Tax Court: 7.5 Percent or 30.6 Percent DLOM?

Estate of Koons v. Commissioner, 2013 Tax Ct. Memo LEXIS 98 (April 8, 2013)

In connection with a major asset sale, the decedent formed a limited liability company (LLC) and made a will under which he left the residue of his estate to a revocable trust. At the time of death, the trust owned a 50.50% total interest in the LLC, whose value was over $300 million. When the estate challenged the Internal Revenue’s deficiency determination as to estate and generation-skipping transfer taxes, the primary issue was the valuation of the trust’s interest in the LLC—which hinged on the magnitude of the applicable marketability discount (DLOM).
The decedent owned a company that was in the vending-machine business and claimed exclusive rights to selling Pepsi beverages in its territories. In 2004, the company agreed with PepsiCo. Inc. to sell its business to a Pepsi affiliate. For this purpose, the company, whose shareholders included the decedent and his four children, transferred all of its assets to a wholly owned subsidiary (the LLC) and the shareholders executed a stock purchase agreement (SPA) with the Pepsi affiliate. Among other things, the SPA specified that the LLC would sell all shares for approximately $340 million, plus working capital (the final purchase price was $352.4 million). Moreover, the LLC assumed certain environmental, health, and safety liabilities related to the company’s Florida production facility; ,and it committed to own liquid assets with an aggregate fair market value of at least $10 million and maintain a positive net worth of at least $40 million until January 2012. Importantly, the four children’s agreement to sell their company shares to the LLC was contingent on the latter’s offer to redeem their varying membership interests.
By March 2005, the date of the decedent’s death, all four children had accepted the redemption offer. At the end of April 2005, the redemptions closed, with the final payments occurring around July 2005. The decedent had contributed his membership interest in the LLC to a revocable trust established some 15 years earlier. He had amended the terms of the trust such that its beneficiaries were no longer the children, but the grandchildren, their lineal descendants and surviving spouses; shortly before his death, he instructed the trustees to vote in favor of amending the LLC’s operating agreement such that it: (1) eliminated his children as permitted transferees of membership interests; (2) eliminated the board of advisors, which included his children; and (3) for the first 15 years of the LLC’s operations, limited discretionary distributions per year to LLC members to 30% of the difference between distributable cash and income tax distributions.
Only weeks before the decedent died, in February 2005, one son wrote a letter calling the redemption offer “punitive” but expressing gratitude for the “exit vehicle” and stating that the children would “like to be gone.” He said the operating agreement “guarantees litigation.”
At the time of death, the revocable trust had a 50.50% total percentage interest in the LLC, resulting from a 46.94% voting interest and a 51.59% nonvoting interest. The redemption of the children’s interests increased the percentage to 70.93%. The LLC’s net asset value was about $317.9 million. At the beginning of 2006, it had over $200 million in highly liquid assets and owned two companies whose combined assets made up only 4% of its total assets.
Besides its interest in the LLC, which was held through the revocable trust, the estate had assets totaling over $26.6 million, which is the amount it reported on the estate tax return. The IRS issued notices to the estate initially claiming a deficiency in estate taxes of nearly $42.8 million and to the revocable trust for a deficiency in generation-skipping transfer tax of nearly $15.9 million.
The agency subsequently increased the deficiencies based on its determination that the trust’s interest in the LLC at the time of death was worth over $148.5 million. The estate and the trust challenged the notices and petitioned the federal Tax Court for review. Both sides offered valuations from notable financial experts as to the trust’s fair market value.
Gaping DLOM difference.
The parties agreed that, assuming the trust had a 50.50% total interest in the LLC and the latter had a value of some $371.9 million, the trust’s pro rata asset value was over $160.5 million. They further agreed that its actual value was less because of a lack of marketability but strongly disagreed over the size of the applicable marketability discount.
Estate and trust’s expert. The petitioners’ expert was Mukesh Bajaj, whose DLOM determination drew on his influential 2001 regression study of 88 companies. (See “Firm Value and Marketability Discounts,” 27 J. Corp. L. 89 (2001)). There, he used an equation to explain the difference between the price of the publicly traded stock of a company and the price of the same type of stock of the same company sold privately pursuant to a restriction that the buyer must wait before reselling the shares. When Bajaj applied the equation to the trust’s 50.50% interest in the LLC, he arrived at a 26.6% “initial marketability discount.” But, he said, the differences between the trust’s interest and the shares in the 88 companies required further adjustments. He added a second—4%—discount to account for certain limitations that applied to the LLC, including environmental obligations it had assumed under the SPA. Because the LLC was closely held, small, and unknown and selling an interest in it to persons who were not direct descendants required a 75% vote of its members, he applied a third—3%—discount and arrived at a 31.7% DLOM. As a result, he concluded the trust’s interest equaled the pro rata net asset value of the LLC’s assets minus 31.7%, yielding a value of approximately $110 million.
