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Tax court determines valuation discounts.

A decedent (L) and his predeceased wife (P) had organized a Texas limited partnership (LP). After L's death, the estate employed an appraisal company (A) to prepare a valuation of L's interests in closely held entities. A concluded that a 53.5% valuation discount applied. The IRS issued a deficiency notice, determining that the discounts claimed by the estate were too high.

Minority Discount

Pursuant to the LP agreement, a buyer of all or any portion of transferred interests would have limited control of his or her investment. A hypothetical willing buyer would account for this lack of control by demanding a reduced price (i.e., a price below the net asset value (NAV) of the pro-rata share). Thus, the court applied a minority discount in this case.

Each expert witness determined a minority interest or lack-of-control discount by reference to general equity closed-end funds. The experts divided the comparable closed-end funds into quartiles by price-to-NAV ratios. In computing the minority discount, A determined that LP would be most comparable to the closed-end funds in the fourth quartile, with price-to-NAV discounts of 21.8%-25.5%. A then further adjusted the discount based on several factors and restrictions inherent in LP and by using other partnership studies.

According to the court, A's exclusive use of the fourth quartile of closed-end funds was improper. "While we have utilized small samples in other valuation contexts, we have also recognized the basic premise that '[a]s similarity to the company to be valued decreases, the number of required comparables increases'" (McCord, 120 TC 358, 384 (2003) (quoting Est. of Heck, TC Memo 2002-34); see also Lappo, TC Memo 2003-258). A's analyses of studies on minority discounts contain some element of discount for lack of marketability, and these studies result in an overstatement of the minority discount.

The court believed a correct analysis would be to take the arithmetic mean of all of the closed-end funds, as shareholders in all closed-end funds lack control. In using only the fourth quartile, A combined elements of the lack-of-marketability discount with the minority discount, because the funds in the fourth quartile had the lowest demand and, thus, the highest marketability discount. As a result, A's discount for lack of control was too high, and was incorrect to use solely the fourth-quartile funds.

The court applied a 12% discount on the grounds that (1) the IRS had effectively conceded that a discount factor of up to 12% would be appropriate and (2) the estate failed to prove that a figure greater than 12% would be appropriate.


A lack-of-marketability discount is appropriate in valuing the interests in LP, as there is not a ready market for partnership interests in a closely held partnership.

There are several ways to determine such discount. Two of the most common include the initial public offering (IPO) approach and the restricted stock approach; see McCord. IPO studies compare the private-market price of shares sold before a company goes public with the public-market prices obtained in the IPO of the shares or shortly thereafter. Restricted stock studies compare private-market prices of unregistered (restricted) shares in public companies with the public-market prices of unrestricted but otherwise identical shares in the same corporations. A variant of the restricted stock approach--the private placement approach---attempts to isolate the effect of impaired marketability on the discount determined under the restricted stock approach.

A used the restricted stock approach by drawing an analogy between partnership interests in LP and the common stock of a private, closely held corporation. In doing so, A considered several restricted stock studies and their findings. A also listed various barriers to marketability of an LP interest. A then determined that a 38% marketability discount was appropriate for an interest in LP.

However, the court was not persuaded by A's recommendation of a 38% marketability discount. The restricted stock studies referred to in A's expert report examined mostly operating companies. There are fundamental differences between an investment company holding easily valued and liquid assets (e.g., cash and certificates of deposit), such as LP, and operating companies.

In McCord, the court focused on a different study and found that a 20% marketability discount was appropriate for interests in a family limited partnership (FLP) classified as an investment company. In Lappo, TC Memo 2003-258, the court found that a 21% initial discount was appropriate for a FLP interest consisting of marketable securities and real estate subject to a long-term lease. It then made a further upward adjustment of 3% to the marketability discount, because (1) the partnership was closely held with no real prospect of becoming publicly held, (2) the partnership was relatively small and not well known, (3) there was no present market for the partnership interests and (4) the partnership had a right of first refusal to purchase the interests.


The court concluded that a 12% minority discount and a 23% marketability discount were appropriate in valuing the LP interests. EST. OF WEBSTER E. KELLEY, TC MEMO 2005-235
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Author:O'Driscoll, David
Publication:The Tax Adviser
Date:Jan 1, 2006
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