CHAPTER 2

Fair Market Value in Estate and Gift Tax

INTRODUCTION

In this chapter, we review the history and development of fair market value and address the elements comprising this standard of value, which is cited more frequently than any other standard of value. In fact, one court remarked:

Disputes over valuation fill our dockets, and for good reason. We approximate that 243 sections of the Code require fair market value estimates in order to assess tax liability, and that 15 million tax returns are filed each year on which taxpayers report an event involving a valuation-related issue.1

Fair market value is a theoretical construct commonly used in judicial valuations. It is the most widely utilized standard of value, as it applies to all federal and many state tax matters, including estate taxes, gift taxes, income taxes, and ad valorem taxes, as well as in certain states for marital dissolution cases and in a few states for shareholder oppression and dissent. In this chapter, our focus is on fair market value as it applies in federal estate, income, and gift tax matters because of the well-developed body of rulings, regulations, expert opinion, and case law regarding each element of this standard of value for those purposes. More specifically, we look at various court rulings that have addressed the theoretical underpinnings of fair market value.

In later chapters of this book, we discuss other standards of value that arise in judicial valuations. These standards, particularly fair value, may best be understood by comparison to the elements of fair market value and the assumptions that follow. Many of the assumptions in those standards are derived from an understanding of fair market value.

Hundreds of sources define fair market value in various ways and provide guidelines for its application.2 Although the term is almost ubiquitous in valuation, there is often little consistency in the underlying assumptions and its application. Recently one commentator noted:

Critics of the term “fair market value” correctly point out that its application is highly uncertain, sometimes with little connection with objective reality.3

These sentiments are not particularly new. In the 1930s, Bonbright commented:

On the whole, . . . however, the courts have preferred to keep the statutory language, fair market value, while not taking its implications too seriously.4

Later in this chapter, we discuss the hypothetical nature of fair market value and its similarities and differences with actual real-world transactions.

Common Definitions of Fair Market Value

Fair market value is probably the most pervasive standard of value that exists. Its popularity stems from its longevity and the considerable amount of attention paid to its theoretical underpinnings.

Although Congress has never defined fair market value,5 Estate Tax Regulation Section 20.2031-1 defines the term in this way:

The fair market value 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 relevant facts.6

These regulations go on to explain that fair market value should not be determined by virtue of a forced sale, nor should it be determined in a market other than that where it is most commonly transacted. This definition clearly places fair market value under a value-in-exchange premise. Therefore, the price in question is the asset's value in a real or hypothetical exchange rather than its value in its current state to the current owner.

The International Glossary of Business Valuation Terms defines fair market value similarly, going into slightly more detail:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.7

Although this definition is somewhat different from the one in Estate Tax Regulations, it expresses many of the same underlying assumptions. Willing buyers and sellers are assumed to be able, and transactions are assumed to take place at arm's length.

Interestingly, later in this chapter we will see that British and Canadian courts include the term highest price in their definition of fair market value for business and real property valuation. Thus, in Britain and Canada, unlike in the United States, potential synergies8 can be reflected in fair market value. In the United States, there continues to be an ongoing debate between analysts as to whether potential synergies should be included in a valuation9.

History of Fair Market Value

While most practitioners are familiar with the definition of fair market value as it appears in the Internal Revenue Service's (IRSs) Revenue Ruling 59-60, the term fair market value has its roots in the early nineteenth century. One of the earliest mentions of fair market value is from a case involving a false invoice on 14 packages of pins shipped from England to the United States, discussed next.

United States v. Fourteen Packages of Pins

In the 1832 case of the United States v. Fourteen Packages of Pins,10 a case dealing with tariffs, the court questioned a discrepancy in invoices prepared on two different dates in two different cities prior to the shipment. The earlier invoice, printed as a regular bill of sale between the buyers and sellers in London, showed a higher price than the later invoice printed in Liverpool, the city from which the pins were shipped.

Because of the discrepancy, the United States looked to prove that the second invoice was created only for the purpose of defrauding the ad valorem tax on the shipment. The judge instructed the jury in this way:

All the evidence which has been given of prices, or market value, or fair market value, or current value, or true value, or actual value, is to bring you to the same conclusion, to a satisfactory answer to the question you are trying, to wit, is the valuation of these goods in this invoice a “false valuation,” which is the offence described in the act of congress of 1830, on which this information is founded? Were these goods really worth more in the London market? Were the buying and selling prices higher in that market than those charged in this invoice, at the time when this invoice was made up? However the phrases may vary in the different acts of congress, current value, actual value, or market value, the inquiry with you always is the same; does this invoice contain a true valuation of these pins, or a false one? The phraseology of the laws is important on this issue, only as it may assist you in answering and deciding the question whether these pins, or similar pins, were bought and sold in the London market, in June, 1830, at these prices? Or is the valuation false and untrue, and the prices not those at which such pins were bought and sold at that time and place? You are not to take a sale under particular circumstances which may have depressed or raised the price, but the fair and just price of buying and selling in the market.11[emphasis added].

The jury found in favor of the United States.

Although United States v. Fourteen Packages of Pins introduced the term and the principle of an uncompelled fair and just price, other elements of fair market value evolved along with tax law in the United States. To put this evolution into context, we provide a short background on the institution of federal taxes from the late eighteenth to the early twentieth century and look at the development and purpose of various taxes that were instituted (and in some cases repealed) during this period.

