The March 2, 2020, decision in Pierson M. Grieve v. Commissioner (T.C. Memo. 2020-28) will be one of the most talked-about cases in 2020 and for many years to come. This is primarily due to the fact that the case tackled the often-discussed issue of how to value a large majority interest (99.8%) with no voting rights in a holding entity. To further amp up the excitement level, throw in a brief discussion on dual level discounts, utterly divergent valuation approaches, and “hot tubbing” all in the context of two entities holding primarily public stock and cash.
Pierson Grieve was a highly successful businessman as chairman of publicly traded Ecolab. Shortly after his wife’s passing in 2012, his family updated their estate plan by setting up two LLCs with the basic structure of his daughter being the owner of a 0.2% voting manager interest by way of the Pierson M. Grieve Management Corp., and the remaining 99.8% non-voting interest being held by the family trust and subsequently assigned to a Grantor Retained Annuity Trust (GRAT). It was the transfers of the 99.8% non-voting interests in the two entities that were the subject of the 2013 gift tax deficiency in the amount of approximately $4.4 million.
After both parties agreed on the starting net asset value of the two LLC’s, the primary issue for Judge Kathleen Kerrigan to decide revolved around the determination of the appropriate discounts for lack of control and lack of marketability associated with the 99.8% non-voting interests transferred to the GRAT. It is not surprising that the IRS would select this case to be heard by the Tax Court, as entities holding primarily cash and cash equivalents (approximately $20 million out of $40 million between the two entities) in combination with a large majority interest has always been a point of contention with the agency.
The taxpayer’s initial expert had used a relatively standard analysis consisting of closed-end funds to determine the lack-of-control discount and restricted stock studies to determine the lack-of-marketability discount, concluding on discounts of approximately 13% for lack of control and 25% for lack of marketability for both entities (with slight variations in the lack-of-control discount due to a differing asset mix between the two entities). Recognizing that the matter was not going to settle, the taxpayer’s legal team brought in an expert team from Stout who not only used a similar closed-end fund/restricted stock approach (a Market Approach) but also introduced an Income Approach. The non-marketable investment company evaluation method (NICE), which uses an Income Approach to value the non-controlling interest that takes into consideration the investment risk and the expected returns on an entity’s assets. Giving the Market Approach and the Income Approach equal weighting resulted in Stout concluding an overall discount for the entities that was slightly higher than the discounts originally filed with the gift tax returns.
The IRS’ expert used a completely different valuation approach, but one that many in the valuation industry have been exposed to vociferously by the IRS in the past. As a matter of fact, it is less of a valuation approach, more of a theoretical construct. The IRS’ argument (summarized for simplicity) is that under the game theory argument, a rational investor would not part with his 99.8% interest at a large discount if he could alternatively approach the 0.2% interest holder who has all the voting power and acquire their interest. This in turn would consolidate their ownership to 100% and eradicate the diminution in value resulting from lack of control and lack of marketability. To numerically support this theoretical construct, the IRS expert assumed that you would have to pay the controlling 0.2% voting member a premium above their undiscounted net asset value. Using various unsupported mathematical premium assumptions, the IRS concluded at an appropriate discount for the 99.8% interest of approximately 1.5% for both entities.
Given that the holder of the 0.2 % voting interest testified that she had no intention of selling her interest and subsequent to a “hot tubbing” session with the experts, the court concluded that any construct revolving around the purchase of the voting interest was not “reasonably probable.” The court went on to state:
“Elements affecting the value that depend upon events within the realm of possibility should not be considered if the events are not shown to be reasonably probable … The facts do not show that it is reasonably probable that a willing seller or a willing buyer of the class B units would also buy the class A units and that the class A units would be available to purchase.”
The court concluded that the taxpayer’s appraisals were most reliable and accepted the return as initially filed.
Stay tuned for a more in-depth analysis of this seminal case from the experts at Stout that were in the hot tub. For the time being, a combined discount of 35% for entities holding primarily cash and public stock is an excellent and appropriate result, when pitted against the theoretical construct of the game theory premium acquisition approach resulting in a 1.5% discount.