Editor’s note: The impetus for this article is that the author continues to receive requests to do a “discount study” to appraise a minority interest in a family limited partnership. This is a shortcut method that typically uses a net asset value approach and deducts discounts without taking the time to do a proper analysis. Although the requests for these abbreviated analyses are less common than before, there are enough of them to compel the author to write this article.
The purpose of this article is to recommend the best practices and terminology to use when valuing minority interests in family limited partnerships (FLP) and limited liability companies (LLC). In the Estate of Church, which was the first FLP case to be challenged in court, the judge concluded:
Plaintiffs are entitled to a refund based on the proper valuation of Mrs. Church’s Partnership.[1]
As the plaintiff’s expert in this case, I have been asked many times what the “proper valuation” methodology was and how did my report successfully support a 57.6% discount from net asset value (NAV). This is not the highest discount ever allowed in court, but the case set a precedent, and the discount was much higher than what we typically expect. My goal as an appraiser was not to get a high discount for lack of control and lack of marketability but to use real-world methodologies grounded in financial theory to determine the appropriate rate of return for the risk of a privately held, minority limited partnership interest. The discount was the result of what an investor would demand in terms of a reasonable rate of return.
Back when this case was decided, it was common to have attorneys, CPAs, and even appraisers ask me to conduct a “discount study” to appraise a minority interest in an FLP or LLC. In most cases, a discount study uses the NAV method of the asset-based approach to value a minority interest by deducting discounts for lack of control and lack of marketability based on average discounts from published studies. The problem with issuing a discount study is that it applied discounts without sufficiently explaining how the discounts were derived and supported. In the 6th edition of Valuing a Business, the risks of applying average discounts from published studies without the proper analysis are addressed:
When making investment decisions in the real world, arm’s length buyers and sellers of minority interests do not rely on general averages from published discount studies, and neither should the valuation analyst.[2]
A comprehensive appraisal report provides the proper methodology and analysis to establish a value based on an investor seeking a certain rate of return to compensate for the risks of an investment in a privately held interest. The higher the rate of return, the less an investor will pay for the interest, resulting in a discount from NAV. The key problem is not that discounts exist, but how to support the value derived (Exhibit 1).
Today, most appraisers realize this and provide sufficient comparisons to support any reduction or adjustment to the NAV. However, we have carried over some of the old terminology that sometimes confuses the court by using the NAV method when what we are really doing is applying the methodologies of the market approach.
Court cases. An examination of numerous court cases reveals that the problem with using the NAV method lies with the explanation for the discounts and the court’s skepticism of the applicability of the NAV method. In the Estate of Newhouse v. Commissioner [94 TC 193 (1990)], the court stated:
[W]e believe that no willing buyer or willing seller being fully informed would have used such a method (NAV Method) to determine the value of the common stock.
Appraisals that conform to IRS regulations and the Uniform Standards of Professional Appraisal Practice (USPAP) must provide an analysis of the entity being valued, an explanation of the appraisal process, and support for the value conclusion. USPAP Standard 10-2 states, among many other disclosures, the following:
Standard 10-2(xi)(4): summarizing the information analyzed and the reasoning that supports the analyses, opinions, and conclusions, including the reconciliation of the data and approaches.
This explanation, support and analysis, is sometimes missing in discount studies when average discounts from published studies are applied. Consequently, discount studies are not the same as appraisals because appraisals require thoughtful analysis of the risk and return characteristics of the interest being valued.
Here is a list of the major court cases over the last 40 years that address the Tax Court’s displeasure with the lack of support of discounts for lack of control and lack of marketability (Exhibit 2).
As a result of the Tax Court’s decisions, most appraisers have taken note of these cases and now present more thoughtful analysis when valuing noncontrolling interests in holding companies. By looking at some of these cases, we can learn the rationale of the courts’ decisions and how we can apply them to our current work. In the Estate of Berg v. Commissioner, the court dismissed the taxpayer expert’s report because:
The taxpayer’s expert relied on previous tax court decisions and average discounts from published studies rather than specific transactional data.
In the Estate of Perrachio v. Commissioner, the court stated:
[The appraiser] makes no attempt whatsoever to analyze the data from those [restricted stock] studies as they relate to the transferred interests. Rather, he simply lists the average discounts … asking us to accept on faith the premise that the approximate average of those results provides a reliable benchmark for the transferred interests. Absent any analytical support, we are unable to accept that premise.
In the Estate of Kelley v. Commissioner, the court concluded:
[The taxpayer’s appraiser] did not analyze the data from these studies … therefore we cannot accept the premise that this average discount [for lack of marketability] is appropriate.