In the late eighteenth and early nineteenth century, the states experimented with various taxes to raise revenue, including tariffs, property taxes, and progressive income taxes. By the Civil War, most states had instituted a property tax that covered not only real estate and fixtures but also intangible personal property, such as cash, credits, notes, stocks, bonds, and mortgages. The government also relied considerably on tariffs to raise revenues. During the Civil War, the need to bring in revenue to fund wartime expenditures led the Republican Congress to increase tariffs and excise taxes. This led to the creation of the Office of the Commissioner of Internal Revenue.12

In a further attempt to raise money to fund Civil War expenditures, in 1862 the federal government instituted an income tax. The first income tax imposed a basic rate of 3% on incomes above a personal exemption of $800. Subsequently, the tax was modified to impose a 5% tax on incomes between $600 and $5,000 and 10% on incomes over that level. In 1865, the income tax produced 21% of federal tax revenues. After the war, however, more affluent citizens lobbied Congress to discontinue the tax. In 1872, the tax was allowed to expire, but high tariffs and certain taxes on alcohol, tobacco, and luxury items remained in place from the Civil War tax system.13

When the Democrats took control of Congress in the 1890s, they attempted to again raise an income tax affecting mainly the wealthiest families. However, because of the direct nature of the tax and the fact that the federal government had failed to allocate the tax across states according to population, the tax was ruled unconstitutional in the 1895 Supreme Court decision Pollock v. Farmers' Loan and Trust Co.14

In 1888, the idea of taxing an estate for an intergenerational wealth transfer was raised by economist Richard T. Ely, who believed that each person should start equally in the race of life. The nation's wealthiest citizens viewed the tax as less threatening than an income tax, and some supported the idealism embodied by the tax. This led the Republican leadership to institute the tax in 1898, when funds were needed for intervention in the Boxer Rebellion among other conflicts. The tax was repealed in 1902.15

Over the following years, support for taxation grew. In 1913, the Underwood-Simmons Tariff Act reestablished the income tax and established a “normal” rate of 1% on nearly all personal and corporate income with a personal exemption of $3,000. After several years of income tax, about 2% of American households paid taxes.16 The Sixteenth Amendment to the Constitution allows Congress to levy taxes without apportioning among the several states and without regard to any census or enumeration.17 The amendment was ratified on February 3, 1913.

In Bank One Corporation v. Commissioner,18 Judge David Laro traces the modern history of fair market value and the establishment of the IRS. A summary based on the material presented in Judge Laro's decision follows.

Fair market value's modern history begins with the implementation of the modern income tax with the Revenue Act of 1918.19 This act provides that, for purposes of determining gain or loss on the exchange of property, the value of any property received equals the cash value of its fair market value.

Over time, various judicial tribunals defined the term by articulating certain elements that should be addressed in a determination of fair market value. The Revenue Act of 1918 created an Advisory Tax Board, whose function was to advise on the interpretation or administration of income, war profits, or excess profits tax.20 While this board was in existence for only a short time, in 1919, it recommended that fair market value should be the “fair value that both a buyer and a seller, who are acting freely and not under compulsion and who are reasonably knowledgeable about all material facts, would agree to in a market of potential buyers at a fair and reasonable price.”21

Soon after, the Board of Tax Appeals, the predecessor of the current Tax Court, was formed by the Revenue Act of 1924.22 In a 1925 decision, this board described the buyer and seller as “willing” in a fair market value context.23 In the same decision, the board advised on subsequent events, stating that the fair market value must be determined without regard to any event that occurs after the date of valuation.

Two years later, the Board of Tax Appeals adopted the Advisory Tax Board's opinion on the willingness of the buyer and seller under no compulsion.24 The Board of Tax Appeals soon after adopted the concept that the buyer or seller in question was not a particular person, but a hypothetical person mindful of all the relevant facts.25

In the 1930s, the concept of the “highest and best use” for the subject of the valuation was recognized as a requirement for fair market value of real property, when the court held that two adjacent pieces of land should be valued at the same per square foot, regardless of the fact that one was being used in its highest and best use while the other was not.26 While the term highest and best use is generally used in real property valuations, it is not explicitly used in U.S. business valuations but rather covered under the assumption that the business should be operated to maximize its shareholders' wealth. As will be discussed, Canada and Britain utilize the concept of highest and best use in business valuations.

The next section decomposes the definition of fair market value and discusses some of the issues that have arisen in interpreting it. We also highlight several important cases and IRS Revenue Rulings that have enhanced our understanding of fair market value. Further, we discuss the implications of each element of the definition and their effects on the appraisal process. Throughout the chapter, we look at these elements through the prism provided by various tax cases that have addressed this issue.

ELEMENTS OF FAIR MARKET VALUE

We begin by looking at the elements of value applicable in fair market value, the basic assumptions that the elements provide, and one court's view of how elements of value affect the ultimate valuation. We then decompose the definition and define its constituent parts:

• Price at which a property would change hands
• The willing buyer
• The willing seller
• Neither being under any compulsion
• Both having reasonable knowledge of the relevant facts
• Valuation date and use of subsequent events

Price at Which a Property Would Change Hands

Premise of Value

Determining fair market value requires the establishment of the premise of value to understand exactly how the business should be valued. The general premise driving the theoretical underpinnings of fair market value is that fair market value is a value in exchange. This value in exchange is estimated whether the property is offered for sale or not; it is presumed to be for sale in a hypothetical transaction at a point where there is a meeting of the minds between a willing buyer and willing seller. As such, fair market value presumes the property is exchanged for cash or cash equivalents in a hypothetical sale consummated between a willing buyer and willing seller. Simply stated, when the property is sold, the seller gets cash and the buyer gets the property.

