Financial valuation Applications and Models phần 6 pot

Addendum 499 ______ Any documents showing any offers to buy or sell or indications of interest in buying or selling the restricted shares ______ Latest company prospectus ______ Three to five years of annual reports ______ Trading prices and trading volume and the related class of traded securities one month preceding the valuation date ______ The relationship of the parties to the agreements concerning the restricted stocks, such as whether they are members of the immedi- ate family or whether they are officers or directors of the company ______ Whether the interest being valued represents a majority or minority ownership 6. Weighing Facts and Circumstances Material to Restricted Stock Valuation ______ Depending on the circumstances of each case, certain factors may carry more weight than others ______ Earnings, net assets, and net sales must be given primary consideration ______ In some cases one element may be more important than others ______ For manufacturing, producing, or distributing companies, primary weight must be accorded earnings and net sales ______ For investment or holding companies, primary weight must be given to the net assets ______ Careful review of resale provisions found in restricted agreements ______ The two elements of time and expense should be reflected in a discount ______ The longer the buyer of the shares must wait to liquidate the shares, the greater the discount ______ If certain provisions make it necessary for the buyer to bear the expense of registration, the discount is greater ______ If the provisions of the restricted stock agreement make it possible for the buyer to “piggyback” shares of the next offering, the discount would be smaller ______ The relative negotiating strengths of the buyer and seller of restricted stock ______ A tight money situation may cause a buyer to have more negotiating strength ______ In some cases the relative strengths may tend to cancel each other ______ The market experience of freely tradable securities of the same class as restricted securities is also significant ______ Whether the shares are privately held or publicly traded 500 ESTATE, GIFT, AND INCOME TAX VALUATIONS ______ Securities traded on a public market generally are worth more to investors than those not traded on a public market ______ The type of public market in which the unrestricted securities are traded can be given consideration Revenue Ruling 93-12 The IRS revoked Revenue Ruling 81-253, which applied family attribution to deter- mine control when valuing minority interests in closely held companies. After Revenue Ruling 81-253 was issued, the IRS lost a majority of the court cases con- cerning family attribution. Revenue Ruling 93-12 states that a minority discount on stock transferred to a family member will not be challenged solely because the transferred interest, when aggregated with interests held by other family members, will be a part of a control- ling interest. This ruling arose from a gift tax case. Issue ______ If a donor transfers shares in a corporation to each of the donor’s children, is the factor of corporate control in the family to be considered in valuing each transferred interest? Facts ______ Taxpayer owned all the shares of stock of a corporation ______ Taxpayer made simultaneous gifts of 20 percent blocks of stock to each of five children Law and Analysis ______ The value of the property at the date of the gift shall be considered the amount of the gift ______ The value of the property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of rel- evant facts ______ Fair market value on the date of the gift ______ Among the factors to be considered is the degree of control of the business being represented by the block of stock to be valued ______ Revenue Ruling 81-253, 1981-1 C.B. 187 holds that, ordinarily, no minor- ity shareholder discount is allowed with respect to transfers of shares of stock between family members if, based on a composite of the family mem- bers’ interests at the time of the transfer, control (either majority voting con- trol or de facto control through family relationships) of the corporation exists in the family unit ______ Revenue Ruling 81-253 states that the Internal Revenue Service will not fol- low the decision in the 1981 case Est. of Bright v. United States ______ In Bright the court allowed a 27.5 percent interest to be valued as a minor- ity interest, even though the shares were to be held by the decedent’s sur- viving spouse ______ Propstra v. United States (1982), Est. of Andrews v. Comm (1982) and Est. of Lee v. Comm (1978). These cases held that the corporations’ shares owned by other family members cannot be