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Voting Control of LLC Shrinks Valuation Discount

May 2013 | Issue 66

The primary issue in Estate of Koons v. Commissioner (T.C. Memo. 2013-94, April 8, 2013) was the determination of the fair market value, at the date of his death, of John Koons’ 50.5% interest (47% voting) in a company called Central Investment LLC.  Central had been established as an entity to hold investment assets of the Koons family.  At the date of Mr. Koons’ death, March 3, 2005, the net asset value of Central was $318 million. Cash made up more than 90% of the company’s assets, the result of a recent sale by Central of a bottling company to PepsiCo.

The Estate’s Case

As is usual in these kinds of cases, both sides had valuation experts.  The expert for the estate, Mukesh Bajaj, first concluded that no valuation premium or discount for control should be applied.  He did believe, however, that a 31.7% discount for lack of marketability should be applied to the net asset value of John Koons’ share of Central.  Applying this discount produced a value of $110 million for the portion of Central held in the estate ($318 million x .505 x (1-.317)).

The lion’s share of Dr. Bajaj’s lack-of-marketability discount was derived from a regression study he had performed in 2001 which related the size of lack-of-marketability discounts found in 88 private stock transactions to the size of the block held.

The IRS’ Case

Francis Burns was the expert for the IRS.  Like Bajaj, Mr. Burns concluded that no premium or discount for control need be applied.  The next step in his analysis was to determine a discount for lack of marketability.  He opined that a 5-10% lack-of-marketability discount was warranted.  In reaching this conclusion he considered the following:

  • Central had entered into an agreement to redeem the approximately 23% LLC interest in Central held by the four children of John Koons.
  • Once the redemption of the children’s interests was accomplished, the estate would then be the holder of a majority voting interest in Central. This would allow it or a potential buyer to carry out a distribution of Central’s assets at will.
  • Central had some remaining indemnification obligations to PepsiCo under the terms of its recent sale of a Pepsi bottling company to PepsiCo.

Burns reasoned that there was only a small chance that the redemptions of the children’s shares wouldn’t take place.  He felt that a discount of 5 to 10% would be appropriate under all the circumstances, and settled on the midpoint – 7.5%.

The Court’s Analysis

The court observed that a major source of the disparity in the two valuations was that the two experts disagreed on the likelihood that the redemption of the children’s’ shares would take place.  If it didn’t take place, the holder of the estate’s interest in Central would control only a 47% voting interest in Central, not enough to force a distribution of assets or liquidation.

The court performed a legal analysis, and satisfied itself that the redemption agreements were enforceable.  Accordingly, it concluded that it was proper to assume that the redemption would take place, and that the remaining share holder could bring about a distribution of assets or liquidation of Central.

The court also came to the conclusion that Dr. Bajaj’s 2001 regression analysis was not something it should rely on in valuing Central.  Among other reasons, the 2001 study was based on transactions in the stock of operating companies.  Central is a holding company.

The court concluded that Mr. Burns’ discount opinion was based on “experience and common sense,” and adopted it.  The court calculated a final value of $149 million ($318 million x .505 x (1-.075)).

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.