How will the property be sold? The valuation of an ongoing business is usually conducted under the premise that the business will continue as a going concern. The going concern premise provides the framework that drives the other assumptions in the appraisal process. In other situations, a business may be valued under a liquidation premise. It may be liquidated and broken up for the value of its underlying assets.

The value in exchange presumption is different from the premise of value concerning the operational characteristics of the enterprise (i.e., going concern or liquidation). As it applies to the enterprise, the premise of value is the value of the business in a hypothetical sale either operating as a going concern or, when appropriate, in liquidation. Those are two different concepts: Value in exchange deals with the base from which the property is valued, whereas consideration of the enterprise as a going concern or in liquidation deals with operational characteristics of the business rather than the ideological framework of the valuation.

Under the value-in-exchange premise, a business can be viewed as a going concern or in liquidation, a determination that can depend on a number of factors, including the nature and condition of the company and the prerogatives of control inherent in the interest being valued. A company may be worth more in liquidation than as a going concern. In making such an assessment, the practitioner may consider the likelihood of liquidation (and the rights of the shareholder to liquidate). Such was the issue in Estate of Watts v. Commissioner.27

This case has been distinguished from cases where partnership agreements have differing requirements upon the death or departure of a partner, including less clear guidance on the continuation of the corporate form at the shareholder's death.28 As we have discussed, the particular facts and circumstances of a given case may have substantial effects on the final outcome.

Price versus Value: Cash or Cash Equivalent

The definition of fair market value begins with finding the price at which a property would change hands in a transaction. Black's Law Dictionary defines price as “The amount of money or other consideration asked for or given in exchange for something else; the cost at which something is bought or sold”;29 value is defined as “1: the significance, desirability, or utility of something to the general public. 2: The monetary worth or price of something; the amount of goods, services, or money that something will command in an exchange.”30

Although these definitions use the terms price and value interchangeably, they are not always viewed to mean the same things. As discussed in Chapter 1, there can be a significant difference between price and value. The important issue is that the first element of the definition of fair market value establishes that the premise of value is a value in exchange. As we have indicated, value is determined in a hypothetical transaction regardless of whether the asset is expected to be sold. Moreover, the term price requires a single-point estimate, not a range of value. As will be discussed, value is determined at the single point where the expectations of the buyer and the expectations of the seller meet. The point estimate is viewed in terms of cash or cash equivalent. The concept of cash and cash equivalency is a critical component of this standard of value. The fact that the definition of fair market value refers to price generally indicates that value should be expressed in terms of money or money's equivalent, that is, cash today or the present value of future consideration.

This is an important distinction in that many real-world transactions take place in stock for stock deals that may be either more or less valuable than a cash transaction.31 By receiving stock, the seller is subject to more risk because of the lack of immediate liquidity of the stock. Therefore, while there may be, over time, an upside to this form of payment should the stock appreciate, there is also the possibility that the stock will decline in value. This risk does not occur in an all-cash transaction, nor are the potential gains available with stock available with cash. The fair market value construct does not allow the kind of flexibility seen in real-world transactions, as all of these considerations are impounded in a single-point estimate.

Willing Buyer

Marketplace

The value at any particular time is the result of supply and demand, and is always that which is necessary to create a market for the existing supply.32

By definition, fair market value will be the price a hypothetical willing buyer and a hypothetical willing seller will arrive at after successfully negotiating a sale of the property or asset in question.33 This theoretical meeting of the minds needs to occur in some kind of marketplace. As stated by a 1923 case in the Third Circuit, Walter v. Duffy,34 the existence of a market suggests the existence of both supply and demand for a property. Offers to sell without buyers to buy are not evidence of fair market value, and neither are offers to buy without anyone willing to sell.

A marketplace should not be made up only of sellers, nor can it be made up only of buyers. While the buyer is viewed as willing, this buyer will buy only for a rational economic amount. Similarly, sellers will sell only for a rational economic amount. A market will be created only when the rational economic analysis of value intersects between buyers and sellers.

The most probable market for a business may not be easily identifiable. Minority shares in closely held corporations are usually not readily marketable. In the case of various closely held businesses or business interests, there may be no readily apparent market or probable buyers or sellers. The courts typically look for evidence of what a willing buyer and seller would agree on if they indeed existed. The court in Alvary v. United States,35 for example, suggested that there is a difference between value and liquidity, and a lack of readily accessible buyers does not mean that they do not exist. The risks of a private corporation may be higher due to the lack of liquidity, but in turn there may be a higher potential for reward. A willing buyer of a private corporation will look to analyze the same information that a willing buyer of a public corporation would, comparing its risks and returns to other potential uses for that investment.

Individual Buyer or Pool of Buyers

On the surface, in a strict fair market value interpretation, a marketplace of hypothetical buyers and sellers will bid and eventually reach an agreeable price. The marketplace, however, may be made up of a variety of different types of buyers.36 There might be entrepreneurs looking to continue the business on their own. There might be financial buyers who see the business as a good investment. There may also be synergistic buyers who see a conjunctive value with other acquisitions or owned assets.

As discussed earlier, the Estate Tax Regulations require that the value of the property be measured in the market where it would most likely be sold. When assessing the price that a hypothetical willing buyer would pay, the practitioner seeks to identify that marketplace. By definition, buyers are presumed to have reasonable and relevant knowledge of the facts. This reasonable knowledge will include an understanding of prior transactions and identification of other shareholders. There may be an instance in which only a specific pool of buyers make up the usual marketplace for a certain block of stock. The practitioner should carefully analyze the marketplace so as to identify who would constitute the most likely pool or pools of potential buyers.

The issue of marketplace was addressed in the Estate of Newhouse v. Commissioner,37 where the valuation involved a block of common stock in a large media conglomerate.