attributed to an individual fam- ily member for determining whether the individual family member’s share should be valued as a controlling interest of the corporation ______ The IRS has concluded, in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of other family members will not be aggre- gated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest ______ The five 20 percent interests that were gifted should be valued without regard to the family relationship of the parties Holding ______ If a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family is not considered in valuing each transferred interest ______ The IRS will follow Bright, Propstra, Andrews, and Lee in not assuming that all voting power held by family members may be aggregated as part of a controlling interest ______ A minority discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, will be part of a controlling interest ______ This will be the case whether the donor held 100 percent or some lesser per- centage of the stock immediately before the gift Effect on Other Documents ______ Revenue Ruling 81-253 is revoked Addendum 501 Valuation of Family Limited Partnerships T he family limited partnership (FLP) is a sophisticated financial planning tech- nique that, when implemented properly, enables a family to hold and manage its wealth, including the family business, within several generations of family members as partners. Families with significant wealth increasingly establish an FLP rather than a corporation because the FLP often is better suited to achieving certain objectives. Some background on corporations and partnerships is helpful to understand- ing the FLP. The profits of a C corporation are taxed at a maximum rate of 35 per- cent (for federal tax purposes); when the after-tax profits of the C corporation are distributed to the shareholders as dividends, those same profits are taxed a second time to the individual shareholders, up to the maximum federal statutory rate of 38.6 percent. The combined corporate and personal tax rate can easily exceed 60 percent, even before state and local income taxes are taken into account. Alternatively, the profits of a subchapter S corporation are, in general, taxed at the shareholder level only—making the S corporation a more appealing structure than the C corporation in many instances. However, there are numerous restrictions on the qualifications for functioning as an S corporation, even after the liberalizing amendments enacted in 1996. By comparison, a partnership is a pure “flow-through” entity, meaning that the income realized by the entity flows through and in all cases is taxable to its individ- ual owners and not to the business per se. As a result, the limited partnership has become increasingly popular as a flexible and tax-efficient vehicle for conducting business—particularly as compared to a corporation, which is more a formal and generally can be a tax-inefficient means for conducting business. Further enhancing the desirability of partnerships is the Uniform Limited Partnership Act adopted by a large majority of the states. This statute standardizes and simplifies the laws governing a limited partnership’s conduct of business in more than one state. FAMILY LIMITED PARTNERSHIP USES In addition, FLPs may be used by families as the means: • To provide a resolution of any disputes that may arise among the family, preserve harmony, and avoid the expense and problems of litigation • To maintain control of the family assets 502 CHAPTER 12 • To promote the efficient and economic management of the assets and properties under one entity • To consolidate fractional interests in family assets • To increase family wealth • Whereby annual gifts can be made without fractionalizing the underlying family assets • To restrict the right of nonfamily members to acquire interests in the family assets • To provide protection of the family assets from claims of future creditors • Of preventing the transfer of a family member’s interests as a result of a failed marriage • To provide flexibility in business planning not available through trusts, corpora- tions, or other business entities • To facilitate the administration and reduce the cost associated with the disability or probate of the estate of family members • To promote the family’s knowledge of and communication about the family assets These goals can be achieved as a result of the FLP’s ability to: • Engage in the real estate business, i.e., to acquire, own, hold, develop, and oper- ate real estate enterprises • Invest funds and to raise funds to be invested in furtherance of the underlying purposes • Invest, manage, and operate various investments including but not limited to marketable securities, stocks, bonds, gold, silver, grain, cotton, other commodi- ties, and debt instruments TAX ADVANTAGES This type of entity structure also provides a vehicle to maximize the profits and yield to the family members due to three factors: 1. A partnership structure eliminates the possibility of double taxation (i.e., taxa- tion at the entity and the individual level). This will provide higher returns to the family members, by reducing their tax burden. Unlike outright gifts, this struc- ture minimizes the possibility that any new partners could impair the value of the assets. 