March, 2006 | Issue 2
Introduction
The case of W. G. Anderson et al. v. United States (No. 02-2168-S; Western District of LA; 2/16/06) tells the story of how a strongly-prepared valuation case made by the Estate resulted in a handsome refund.
Gertrude Anderson died on February 3, 1997. The Estate filed its Estate Tax return on March 21, 1998 (after an extension), showing a taxable estate of $34,650,000 and a net estate tax of $14,599,000. The IRS selected the return to be audited and claimed that the Estate owed an additional $3,053,000 in taxes and interest. The Estate paid under protest and filed for a refund.
The principal amount in dispute related to the fair market valuation of the decedent’s minority ownership interests in four limited liability companies (collectively referred to as the “LLCs”). These companies owned oil and gas mineral interests and operations.
Areas of Agreement
At an early stage in the proceedings, the Court ruled that the LLC interests should be valued using a combination of the net asset approach and the market approach, giving a 2/3 weight to the net asset approach and a 1/3 weight to the market approach.
Three valuation experts and a rebuttal expert testified in the case. The parties had accepted the asset appraisal, which had been prepared by a petroleum engineer. The dispute between the IRS and the Estate revolved around the valuation of the LLCs under the market approach.
The IRS and the Estate experts both began their analysis by selecting a group of publicly-traded companies that could be considered comparable to the closely-held LLCs. Although the experts relied on different companies to make their calculations, neither party challenged the validity of the other’s selections. Accordingly, the Court treated each party’s comparables as equally valid.
Areas of Disagreement
Both sides also agreed that price-to-cash-flow ratios derived from the comparable companies were an appropriate measure to use in valuing the LLCs. The two sides could not agree, however, on which price-to-cash-flow ratios to use.
The Estate’s experts felt that the ratios should be taken from the lower end of the range derived from the comparable companies. They justified this based on the LLCs’ smaller size, lower operating margins, non-operator status, dependency on thin outside management, history of capital calls, and a pending arbitration.
The expert for the IRS, on the other hand, believed that the range of ratios should not be as low as the Estate had suggested, primarily due to the LLCs’ lack of debt, their history of distributions, their profit margins, and their overall good financial condition. The IRS expert relied for his ratio range on an analysis of acquisition prices for publicly-held versus privately-held companies as reported in Mergerstat, a data service.
The Court Weighs In
The Court found the merger data to be unpersuasive because it was too general and did not allow comparisons with the oil and gas industry. Accordingly, he placed greater weight on the cash flow analysis made by the Estate. He also supported, over the objection of the IRS expert, the use of a price-to-appraised-value ratio calculation included by the Estate in the market value analysis. The IRS felt that such a calculation “double counted” the value of the LLCs’ assets. The Court felt, however, that it provided another comparison point between the LLCs and the comparable public companies.
Having reached values for the LLCs as a whole, the Court then applied a 10% discount for liquidation costs to the net asset approach, a 10% minority discount to the net asset approach, and finally a 40% discount for lack of marketability to both the market and net asset approaches.
Conclusion
The diminution in the fair market value of the Estate which resulted from this court proceeding led to an Estate Tax refund of approximately $2 million. The Estate was well rewarded for the skilled and vigorous valuation advocacy it mounted in this matter.