Later, in Estate of Mueller v. Commissioner,38 the court identified a characteristic of the market by stating: “We assume that the potential buyers of the shares would bid up the price of the shares until the person who values the shares most highly . . . wins the bidding.” However, the court also stated that it need not identify a particular potential buyer or class of buyers, as the concern in determining fair market value should be the hypothetical buyer. This suggests that regardless of who the bidders are, the highest price a bidder is willing to pay may be higher than what the market would bring. Indeed, many valuation practitioners believe that fair market value would be best expressed by the amount the second-highest bidder would pay.

Alternatively, according to Estate of Winkler v. Commissioner,39 the willing buyer does not and, indeed, should not necessarily belong to a particular group of individuals. This case addressed the situation when the block of stock in question is 10% of the voting shares of a corporation, where one family held 50% of the company and another family held 40%. These shares could be considered a swing vote, and the court decided that the willing buyer should not be identified as a member of either family, but, instead, the stock should be viewed as an independent unit and valued as if an independent third party were the potential buyer.

Even in a hypothetical transaction, the court may be sensitive to the real owners and the particular facts and circumstances of a given case. This may influence the final determination of value more than the requirements of any stated standard. The court's view of who constitutes a willing buyer appears to be greatly influenced by the facts and circumstances of each individual case.

Synergistic Buyers

When a controlling block of shares is the subject of valuation, a willing buyer with reasonable and relevant knowledge of the marketplace will understand that there may be synergistic buyers bidding for the business. These synergistic buyers may give up a portion of the synergistic value to the sellers in order to outbid other buyers.40 It should also be pointed out that certain synergies are inherent in most acquisitions, as there most likely will be certain cost savings. It is not all synergies that are at issue, but those synergies typically not available to the typical willing buyer.

Some believe that there is an interrelationship between the synergistic value to a seller and the highest and best use to a buyer. The 1936 case of St. Joseph Stock Yards Co. v. United States41 introduced the concept of the highest and best use in real estate valuations. Interestingly, the term highest price is used as part of fair market value in Canadian business valuations. The Canadian definition of fair market value is:

The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.42

British and Canadian courts view fair market value as the highest price that could be achieved upon sale, as there may be consideration of a purchaser willing to include the value of synergies in their offer. Courts in the United States generally look to consider synergistic buyers in the context of investment value.43 However, many courts have looked to determine the highest bid price that could be achieved by willing buyers. Both U.S. and Canadian practitioners acknowledge that if, in addition to ordinary purchasers, several special-interest purchasers are involved in the bidding, the market itself will eventually exclude the ordinary purchasers as the new equilibrium price would reflect the synergistic value.44

In Canada, if a willing and able strategic buyer can be identified, a strategic purpose premium may be added to the standalone fair market value to reflect the additional amount a strategic purchaser would pay, although that premium would be difficult to quantify. However, cases in both Canada and Great Britain do not allow a hypothetical strategic purchaser.45 Instead, in order to apply a strategic premium, there must be evidence that an actual purchaser exists, has made an offer, is able to pay that price, and that these facts were known publicly.46

Although Canada has the “highest price” requirement, a premium is not necessarily required to reflect the highest price. A single strategic purchaser will not have to pay far above the fair market value to outbid regular market purchasers. If there were others willing to compete with the strategic purchaser at the higher price, a new market would be created where the equilibrium price will reflect any strategic premiums.47

In Mueller v. Commissioner,48 the court looked to an expert analysis to determine the fair market value of a family corporation that was in the midst of a sale at the time of the decedent's death. The court received three separate valuations, one of which represented a range of values over which the fair market value could fall. All of these valuations considered a discount from the executed purchase price (due to uncertainty of sale and illiquidity) a few months after the decedent's death. One expert asserted that the willing buyer would be looking to obtain the low-end price and the willing seller would be looking to obtain the high-end price, and then averaged the two to find the fair market value. The court did not accept the midpoint in the range, but instead considered an auction-based environment, where the willing buyers will outbid each other until a maximum bid price is reached. The court ultimately accepted the high-end value.

The case of BTR Dunlop Holdings, Inc. v. Commissioner49 addressed the issue of whether synergistic buyers should be considered as a factor in determining fair market value.

Valuation practitioners do not have the luxury of knowing whether the buyer with the highest synergistic value will prevail. Typically, no buyer is going to offer more than the market clearing price, and there may be several buyers willing to pay that price.50 In a fair market value context, by assuming reasonable knowledge and ability to negotiate at arm's length, it is likely that if synergistic buyers are available, they will bid to reach the highest price available for a business.

Roger Grabowski has pointed out:

The first step in estimating fair market value should be assessing the make-up of the likely pool of hypothetical willing buyers. In this author's experience, the pool differs in cases where one is valuing a minority interest in a closely held entity versus cases where one is valuing controlling interests or entire closely-held companies.51

Knowledge of the marketplace for willing minority buyers typically includes the identities of the other shareholders and the blocks of stocks owned by those shareholders. When valuing controlling interests in closely held businesses, the valuation consultant should study the market of potential buyers, including entrepreneurs or financial buyers on the one hand or a pool of potentially synergistic or strategic buyers on the other hand.52

Unfortunately, there is no conclusive guidance on whether potential synergies are applicable in every determination of fair market value. Whether synergies are a relevant consideration will depend on the facts and circumstances of the case.