2. Internal Revenue Code Section 754 permits a partnership to file an election upon the death of a partner to adjust the basis under IRC Section 743(b). Again this provides additional value to the family members. 3. Internal Revenue Code Section 2036(b) provides that the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation is a retention of the enjoyment of transferred property. Accordingly, the value of such stock is still includable in the estate of the transferor. However, IRC Section 2036(b) does not apply to partnership interests. Tax Advantages 503 HOW FAMILY LIMITED PARTNERSHIPS ARE FORMED The family limited partnership usually is formed by the senior generation by trans- ferring assets in return for general and limited partnership interests. These interests carry certain rights as to distributions, cash flows, and/or access to assets based on the state law provisions specific to the state of governance. Assets are generally investment real estate, marketable securities, bonds, or other assets that are expected to appreciate. General partner interests usually range from 1 to 5 percent. Alternatively, limited partner interests usually range from 95 to 99 percent. Further, general partner interests usually are held by the senior genera- tion or by a separate entity, whereby the senior generation retains control of the entity and the underlying assets. Subsequently, gifts generally are made to the junior generation of limited part- nership interests as a highly efficient means of transferring value and assets out of the estate of the senior generation while maximizing the use of the federal and state estate and gift tax structure. Such efficiency and tax structure benefits are made pos- sible because federal and state laws and regulations treat an ownership interest in a limited partnership substantially differently from a direct ownership interest in par- ticular assets. For example, assume that a husband and his spouse own various marketable securities worth $1 million. They both transfer these assets to an FLP. Later, they transfer a 10 percent interest to their child. This transfer typically will be taxed for gift tax purposes based on the value transferred. If a 10 percent interest in the underlying assets were directly transferred, the taxable value would be $100,000 ($1,000,000× 10 percent). However, through the use of the FLP, the taxpayers (husband and spouse) can leverage the amount of the gift. The taxable value, due to the nature of the interest transferred, would not be a pro rata interest in the underlying assets. Rather, it would be the amount that a “hypothetical buyer” would pay for a 10 percent interest in a limited partnership. This interest would consider the fact that a limited partner’s interest (or an assignee’s interest) can- not and does not have access to partnership assets and cannot force any distri- bution or effectively control the ability to receive a return on his or her investment. As a result, the transferred interest above would be discounted for these own- ership and marketability issues and might be valued as follows: Value of underlying assets $1,000,000 Interest transferred ϫ 10% __________ Prorata value of interest 100,000 Discount for lack of control 25%* Ϫ 25,000 __________ 75,000 Discount for lack of marketability 30%* Ϫ 22,500 __________ Value of interest transferred $ 52,500 __________ __________ *Note: For illustrative purposes only 504 VALUATION OF FAMILY LIMITED PARTNERSHIPS By utilizing this type of transfer structure, the taxpayers have effectively reduced their exposure to estate and/or gift taxes by $26,125 ($100,000 pro rata value – $52,500 discounted value = $47,500 × 55 percent marginal estate/gift tax rate = $26,125) or 26.0 percent. This type of “wealth preservation planning” technique can accomplish multi- ple goals with respect to an individual’s assets, wealth, and estate. However, these benefits do not come without their share of issues. OTHER CHARACTERISTICS OF FAMILY LIMITED PARTNERSHIPS • Family Limited Partnerships require at least two different partners: one general partner and one limited partner. • The