These cases show us that the courts require more than just listing the results of published studies and asking the reader to accept on faith that the conclusion is reasonable. The courts want to see comparisons to actual transactions, not averages from studies. This is where terminology is important. Historically, appraisers have used the NAV method, but the courts are asking for more persuasive comparisons like we would find in the market approach. For some, this is just semantics. One appraiser’s NAV method is another appraiser’s market approach.
However, my experience with the IRS and past Tax Court testimony suggests we take this matter more seriously. Accordingly, I recommend the use of pricing multiples, such as price-to-NAV ratios, from Partnership Profiles or closed-end fund data and refer to this methodology as the market approach rather than deducting discounts using the NAV method. As stated, the resulting conclusion is the same but using priceto-NAV ratios from comparable guideline entities is actually the market approach. The market approach takes the emphasis off of discounts and puts it on determining the proper pricing multiple using comparable entities. As shown in Exhibit 3, a price-to-NAV ratio of 0.750-to-1 is equivalent to a discount for lack of control of 25%, so the resulting answer is the same.
In addition to using the market approach, a number of court cases have also emphasized the use of the income approach to value minority interests. In the Estate of Weinberg v. Commissioner (T.C. Memo. 2000-51):
[W]e agree with petitioner’s expert that for purposes of computing the fair market value of the subject limited partnership interest under the capitalization of income approach, it is appropriate to use the average of the distributions made during the years 1990 through 1992.
In the Estate of Giustina v. Commissioner (T.C. Memo. 2011-141), when the ownership interest does not have the ability to realize the value of the underlying assets, the income generating ability of the entity is of primary importance:
[T]he cash flow method is appropriate to reflect the value of the partnership if it is operated as a timber company and the asset method [NAV method] is appropriate to reflect the value of the partnership if its assets are sold.
The importance of earnings for the value of a noncontrolling interest was emphasized in the Estate of Cecil v. Commissioner (TC Memo 2023-24):
[W]e believe that TBC’s earnings rather than its assets are the best measure of the subject stock’s fair market value … reliance on the assetbased approach also appears to be inconsistent with the Uniform Standards of Professional Appraisal Practice (USPAP). [3]
It is evident from the cases above that the courts are looking for a detailed analysis and explanation. Accordingly, a business appraisal report should clearly discuss the factors and characteristics the appraiser considered along with an explanation of the methodologies used to calculate the value. The use of the market approach and income approach appear to be the best methodologies to accomplish this.
Terminology matters. Most of the time, when appraisers are discussing methodologies, it is with other appraisers who have significant financial backgrounds. However, in audits, IRS appeals, and Tax Court situations, the parties involved (taxpayer representatives, the IRS/DOJ representatives, and the judge) are all attorneys with legal backgrounds. Whereas financial minds focus on rates of return and investment criteria, attorneys typically focus on case precedent and authoritative texts to establish their position. Being aware of these differences, appraisers need to use the terminology that is promulgated in USPAP, BV standards, and peer-reviewed texts.
So what terminology should we be using and referencing? When challenged in court, it is likely that opposing counsel will ask you what treatise or published texts you relied on. The two primary texts for business valuation are Valuing a Business and Guide to Business Valuations. These peerreviewed and authoritative texts state that, when valuing minority interests in FLPs and LLCs:
[A]ppraisers should identify the specific risk/ reward relationship of the interest that is being valued and consider an empirical method for valuing the subject noncontrolling, nonmarketable interest. To that end, the Income Approach and the Market Approach generally provide a more direct manner to value a noncontrolling interest.[4]
These texts state that the asset-based approach should be used for controlling interests and that the income and market approaches are superior for valuing minority interests.[5] The use of the NAV method terminology is best reserved for valuing controlling interests in ongoing entities but can be confusing when applied to valuing noncontrolling interests because:
As an appraiser, you do not want to be on a witness stand during cross-examination when the opposing counsel asks you why you used the NAV method when the authoritative texts say to use the income approach and market approach. While financially minded appraisers know it is semantics, this can be confusing and detrimental to your court testimony.
So, if the NAV method is not the terminology we should use, how do we present the income and market approaches so that they are understandable, supportable, and logical?
Income approach. For the income approach, the discount cash flow (DCF) method is best to model the forecast of future net cash flow available for distribution to a minority shareholder because it can forecast a future liquidation. Under the income approach, the anticipated future income from distributions (annual net cash flow) and capital gains (future liquidation) define the benefits of ownership. Investors in both public and private investments use this method extensively. Here is an example of a simple net cash flow forecast for a real estate FLP (Exhibit 4).