Valuation of Different Classes of Stock

An interesting issue arises when valuing different types of stock held by one person. Nonvoting shares are generally less valuable than those with voting power and are generally valued at a discount when valued as standalone shares. However, when held in conjunction with control voting shares of a corporation, are they any less valuable to a potential willing buyer? The question is, would the buyer purchase one block of stock (both voting and nonvoting) at one price, or would the stock be considered as two blocks because of the two types of shares within? The Estate of Curry v. United States53 addressed this issue.

Estate of Simplot v. Commissioner56 is another example of a case dealing with the valuation of different classes of stock.

This holding should not be confused with the treatment of discounts addressed in Revenue Ruling 93-12 (family attribution). This Revenue Ruling addresses the situation where the holder owns a noncontrolling share of stock, but the family as a whole owns a control share (either before or after the decedent's shares are acquired). This ruling instructs that the gifted or bequeathed shares should not be valued as a family unit, but should be valued in their form as held by the estate. Revenue Ruling 93-12 also specifically refers to a corporation with a single class of stock, and therefore is not in conflict with either case just described.57 The ruling refers to the particular buyer or seller, while the “one-block” concept may be applied to any willing seller owning both classes of stock.

Willing Seller

Like the willing buyer, the willing seller considers certain information before deciding to engage in a transaction, including liquidity, alternative uses for the investment, future cash flows, and risk.58 A willing seller is one who can be convinced to sell for the right price, for a variety of reasons, including gaining liquidity or desiring the ability to invest in a higher-yielding investment. The hypothetical buyer evaluates the same economic and financial conditions as the seller. Therefore, when a hypothetical seller chooses not to sell, theoretically, he or she willingly buys the asset by retaining the interest with the asset's existing opportunity costs and associated liquidity (or illiquidity). The owner prefers owning the property to the alternative of selling it.

The Tax Court has been critical of those who view fair market value from only the perspective of the buyer. Both the buyers' and the sellers' perspectives should be considered. In the case of Mandelbaum v. Commissioner,59 the court addressed one expert's overreliance on a willing buyer while ignoring the need for a willing seller.

EXHIBIT 2.1 Factors and Adjusted Benchmark Percentages in Mandelbaum

This case points out that consideration of a willing buyer is not enough. A willing buyer seeking stock in Big M would likely demand a large discount on its value based on the family nature of the company and the agreements in place. However, if shareholders of Big M were willing to sell, that might lead to a substantially different value.

Another example of having to consider the willing seller is the recent case of Giustina v. Commissioner.60

Earlier we briefly discussed the family attribution principle in Revenue Ruling 93-12. This issue is best understood from the point of view of the willing seller. In the case of Bright v. United States,62 the government attempted to add a control premium to non-controlling shares of the decedent's wife because the husband owned the balance of the shares that would add up to a controlling value when combined with the wife's shares. The government claimed that the husband would not be willing to sell his 27.5% of the shares unless it was part of the 55% control block combined with the decedent's shares. The court cited several cases where this type of family attribution was rejected, ultimately rejecting the government's argument and affirming the district court's ruling that the interest to be valued was only the 27.5% common stock interest. This brings us back to the fact that a seller is a hypothetical willing seller, selling in a hypothetical market, rather than a specific individual selling in a specific market. The question was not the value the estate would accept if it held 27.5% of shares that could potentially be sold as part of a 55% control block, as the government contended, but instead the value that a willing seller would accept for 27.5% of a property's shares.

A similar issue was discussed in the case of Propstra v. United States.63 In this case, the Court of Appeals addressed issues of the willing seller and control as well as of the effect of subsequent events on claims against property.

No Compulsion to Buy or Sell

In the real world, the parties involved in a transaction may be compelled to buy or sell based on involvement in bankruptcy or insolvency, a need for immediate liquidity, the need of an immediate sale for charitable purposes, or a variety of factors.65 This is another reason that a sale price in and of itself is not necessarily evidence of fair market value. In a fair market value transaction, the buyer and seller have equal negotiating power. The buyer is looking for the lowest price at which to buy, and a seller is looking for the highest price to sell.66 There will be competition in the marketplace from other bidders willing to offer a higher price or from other sellers willing to sell for less. The fact that there is no compulsion to sell also suggests that the company be valued with ample exposure to an appropriate market, rather than in a forced liquidation.67

In the 1923 Tax Court case Walter v. Duffy,68 the court addressed the value of stock in what was judged to be a forced liquidation.

There may be many types of compulsion. Financial pressure might cause a buyer or seller to act more quickly, thereby causing insufficient exposure to the marketplace. In the case of Troxel Manufacturing Co. v. Commissioner,69 the sale of the property was seen to be made in haste, as the seller was in urgent need of cash and had to sacrifice a particular property at a price less than its supposed real value. The court in that case decided that the sale was not an arm's-length transaction and that the price reached was not representative of fair market value. However, the desire for cash in lieu of property may be viewed by some as a preference rather than compulsion, as represented by the dissenting opinion in McGuire v. Commissioner,70 where a dissenting judge states that a seller is not necessarily unwilling if the decision to sell is a matter of wanting cash over property.

Importance of Restrictive Agreements

Transactions in a hypothetical market may not be subject to the restrictions that may exist on an open market. That does not mean, however, that these restrictions cannot or should not be considered in a fair market value transaction. Instead, buyers are often assumed to account for these restrictions in assessing the value of the business interest because they themselves will be subject to these restrictions after purchase.71

Internal Revenue Code (IRC) § 2703(b)72 sets forth four general considerations in determining the applicability of a buy–sell agreement to fair market value.