general partner(s) has (have) full control over the management, decisions, and day-to-day operations of the partnership affairs. • The general partner(s) is (are) responsible for all financial and legal obligations of the partnership. • The limited partner(s) is (are) viewed as silent family members with no voice in the partnership operations or management. • The limited partner(s) is (are) not responsible for any unguaranteed financial and legal obligations in excess of the investment. STATE LAW, PROPERTY RIGHTS, AND THEIR IMPORTANCE TO THE VALUATION PROCESS To fully assess the magnitude and volatility of an investment’s risks and returns, the valuation analyst needs to begin with a precise definition of the specific investment or ownership interest to be valued. The analyst’s function will then be to quantify the value of the “bundle of rights” associated with the investment or specific ownership interest. The characteristics of this bundle of rights heavily impact the value of the investment and provide some indication of the risk and return associated with it. In addition, the more rights associated with the invest- ment or ownership interest, the more valuable it is. Consequently, the analyst also must precisely define the bundle of rights associated with the subject inter- est, or the resulting value (although mathematically correct) may be of the wrong investment. Rights are granted to a specific ownership interest by the underlying state laws that govern the investment to be valued. For this reason, attorneys are best qualified to opine on the characteristics of the bundle of rights associated with the subject investment. To assure accuracy of the legal assumptions on which the value opinion will be based, the analyst may want to include legal counsel in early discussions of the property being valued and the state laws and property rights associated with it. For instance, the value on a per share basis of a 32.5 percent interest in a closely held California corporation and a 33.5 percent interest in the same California cor- poration are not necessarily the same. As discussed in Estate of Luton vs. Commissioner, T.C. Memo. 1994-539, an interest in a California corporation of one-third or greater has the ability to force liquidation under certain circumstances. State Law, Property Rights, and Their Importance to the Valuation Process 505 Accordingly, the liquidation rights associated with the 33.5 percent interest increase its value since an investor may be willing to pay more on a per-share basis for such rights. By way of another example, an assignee interest typically will have the lowest level of rights of any interest, which may include factors such as the following: • A right to receive, to the extent assigned, nonliquidating distributions and liquidating distributions to which the assignor/partner would be entitled as well as a right to receive, to the extent assigned, allocations of income, gain, loss, deduction, credit, or similar item to which assignor/partner would be entitled. • No right to require any information or account of the FLP transactions. • No right to inspect the FLP books. • No right to vote on any matters that a general or limited partner would be enti- tled to vote. • No right to call partnership meetings. • No voice in the management of the FLP. • No ability to maintain an action (lawsuit) against a general partner for breach of fiduciary duty. • No right to withdraw from the FLP and receive fair value for its assignee inter- est prior to the expiration of the term of the partnership. FLP property rights consist of either or both: (1) an ownership interest in the partnership and (2) management rights. Both general and limited partners, as well as their assignees, have no interest in the underlying assets owned by the FLP because these assets are no longer owned directly by the contributing partners. They are now owned by the FLP. The contributing partners received interests in the part- nership in exchange for their contribution of assets and surrendered their ownership interest in the underlying partnership assets. Therefore, an interest in the partnership is considered intangible personal prop- erty and consists of the partner’s share of FLP distributions and the allocation of income, gain, loss, deduction, credit, or similar items, irrespective of the actual phys- ical character of the underlying partnership assets. 