In This Issue:

• Tax Court Reaffirms Taxpayer-Friendly 2704(b) Position on FLP's
• Discounts for Trapped-in Capital Gains
• M&A Pricing Data Released

Estate planners often design family limited partnerships with features that make it difficult for limited partners to get their money out. When they do this, appraisers are justified in applying a valuation discount to these limited partnership interests, thus reducing estate and/or gift taxes. Section 2704(b) of the Internal Revenue Code attempts to curtail this practice by saying that such restrictions, called "applicable restrictions," can’t be taken into account for valuation purposes if they are more restrictive than those found in the law of the state where the partnership is created.

In the last issue of The Hempstead Letter (Volume XVIII, No. 1) we discussed a case called Kerr vs. Commissioner, 113 TC No. 30 (12/23/99) in which the IRS challenged the valuation of an interest in a Texas family limited partnership. The court concluded that although Texas law permitted a partner to withdraw upon six months notice, this did not trigger 2704(b) because only the liquidation provisions in Texas law needed to be consulted to apply the 2704(b) test. In the Kerr case, the partnership passed muster since its liquidation provisions were no more restrictive than the liquidation provisions of Texas law. In effect, the court held that Section 2704(b) contemplates that the concept of "applicable restrictions" pertain only to liquidation, not to withdrawal.

In a more recent Tax Court case, Estate of Harper vs. Commissioner, (T.C. Memo. 2000-202 (6/30/00) (Judge Wells), the IRS asked the court to decide whether the restrictions on the right to liquidate the Harper family limited partnership, which was a California partnership, are applicable restrictions pursuant to Section 2704(b) and accordingly are to be disregarded when valuing the shares of the partnership. The court referred back to its Kerr vs. Commissioner decision, which held that provisions in a Texas partnership agreement (which were substantially similar to those in the Harper California partnership) were not more restrictive than the requirements of the applicable limited partnership law in the state of Texas. The court concluded that the facts of the Harper case were indistinguishable from those of the Kerr case in that the Harper liquidation provisions were no more restrictive than those of California law. The court said "accordingly,....the limitations on liquidation contained in the partnership agreement are not applicable restrictions within the meaning of Section 2704(b) and, consequently, must be taken into account in valuing a limited partnership interest in issue in the instant case."

The IRS may attempt to litigate this issue again, possibly in cases coming from states that have limited partnership laws that are substantially different from those of Texas or California.

Discounts for Trapped-in Capital Gains Entering the Main Stream

It used to be a matter of some contention and speculation as to whether a business appraiser was justified in taking into account "trapped" capital gains tax liability related to a corporation’s assets in determining the value of that company’s stock.

A recent Tax Court case, Borgatello vs. Commissioner, TC Memo 2000-264 (8/18/00) (Judge Wells) illustrates how far we have come on this issue. The issue in this estate tax matter was the fair market value of decedent’s 82.76% interest in Valley Improvement Co., Inc., a real estate holding company, as of January 12, 1994. There was no dispute between the parties as to whether or not trapped-in capital gains should be taken into account, only as to the extent. The IRS contended that a discount to net asset value of 20.5% should be applied to reflect the potential tax liability, while the taxpayer argued that a 32.3% discount should be applied. The difference between the two positions arose because the IRS assumed a ten year holding period before the assets were sold and the tax paid, whereas the estate calculated the discount as if the assets were to be sold immediately. The judge felt that both positions were somewhat extreme and opted for a middle ground, assigning a discount of 24% to account for the tax liability inherent in the company’s assets.

It is interesting to note that the court also allowed an additional 9 percentage points of discount to account for restrictions on stock transfer and other potential transaction costs, notwithstanding the fact that the valuation was of a majority interest.

It is significant to note that another Tax Court valuation case embraces recognition of trapped capital gains tax. See the article entitled, "Sixth Circuit Court Allows Capital Gains Discount" for a discussion of Welsh vs. Commissioner, where the concept was also upheld on appeal.

Welsh vs. Commissioner, 2000 US App. LEXIS 3315 (Sixth Cir., 3/1/00) (Judge Holschuh). This case, reversing the Tax Court’s refusal to grant a discount for trapped capital gains tax on real estate, reaffirmed the Second Circuit’s prior decision in Eisenberg vs. Commissioner, 155 F. 3d 50 (2nd Cir. 1998). Under Eisenberg, the appropriate consideration for the Tax Court in deciding whether to consider trapped-in capital gains in valuing corporate stock is whether a "hypothetical willing buyer, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains.....in making a sound valuation of the property."

The IRS argued before the Appeals Court that the estate, which had the burden of proof, did not provide the court with any basis for arriving at a discount for capital gains tax. The Sixth Circuit disagreed and remanded the case to the Tax Court for a new hearing to determine the value of the decedent’s stock, taking into account potential capital gains tax liability.

The International Merger and Acquisition Professionals has released a study on the pricing of middle market acquisition during 1999. This study was based on an analysis of 148 transactions and measured purchase price in relation to earnings before interest and taxes (EBIT) of the acquired companies.

The data revealed that pricing is somewhat higher for larger companies than for smaller ones. The median selling multiple of all manufacturing companies with annual revenues over $50 million was 7.5, whereas those with revenues of less than $10 million had a median selling multiple of just 5.4. The results are shown in the table below. Further details on this data can be found on the IMAP website at www.imap.com.

We are happy to welcome Stephen Wong to our firm as an Appraisal Associate. Stephen is a graduate of Colby College and holds an MBA from Rollins University. He will be working with us as a financial analyst, preparing valuations of closely-held businesses.

Mark Penny, ASA, Managing Director, participated as a presenter in the Annual Advance Business Valuation Conference of the American Society of Appraisers held in Philadelphia in early November. Mark was also recently elected First Vice President of the Philadelphia Chapter of the American Society of Appraisers.

John E. Hempstead, ASA, CFA, Managing Director, served on a panel devoted to the subject of fairness opinions at the ASA Advanced Business Valuation Conference in Philadelphia. More recently, he made a presentation to the Delaware Tax Institute at its annual conference held at the University of Delaware. John has also been elected President of the Estate and Financial Planning Council of Southern New Jersey.

The material presented in the Hempstead Letter should not be construed as definitive legal, financial, or business advice nor should it be acted upon without consultation with legal or other professional counsel.

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Hempstead & Co. is a financial consulting firm providing services in the following areas:

• Valuations of Businesses and Corporate Securities
• Valuations of Intangible Assets
• Loss of Business Damage Analysis
• Mergers & Acquisitions

The members of our professional staff have backgrounds in valuation, finance, accounting, economics, engineering, and investment banking. Professional designations include Accredited Senior Appraiser, American Society of Appraisers (ASA), Chartered Financial Analyst (CFA), and Certified Public Accountant (CPA). We welcome the opportunity to serve you. Please call Mark Penny at (800)541-3323 or contact him via e-mail at johnhemp@bellatlantic.net.