He also determined that there should be no control premium because the holder of the trust’s interest only had a 46.94% voting power and as such had not enough control to obtain “private benefits.” Even if the holder obtained a 70.42% voting interest following the redemption of the children’s interests, there were no private benefits because the operating agreement and the SPA imposed restrictions on the LLC. He also saw no reason to apply a discount for lack of control.
Government’s expert. The IRS’s expert was Francis X. Burns. He, too, considered the 2001 Bajaj study but for various reasons declined to perform a regression analysis to predict the marketability discount. As he saw it, the equation resulted from a data set of companies that earned their profits mainly from active business operations; in contrast, the LLC had only two small ones. Also, the equation explained only one-third of the variation in the discounts in the ownership interests in the 88 companies from which Bajaj had generated the equation. Moreover, all 88 transactions involved ownership interests of less than 50.50%. And, the IRS expert said, the Bajaj equation systematically overestimated the relationship between block size and the valuation discount.
Instead, Burns found that a 5% to 10% DLOM was appropriate based on a number of critical factors. Most important, the risk that the redemptions would not go through was small, he found. On the other hand, the SPA imposed obligations on the LLC related to potential environmental, health, and safety liabilities; also, it was reasonable to assume that the LLC would make cash distributions, an owner of the revocable trust’s interest would be able to force the LLC to distribute most of its assets once the redemptions closed, and most of the LLC’s assets were liquid. For all these reasons, he decided a 7.5% DLOM would be a reasonable accommodation between a hypothetical seller and buyer.
Like the petitioners’ expert, he concluded that neither a control premium nor a discount for lack of control was appropriate. Even though the voting interest at the time of death was only 46.94%, the redemption of the children’s interests was reasonably foreseeable, he said. Consequently, the voting power would increase to 70.42%. At the same time, the LLC’s major assets were cash, not operating assets, and it was unlikely that a controlling member of the LLC “could extract value above its pro-rata claim on company assets.” On the other hand, that degree of voting power allowed the owner to control the LLC’s board of managers.
Likelihood of redemption.
The petitioners and their expert objected that Burns’ low discount primarily resulted from the mistaken assumption that the redemption would occur and increase the voting interest of the owner of the trust’s interest from 46.94% to 70.42%. Although each of the four children had signed a redemption offer before the decedent’s death, the petitioners claimed these were not enforceable under applicable state law because they did not include vital terms, including the price at which the LLC would redeem the interests. Further, the son’s February 2005 letter suggested that the children did not intend to sell their interests.
The court agreed that the question of whether the redemptions were likely was pivotal to the valuations. It disagreed with the petitioners and their expert on this point and other points and credited Burns’ analysis. The redemption offers, the court said, expressly stated that the interests were redeemable at a price equal to each owner’s share of the value of the LLC’s assets; since most of the assets were cash, it was easy to establish their value and by extension the redemption price. A state court likely would have enforced the signed letters. Moreover, the LLC successfully could have sued any signer who tried to renege on the contract. What’s more, because a critical aspect of the redemption offers was to remove the children from the ownership of the LLC, a court would have ordered specific performance.
The February 2005 letter equally suggested that the children did not want to remain owners of the company; “they wanted cash,” said the court. At the same time, the LLC’s managers wanted them removed as owners. Accordingly, both sides had incentives to effect the redemptions. The petitioners tried “to create a smokescreen of uncertainty around the redemptions which did not in fact exist as of the valuation date,” concluded the court.
Burns’ assumption that the owner of a 70.42% voting interest in the LLC could order the latter to distribute most of its assets also had traction with the court. Despite the SPA’s provisions regarding liquid assets, it did not bar the LLC from distributing most of its assets. And even if the board of managers were reluctant to do so because the decedent had preferred that the LLC invest its assets in operating businesses after his death, the key was that hypothetical buyers and sellers of the trust’s interest would proceed from the knowledge that the LLC could be forced to distribute most of its assets, the court pointed out. “A majority member who could force the LLC to distribute most of its assets would not sell its interest for less than the member’s share of such a distribution,” said the court.
In this case, if the LLC’s total assets valued almost $318 million and it had to retain $40 million of the assets, per the SPA, it could distribute approximately $278 million to members. Assuming a 50.50% interest in the LLC, the holder could expect to receive about $140 million in a distribution. This amount, said the court, was the minimum sale price of the interest. Therefore, it rejected Bajaj’s $110 million valuation and adopted Burns’—and the government’s—$148.5 million valuation.
Balloon interest payments.
A secondary issue concerned a $10.75 million loan the LLC had made to the revocable trust in February 2006 to pay estate and generation-skipping transfer taxes and for which the estate claimed an interest expense deduction of over $71.4 million. The terms of the loan provided that repayment would be in installments from 2024 through 2031—a deferment that caused the interest to swell and meant the estate would have to remain active throughout the repayment of the loan. Once more, the court agreed with the IRS’s position and did not allow the deduction. There was no need to borrow the money because in 2006 the trust had a 70.42% voting interest in the LLC and the LLC had over $200 million in highly liquid assets. The trust had the power to force the LLC to make a pro rata distribution to its members, including the trust, said the court.