The courts generally have respected restrictions on transfers in determining fair market value, often applying discounts for lack of marketability. In some divorce cases, great weight is afforded restrictive agreements in determining value as long as that agreement is kept current and is used regularly in the course of business; other cases have found these agreements to have no true influence on value as they have never been used. The Tax Court was confronted with the issue of a restrictive agreement in the Estate of Lauder v. Commissioner.74

Another significant case, Estate of Joyce Hall v. Commissioner,75 may be distinguished from Lauder in its consideration that the fair market value of a corporation is affected by certain restrictions in the shareholder agreements. In this case, the agreements were not found to be in place simply for the purpose of an intergenerational wealth transfer.

Alternatively, the value set by a restrictive agreement was ignored in Estate of Obering v. Commissioner.76 In this matter, the agreement gave the first option to the corporation and the other shareholders to purchase the stock at a set price, but allowed sale to the public should the corporation or the shareholders not elect to make the purchase. Because the agreement did not completely exclude a third party from purchasing the stock, the court precluded its representation of fair market value.

In addition to the requirements set forth by IRC section 2703(b),77 buy–sell agreements are scrutinized for their reasonableness, whether they are periodically reviewed, and whether the price arrived at is representative of an arm's-length transaction. This is especially important when the shares of a company are held by family members, where often buy–sell agreements are viewed as testamentary devices that transfer shares at artificially low values. The courts will likely also look at the events and circumstances surrounding the execution of the agreement in determining whether it is a valid agreement. These events might include relationship of the parties, the purpose of the agreement, and the source of the agreement price.78

Reasonable Knowledge of Relevant Facts

Known and Knowable

Fair market value requires that both the willing buyer and the willing seller be reasonably informed of the relevant facts affecting the property in question. This information is generally referred to as that which was “known or knowable” at the valuation date. As discussed earlier, in determining fair market value, a reasonable degree of knowledge is assumed. A valuation at fair market value should include information that is known by any party to the transaction as well as any information that may not be apparent at the valuation date but would have been knowable at that time by the parties involved.79

The Fifth Circuit Court of Appeals case United States v. Simmons80 demonstrates that value may exist, even if it is unknown at the valuation date. In this case, after the decedent's death, the estate hired an accountant to investigate the decedent's tax filings. After discovering evidence of a deficiency payment made in error, the estate filed a claim for a refund. In the meantime, when the estate filed its estate tax returns, it assessed the claim at no value because there was no certainty that it would ever have any value. Eventually, the claim did settle for $41,187. In a trial to determine whether the $41,187 should be included in the estate, the jury found that the claim had no value at the decedent's death. The Court of Appeals did not agree. The court reasoned that even if the fact that the claim had value was unknown, the estate suspected that value existed because it retained professionals to investigate the decedent's tax records. Consequently, the Court of Appeals ruled that, although the estate may not have known that value existed, value (even if not in the full amount of the settlement) did indeed exist at the time of death.

Reasonable knowledge (as intended by the definition of fair market value) does not require that a buyer have all information and be totally informed, as some previous revenue procedures have suggested.81 Additionally, Revenue Ruling 78-367 suggests that sellers will overemphasize the favorable facts and buyers will attempt to elicit all the negative information pertaining to a sale. These are two extreme views. In the real world, the requirement of perfect knowledge is likely to be unachievable. In determining fair market value, only reasonable knowledge of the relevant facts should be assumed. Therefore, cases addressing this point have insisted only on reasonable knowledge of the relevant facts.82 As one commentator noted:

Reasonable knowledge is a level of awareness that usually falls somewhere between perfect knowledge and complete ignorance—even if the actual owner of the property is at one extreme or the other.83

Estate of Tully v. United States84 held that knowable information that may not be known by the owner can affect the determination of value. In this case, the decedent was not aware that company officials had been illegally rigging bids for contracts with the company's biggest customer. This information came to light four years after the valuation date. The court viewed the bid rigging as a knowable event (although unknown) that could affect value at the valuation date. The court reasoned that information was available at the valuation date that could have led to the discovery of this wrongdoing, particularly, that the gross profits of the business were so high compared to industry standards that careful inspection of the records could have led to the discovery of this impropriety. Therefore, in determining the company's value, the court discounted the value by 30% due to the information that could have been discovered on the valuation date with proper investigation.85

Postvaluation-Date Information and Subsequent Events

Since valuation is as of a particular point in time, practitioners are required to reach their conclusions based on information that is known or knowable (or reasonably foreseeable) at the valuation date. Typically, in a retrospective valuation, postvaluation-date information may be available. Subsequent events that were foreseeable at the valuation date may be considered in a valuation. However, if an event was completely unforeseen at the date of valuation, it is generally not considered. Although the practitioner might want this data to have been available at the valuation date, the possibility of occurrence is not the same as a recognizable probability, and it is important for the practitioner to use judgment in determining that information was truly knowable as of that time. A court may go to great lengths to determine what was known or knowable at the valuation date regarding information or factors affecting value.

The Tax Court's decision in the case Couzens v. Commissioner86 described the ability to include subsequent events if indeed they were reasonably foreseeable at the date of valuation. The court stated:

Serious objection was urged by [the government] to the admission in evidence of data as to events which occurred after [the valuation period]. It was urged that such facts were necessarily unknown on that date and hence could not be considered. . . . [I]t is true that value . . . is not to be judged by subsequent events. There is, however, substantial importance of the reasonable expectations entertained on that date. Subsequent events may serve to establish that the expectations were entertained and also that such expectations were reasonable and intelligent. Our consideration of them has been confined to this purpose. [Emphasis added]

The issue of what was known or knowable as applied to the financial results of the company and its publicly traded counterparts is one that practitioners often encounter. What happens when the valuation date is a few weeks or months prior to the formal issuance of certain financial information? This issue was recently addressed in Gallgher Estate v. Commissioner.87

In Gallagher, the issue was which financial statements for the company and its publicly traded counterparts should have been used. The date of death was July 5, 2004. The appraiser hired, on behalf of the IRS, used internally generated financial statements for the period of June 27, 2004, and financial information for the guideline public companies for the quarter ended June 30, 2004. The Estate's appraiser used the latest (at July 5, 2004) issued internally generated financial statements as of May 30, 2004, and data for the guideline public companies as of the closest quarter, or March 28, 2004, under the assumption that the participants in the hypothetical transaction would not have known of the latest financial statements.