506 VALUATION OF FAMILY LIMITED PARTNERSHIPS Once a valuation analyst has a solid understanding of the bundle of rights, he or she is better prepared to determine how to capture their addition to or detriment from value in the subject’s benefit stream, rate of return, discount applied to enterprise value, or a combination of these. Doing this will involve gaining a picture not only of the rights that exist but, more important, of those rights that do not exist. ValTip IMPROPER FORMATION CAN CREATE PROBLEMS FOR PARTNERS A variety of considerations regarding FLP formation have become the focus of recent Internal Revenue Service (IRS) attacks and litigation. These considerations include but are not limited to: • Gifts on formation • Indirect gifts • Subsequent asset infusions • Asset diversification • Real property assessments “Gift on Formation,” Indirect Gifts, and Subsequent Asset Infusions Gifts of assets on the formation of an FLP typically are transferred to the newly formed entity in return for partnership interests (limited and general). As such, it is important that these initial contributions be transferred on the date the FLP is formed and that they have been appropriately valued to provide the desired basis from which to determine the percentage of ownership to attribute to each con- tributing partner. The percent ownership interest received by each partner in exchange for contributed assets should be based on the relative value of those assets and should be reflected in the individual partner’s capital account. Last, the part- nership should be a “straight-up” pro rata partnership with respect to all alloca- tions. Allocations of all items should be based on the partnership interest percent. If assets are not transferred upon formation in return for the same percentage of partnership interest in relation to the assets, there can be an unintended gift of the value differential between the assets transferred and the interest received. “Indirect” gifts typically are created through non–pro rata allocations of income or capital appreciation and/or the attribution of improper asset values to a particu- lar partner’s capital account at formation. When additional assets are transferred to the FLP after formation and the value of the subsequent assets is not attributed to the donor’s capital account, an indirect gift to the nondonating partners can also occur. Asset Diversification When publicly traded securities are contributed to an FLP, it is important to avoid triggering the gain recognition rules under the “Investment Company” provisions of Internal Revenue Code (IRC) § 351. IRC § 721(a) provides that, as a general rule, no gain or loss is recognized by any partner transferring property to a partnership in exchange for an interest in the partnership. However, IRC § 721(b) provides that the transfer of appreciated prop- erty to a partnership that would be treated as an investment company within the meaning of IRC § 351 (if it were incorporated) would not be a tax-free transfer under IRC § 721(a). The section further states that such a transfer would be con- sidered taxable if: • The transfer results, directly or indirectly, in the diversification of the transferor’s interests Improper Formation Can Create Problems for Partners 507 • The transfer is to an entity holding more than 80.0 percent of the value of its assets, excluding cash and nonconvertible debt instruments, for investment in readily marketable stocks, securities, or interests in regulated investment compa- nies or real estate investment trusts Real Property Reassessment Property tax laws in the governing state are of crucial importance when valuing an FLP. Certain transfers of real property into an FLP can give rise to a reassessment of the real property for real estate tax purposes. In certain states, real property tax reassessment may not be triggered by the initial transfer of real property to the FLP but may be triggered by the subsequent transfer of the FLP interests. In many juris- dictions, the exclusions for reassessment that apply to the direct transfer of real property may not apply in the context of the transfer of FLP interests. As a result, in certain situations (usually upon the transfer of 50.0 percent or more of the FLP interests on a cumulative basis) this may result in a reassessment. In addition, some states have a transfer tax on real property exchanges. VALUATION OF FAMILY LIMITED PARTNERSHIP INTERESTS The valuation of an FLP interest involves a number of considerations and steps: Preliminary Considerations • Information required • Analyzing the agreement • IRC Chapter 14 considerations The Valuation Process • Understanding the assets, operations, and financial components of the partner- ship • Data sources, comparative/benchmark information • Valuation approaches • Application of the data and multiples or adjustments Each of these considerations is discussed in depth below. Preliminary Considerations Information Required As with all valuation engagements, the information required to prepare the valua- tion of an FLP is dependent on the facts in the case. However, where available, cer- tain information should be considered the minimum foundation to complete the assignment. This information includes: • Final partnership agreement and all amendments and assignments associated with it 508 VALUATION OF FAMILY LIMITED PARTNERSHIPS [...]