February 2014 | Issue 71
A recent Tax Court case involved the valuation, for estate tax purposes, of a 16.667% interest in a real estate holding company. The company, called 37-41 East 18th Realty Co., LLC, owned a 78,000 square foot commercial building in Manhattan. The case is Estate of Tanenblatt v. Commissioner, T.C. Memo. 2013-263 (November 18, 2013).
The Operating Agreement
The management of the LLC was governed by an operating agreement. Members participate in the management and control of the LLC. Membership of the LLC is divided among three family groups. Transfers of membership interests outside of these groups is restricted. A nonfamily member transferee cannot become a member of the LLC without the unanimous approval of all of the members. A nonfamily transferee who receives a membership interest but who does not become a member is entitled to receive the distributions and allocations of profit and loss appurtenant to that membership interest but has no right to participate in management and control of the LLC.
Petitioner’s appraiser, Management Planning, Inc. (MPI) valued the subject interest at $1,788,000. This was arrived at as follows: MPI relied on a real estate appraisal prepared by individuals at Jacques O. Tuchler & Associates. To determine the value of the real estate, Tuchler took two approaches. The first was a sales comparison approach, which indicated a value for the real estate of $22,800,000. The second was an income capitalization approach which indicated a value of $19,960,000. The real estate appraiser assigned no weight to the sales comparison approach, and concluded that the value of the real estate was $19,960,000. MPI then adjusted this amount for other assets and liabilities, to produce a net asset value of $20,628,221. MPI applied to this net asset value a 20% discount for lack of control and a 35% discount for lack of marketability, to reach a value conclusion of $1,788,000 for the fair market value of the subject interest. This was the value reported on the decedent’s return.
The respondent believed that petitioner had undervalued the interest. Respondent’s expert, John A. Thomson, accepted petitioner’s net asset value calculation as a starting point for the valuation, but believed that his valuation discounts were too large. Thomson proposed discounts of 10% and 26%, producing a value for the interest of $2,303,000 rather than $1,788,000.
Petitioner attempted to introduce another appraisal report into evidence which supported a value lower than that determined by MPI. The court excluded it on procedural grounds.
The Nub of the Matter
The disagreement then became one over the difference in valuation discounts to be applied to net asset value. Petitioner believed that the larger discounts were appropriate because any nonfamily prospective buyer of the interest would have only a non-member or assignee’s interest in the LLC. Such a buyer would demand a substantial discount. Respondent believed the interest, on the valuation date, was a member’s interest. He therefore rejected petitioner’s high discounts and used lower discounts that he believed appropriate.
The Court’s Conclusion
The court felt that the argument boiled down to the question of whether the interest was a “member’s interest” on the valuation date. He concluded as follows; “because the term ‘member’s interest’ conveniently and accurately describes the rights inherent to a subject interest on the………valuation date, neither respondent nor Mr. Thomson erred in classifying it as such[.]” Furthermore, respondent’s expert “considered restrictions imposed on the transferability of an interest in the LLC as a factor in his marketability discount analysis.”
The court went on to point out that ”while petitioner criticizes [respondent’s expert’s] methodologies for determining both discounts, he has provided no expert testimony from which we might draw different, greater values in those technical areas of analysis.” (The MPI report had not been offered as expert testimony.)
The court concluded that the value of the interest was $2,303,000, the value determined by respondent’s expert.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.