According to Spencer Jefferies of Partnership Profiles Inc., the DCF method is what investors use to value minority interests in the real estate secondary market. Ongoing earnings are forecast based on historical levels of distributions and future capital gains estimated by forecasting a liquidation horizon. Even when a liquidation is not imminent, these third-party Partnership Profiles investors state that they use a five-to-10-year window in order to include capital appreciation in the value. It is recommended to run two scenarios or more of the DCF forecast using different liquidation horizons to determine a range of value to quantify the total return of the investment.
Market approach. The market approach calculates a value based upon comparisons between the subject interest being appraised and similar publicly held entities with third-party buyers and sellers. Revenue Ruling 59-60 states that:
[I]n valuing unlisted securities, the value of stock or securities of corporations engaged in the same or similar line of business which are listed on an exchange should be taken into consideration along with all other factors.
The market approach requires identifying guideline entities and conducting an analysis using financial ratios to compare the subject interest to the alternative publicly held investments. Here is an example (Exhibit 5).
Many times, when I am asked about this, I find it helpful to take a step back from what we assume has been normalized within the appraisal profession and ask the question:
When was the last time we used the NAV method in real life or seen professional investors use it in investment reports? Investors don’t value a 100% interest in Microsoft and go to Mergerstat Review and select an average discount for lack of control based on control premiums.
As an investor, we analyze the future incomegenerating ability of Microsoft (i.e., the income approach) and compare its price-to-earnings ratio to alternative tech stocks (i.e., the market approach). Consequently, we should use the same diligence and care when appraising a minority interest in an FLP or LLC.
Conclusion. The best practice for valuing minority interests in FLPs and LLCs is using the income approach and market approach concurrently to determine a noncontrolling, nonmarketable value and then make an adjustment for lack of marketability. The adjustment (or discount) for lack of marketability is beyond the scope of this article, but appraisers should include an empirical method that quantifies the DLOM based on its impact on the increase in the rate of return. [9]
Taxpayers, attorneys, and the Internal Revenue Service use discounts as a quick check to determine the reasonableness of an appraised value in their mind. Over time, this thought process sometimes permeates the thinking of appraisers. In reality, investors determine how much they will pay for an investment based on a desired rate of return that reflects the expected future benefits and risk of the investment. While discounts do occur in third-party transactions, the public markets do not value investments based on a discount or a published study of discounts. An investor who is selling an interest looks at the expected return to decide whether they should hold the investment or sell it and reinvest it in another security. An investor who is buying the interest would look at the present value of future benefits or the pricing of alternative investments to determine a price that is reasonable based on the risks and expected returns of the investment.
In my experience as an expert in Tax Court cases, using real-world methodologies has led to not only the correct result, but also the most supportable position. Attorneys for the IRS and Tax Court judges are looking for real-world application of investment methodologies.
When valuing a noncontrolling interest in a privately held entity, it is not a question of whether discounts are appropriate but whether objective data and a proper methodology were used to determine the correct value. Discounts are a result of an investor’s calculation of value based on the analysis of risks and future benefits. The driver for determining value is the rate of return an investor sought. Therefore, as appraisers, we should focus on the rate of return using proven valuation theory and prepare our appraisal report in a manner that is based on real-world methodologies.
References:
[1] Estate of Elsie J. Church v. United States, Cause No. SA-97-CA-0774-OG.
[2] Shannon Pratt and ASA Educational Foundation, Valuing A Business, 6th edition, The McGraw-Hill Companies Inc., 2022, p. 718.
[3] USPAP Standards Rule 9-3: “In developing an appraisal of an equity interest in a business enterprise with the ability to cause liquidation, an appraiser must investigate the possibility that the business enterprise may have a higher value by liquidation of all or a part of the enterprise.… However, this typically applies only when the business equity being appraised is in a position to cause liquidation.”
[4] Shannon Pratt and ASA Educational Foundation, Valuing a Business, 6th edition, 718.
[5] Jay E. Fishman and others, Guide to Business Valuations, Practitioners Publishing Co., 2024, 7-2.
[6] Bruce A. Johnson, Spencer J. Jefferies, and James R. Park, Comprehensive Guide for the Valuation of FLPs and LLCs, 6th edition, Partnership Profiles, Inc., 2021, 3-13.
[7] Estate of Newhouse v. Commissioner [94 TC 193 (1990)].
[8] Shannon Pratt and ASA Educational Foundation, Valuing a Business, 6th edition, 718.
[9] Bruce A. Johnson, Spencer J. Jefferies, and James R. Park, Comprehensive Guide for the Valuation of FLPs and LLCs, 6th edition, 133.