... 5,917 2 ,68 2 118 102 $ 8,819 $300,879 868 29,770 37,8 56 174,300 66 ,904 $309 ,69 8 $ Average 0.38% 9.28% 13. 76% 67 .13% 9. 46% 100.00% 0.24% 8.31% 10.98% 43. 26% 37.21% 100.00% 0.38% 10.97% 14.83% 67 .08% 6. 74% 100.00% 0.13% 7.85% 10.80% 40 .66 % 40. 56% _ 100.00% _ 0.00% 11. 06% 12.47% 65 . 96% 10.51% 100.00% (continues) 0.28% 9 .61 % 12.22%... 9 .61 % 12.22% 56. 28% 21 .60 % 100.00% 2000 1999 _ 1998 1997 19 96 1995 _ 0.71% 12.21% 12.10% 71. 76% 3.22% _ 100.00% _ Average $ 59,190 $ 5,500 4,291 80 144 $ 10,015 $254,252 — 29,238 32, 967 174,300 27, 762 $ 264 , 267 2000 $ 56, 650 _ _ $ 6, 000 3,058 33 1 56 _ $ 9,247 _ $419,378 _ _ 541 33 ,64 4 46, 290 174,300... $428 ,62 5 _ $ 1999 _ $2 16, 123 $ 6, 000 5,544 130 72 $ 11,7 46 $248,105 975 28,509 38,544 174,300 17,523 $259,851 $ 1998 $152 ,61 7 $ 6, 000 — 130 82 $ 6, 212 $3 96, 679 982 33,473 44,237 174,300 149,899 $402,891 $ 1997 $ 31, 362 $ 6, 000 3,200 238 97 $ 9,535 $250,120 975 24,101 35,7 16 174,300... 174,300 24, 563 $259 ,65 5 $ 19 96 — _ _ $ 6, 000 — 99 60 _ $ 6, 159 _ $2 36, 739 _ _ $ 1,732 29 ,65 7 29,380 174,300 7,829 _ $242,898 _ 1995 _ Exhibit 12.4 Analysis of Historical Income, Expenses, and Distributions 534 38.47% 87.11% 83.17% 13.51% _ _ 13.22% _ _ 97.84% _ _ 23.28% 22.40% 96. 21% ... interests is fair market value Long-standing regulations and rulings, such as Treasury Regulation 20.2031-1(b) and Revenue Ruling 59 -60 , 1959-1 C.B 237, have provided definitions for fair market value and guidelines for estate and gift tax valuations for more than 40 years and have been referenced in numerous legal cases ValTip If fair market value is the appropriate standard of value, factors influencing... 2001 2000 1999 1998 1997 19 96 0.813 0.750 0 .68 8 0 .62 5 0. 563 0.500 0.438 0.375 0.313 0.250 0.188 0.125 0. 063 0.000 1995 Price/NAV Price to NAV for 13 Selected Partnerships Year Minimum price to net asset value Average price to net asset value Maximum price to net asset value Valuation Approaches The valuation of an FLP interest utilizes the same approaches that are used in the valuation of business interests... provision language Evaluating and Understanding the Financial Components The analyst needs to evaluate and understand the following financial components of a partnership at a minimum: • • • • • • Assets Liabilities Income Expenses Distributions Investment yield The next sections provide an in-depth discussion of these key financial components Assets The analyst needs to understand the underlying risk associated... value For instance, if an FLP is holding undeveloped land instead of an income-producing property, its value will be influenced by the inability of the undeveloped land to generate a return to partners other than through ongoing appreciation and possible liquidation of the asset 5 26 VALUATION OF FAMILY LIMITED PARTNERSHIPS Another reason for understanding the asset base of an FLP is that it can have... provide a return to the partners and, thus, negatively impact value Income, Expenses, and Distributions An FLP’s ability to generate an income stream and provide distributions to partners is important In some cases, the only distribution to partners comes upon liquidation of partnership assets and/ or termination of the partnership Potential investors seek ongoing liquidity and returns Thus, FLP values... Assist in FLP Valuation Numerous sources of information can assist in the valuation of FLPs Some provide empirical data as a basis to understand the difference in value from the underlying assets or cash flow to the interest to be valued These sources include the traditional Valuation of Family Limited Partnership Interests 527 initial public offering (IPO) and restricted stock studies and the Quantitative . maximizing the use of the federal and state estate and gift tax structure. Such efficiency and tax structure benefits are made pos- sible because federal and state laws and regulations treat an ownership. preserve harmony, and avoid the expense and problems of litigation • To maintain control of the family assets 502 CHAPTER 12 • To promote the efficient and economic management of the assets and properties under. to the maximum federal statutory rate of 38 .6 percent. The combined corporate and personal tax rate can easily exceed 60 percent, even before state and local income taxes are taken into account. Alternatively,