The Tax Court agreed with the IRS expert that the June 2004 financial statements should have been used in valuing the decedent's units. The court opined that, although the June financial information was not publicly available as of the valuation date, the “hypothetical actors”88 could make inquiries of both the subject and guideline public companies and elicit non-publicly available information as to the end-of-June conditions. Further, the court indicated that the June 2004 financial information accurately depicts the market conditions on the valuation date and that there were no intervening events between the valuation date and the June financial statements that would cause them to be incorrect.

This is another example of a court going beyond what was technically known or knowable to reach an equitable conclusion.

Other cases in the Tax Court have dealt with unexpected windfalls after the valuation date. In the case of Ridgely v. United States, the decedent owned a 368-acre farm valued at $372 per acre.89 Around the time of death, the family tried to sell 40 acres of the farm to a local school board for $3,000 per acre. The family reduced the sale price to $2,000 and finally to $1,000. The school board declined to purchase the land because the location was not desirable. The decedent died in January 1962. In February of that year, General Foods began a search for land for a new Jell-O plant. In May 1962, General Foods purchased 112 acres of land for $2,700 per acre. While the IRS claimed that the entire tract was worth $2,700 per acre, the court did not consider the General Foods transaction as an indicator of value, as no one could have foreseen the purchase at the time of death.

As mentioned previously, in the Estate of Tully, the court allowed the use of postvaluation-date information some four years after the valuation date to determine what was knowable at the valuation date.90 The courts have generally acknowledged that evidence of value at the valuation date may be considered, while events affecting value after the valuation date, which were not reasonably foreseeable, are generally not considered.91 An example of this is the case of Estate of Jung v. Commissioner, where the price of a postvaluation-date sale was used to value the company.92

Similarly, in Estate of Scanlan v. Commissioner,93 prior to the decedent's death, shares were gifted to six family members and appraised at $34.84 per share. The date-of-death value was $35.20. Both figures included a 35% marketability discount derived by comparison with publicly traded companies. After the decedent's death, the company received an offer of $75.15 per share, and family members exercised their right to have the company buy out any other shareholders at that price. The IRS considered this information and valued the stock at $72.15 per share and applied a 4% minority discount. The family argued that the offers were for the entire company, not the estate's minority share. As it was so near the valuation date, the court allowed the offer to be considered, but then applied a 30% combined minority and marketability discount and arrived at a value of $50.21 per share.

The same issue was addressed in Estate of Cidulka v. Commissioner,94 where a sale of a commercial billboard corporation four years after the date of death was utilized to establish fair market value. The court acknowledged that four years may be considered too remote to have bearing on the valuation of the stock at the earlier date, but the multiplier for the later sale was similar to that of the sales of comparable companies around the valuation date, and therefore the evidence of the later sale was applicable to the valuation at the valuation date. As will be seen in the next chapter, in some venues this principle has been extended to the determination of fair value in dissenting shareholder actions.

Generally, the courts are careful to note whether later events have changed the value of the property. The distinction between a subsequent event affecting value as contrasted with the event providing evidence of value may be best illustrated by an example set forth in the case of First National Bank v. United States.95 The court stated:

For instance, if the proposition advanced is that a farm had a Fair Market Value of $800,000 on March 13, the fact that oil was unexpectedly discovered on June 13 (causing the Fair Market Value of the property to skyrocket) makes the proposition advanced no more or less likely. However, the fact that someone under no compulsion to buy and with knowledge of the relevant facts bought the property on June 13 for $1,000,000 is relevant, for it makes the proposition advanced (i.e., that the Fair Market Value on March 13 was $800,000) less likely.96

As can be seen, the use of postvaluation-date information dealing both with events that affect value (known or knowable) and with those that provide evidence of value (subsequent transactions) depends on the facts and circumstances of each particular case. Indeed, a plethora of cases have addressed this issue. Exhibit 2.2 presents a compendium of cases compiled by Michael Mard of the Financial Valuation Group dealing with subsequent events in estate and gift tax cases. The cases on this list span from 1929 to 2005, and the chart references the key considerations of each decision. The list should be viewed as informational and not an endorsement of the treatment of the subsequent event. The practitioner should be well advised to use this list as a starting point for the inquiry as it is not to be considered as definitive.

EXHIBIT 2.2 Compendium of Cases

The cases listed in the exhibit provide evidence that courts do consider events occurring after the valuation date. Actual factors considered by the court range from later sales of the asset in question to later sales of comparable companies.

In any case where a transaction occurred after the valuation date and was substantially different from the estimate of value at the valuation date, the analyst would be well advised to attempt to reconcile the two values. This reconciliation could include changes in market conditions, control versus minority status, or a variety of other factors.

