 Migratory Bird Treaty Act and the 1940 Bald and Golden Eagle Protection Act – that says that one cannot traffic in bald eagles, even a stuffed one.

Ms Sonnabend purchased “Canyon” in 1959, well after the 1940 law. In 1981 (yes, 22 years later) the Department of Fish and Wildlife contacted her to inform her that her ownership violated federal laws. She was able to obtain a permit to retain “Canyon” and loan it to museums, but she was forbidden to sell it. She got the permit because Rauschenberg – who made the piece – provided a written statement that the bald eagle had been killed and stuffed by one of Teddy Roosevelt’s Rough Riders, well before 1940.

The government decreed that it must be informed of “Canyon’s” location at all times. If the artwork left the country for an exhibition, it would have to apply for a visa.

Seriously?

Ms Sonnabend died. The executors had to put a value on “Canyon” for the estate tax return.

How do you value art for an estate? You get an appraisal. The estate got an appraisal on “Canyon” from Christie’s, the auction house. Their appraisal? It was worth zero – nada, zippo, subtract one from one. One cannot sell “Canyon” without going to jail, with greatly cuts into its marketability. Two other auction houses gave the same appraisal, so the estate filed an estate tax return showing a zero value for “Canyon.”

The IRS of course saw otherwise. In 2011 the IRS sent the estate a report proposing a value of $15 million for “Canyon.” The estate disagreed and refused to pay. The IRS – in an example of why people hate the IRS – issued a formal Notice of Deficiency upping the value to $65 million.

NOTE: It is not as though your local IRS revenue agent came up with this value. This is specialized work. The IRS has an Art Advisory Panel that helps with these cases. The most that a Rauschenberg has ever received at auction however is $14.6 million, which seriously calls their $65 million figure into question.

Just to put sand in the paint, the IRS levied a special “understatement” penalty of 40%.

So how did the bright bulbs on the Art Advisory Panel come up with the $65 million figure? One of them, Joseph Bothwell, said that there:

... could be a market for the work. For example, a reclusive billionaire in China might want to buy it and hide it.”

Huh? An illegal sale to a “reclusive billionaire in China” is not considered an accepted valuation technique.

Another bulb, Stephanie Barron, further explained that the Panel evaluated “Canyon” without reference to any restrictive laws.

“The ruling about the eagle is not something the Art Advisory Panel considered,”’ she explained.

What? The most important factor in “Canyon’s” valuation and you did not consider it?

We all just cringed at the idea that this had zero value. It just didn’t make any sense,” she continued.   

Good grief.

Let’s have a brief review of the facts for Stephanie Barron. Ms Sonnabend owned an item. The government did not approve of her owning the item. This item could be anything. Let’s say – for example - that it is a Big Gulp in Times Square. The government does not want you to have it and wants to take it from you. The government could call in a drone, I suppose, but it instead shows restraint. The government cleverly takes the item from Ms Sonnabend without actually taking it from her possession. Is that a fair summary of what happened here?

OBSERVATION: One could argue that Ms Sonnabend suffered a theft loss.

The executors had a decision to make. If they didn’t pay the taxes, they would face IRS collections action. If they sold “Canyon” to raise the money to pay the taxes, they would go to prison for violating federal law.

How did this turn out? This month the IRS dropped its claim against the estate of Ileana Sonnabend over “Canyon.” The estate donated the work to the New York Museum of Modern Art. The estate agreed not to claim a tax deduction for the donation, as it previously argued that the work had no value.

This was not the IRS’ finest effort.