Notional Market

As previously noted, judicial valuations make up only a small percentage of price determinations. In the market, every day, supply and demand dictate price in the thousands of transactions that take place, and these transactions largely influence the judicial valuations that follow.97 Judicial valuations do not, however, take place in a vacuum, and the court generally uses wide discretion, regardless of the stated standard of value to achieve what it perceives as an equitable result.98

In the case of Andrews v. Commissioner,99 the court acknowledged that in reality there was a likelihood in the closely held corporation at hand that the stock would be sold to identifiable parties. However, cases like Bright v. United States100 have clarified that while not completely independent of real-world factors, fair market value must be determined with respect to that which a hypothetical willing buyer and seller (who are assumed to exist) would pay for the property rather than that which an actual or specific buyer would pay.

As we have discussed, fair market value transactions do not necessarily take place on the open market. The notional market is a concept that is used mainly in Britain and Canada to distinguish a hypothetical market for the determination of fair market value from a real one where transactions are actually consummated. The requirements of fair market value may not always reflect what would happen in the open market, nor is it usually possible for a completely hypothetical sale to stand on its own without any real-world forces.

The notional market looks to identify a sale price without an actual sale.101 This may occur in the context of an estate or gift tax filing, divorce, the appraisal remedy, commercial litigation, or a variety of other valuations that do not involve actual sales of property.102 Although a British and Canadian concept, the notional market represents many of the underlying assumptions of fair market value in the United States.103

In an open market transaction, the buyers and sellers are identifiable and negotiations between them eventually will lead to an agreed-upon price. In a notional market, the buyer and the seller are not any one person or entity in particular; therefore, the pool of potential buyers is larger. In the notional market, buyers and sellers are assumed to be at arm's length and willing, even though in reality they may not be.104

In addition, while on the open market the buyer and seller may pursue the information necessary to make an informed sale, on a notional market there is an assumption that both buyer and seller have reasonable knowledge of relevant information. In United Kingdom and Canadian fair market value cases, full knowledge is assumed. In the United States, only reasonable knowledge is required.105 In the open market, due to earnouts, contingency payments, and similar deal structures, there are occasions when the final price is not known at the date of sale. In the notional market, these types of payments must be estimated at the valuation date.

Exhibit 2.3, prepared by Jay E. Fishman and Bonnie O'Rourke, compares the elements of a notional market with those of an open market.

EXHIBIT 2.3 Notional versus Open Market Transactions

The notional market assumes: an arm's-length transaction; economic rather than sentimental value; equally informed and uncompelled parties; equal financial strength and bargaining ability; a consistent market; and a free, open, and unrestricted market environment.106 The real world does not always work in these terms, and that is why often there are discrepancies between fair market value and open market price, due to a lack of information, compulsion, or other factors. An example of this is the 1962 Tax Court decision, Dees v. Commissioner.107

This case not only relates directly to the level of information that should be known and knowable in establishing fair market value, but it also shows the difference between open market prices and the assumptions necessary to arrive at fair market value. As was discussed in Chapter 1, there are times when the intrinsic value of a stock is different from its trading price. This is the essence of security analysis in the public market. However, in this case it is apparent that the higher price paid by the public was the result of sales tactics and not a difference due to the intrinsic value of the stock.

While attempting to adhere to the strict guidelines of the willing seller and the willing buyer construct, it may be impossible to ignore the circumstances of real individuals acting out of varying motivations. As one commentator noted:

Though black-letter law may hold that the willing buyer and seller are hypothetical parties, rather than real ones, the circumstances of actual buyers, sellers, and owners are often important in the determining fair market value. Case law on assemblage values, corporate liquidation arguments, charitable donee conduct, and other valuation issues reveal that real parties' individual needs and desires sometimes play a significant role in the valuation analysis.108

Ideally, the desired market for a determination of fair market value may be akin to the notional market as discussed earlier, but real-world issues are likely to affect any valuation. The notional concept does not preclude the practitioner from investigating all available market information but may place constraints on its use—for example, the use of transactions involving synergies not available to all buyers.

The incorporation of actual market data into a valuation can be a good indicator of how a company will fare on the market, whether in the open market or in determining fair market value. This can be seen in the Tax Court's willingness to place weight on the guideline public company method despite seemingly broad criteria for what constitutes meaningful comparison.

Earlier we discussed Estate of Joyce Hall v. Commissioner109 in terms of restrictive agreements, but the court also comments on the use of guideline public companies. The decedent owned shares in Hallmark, the greeting card company. American Greetings was acknowledged as the other leading firm in the greeting cards industry, and the only publicly traded greeting card company that compared to Hallmark. The commissioner's expert based his valuation of the decedent's shares on a comparison with American Greetings. He claimed that American Greetings was the only public company with a similar capital structure and product mix. Alternatively, the taxpayer's expert, not wanting to rely on one guideline public company as the sole basis for comparison, chose a variety of publicly traded companies, such as AT Cross, Coca-Cola, and Lenox, Inc., which he considered comparable to Hallmark based on certain similarities but not in the same industry. The expert believed that these public companies had business and financial characteristics similar to Hallmark, in that they were leaders in their industries producing brand-name consumer goods. The court ultimately applied the taxpayer's expert's logic, finding one company too narrow a comparison for the determination of fair market value under the notion that “the good fortune of one company in an industry may be at the expense of its direct competitors.”110 In this case, the court allowed broad criteria in choosing guideline public companies for comparison purposes with Hallmark.

However, such broad criteria (shared economic influences or use of public companies with dominant market share and brand name recognition) are not always accepted. In some circumstances, the court may consider the subject company unique. For example, in the case of Righter v. United States,111 which involved the valuation of a game company, the court decided that diversified publicly traded toy and game companies were not sufficiently useful as guideline companies when compared to a company producing only two types of games appealing to specific age groups.

This is contrasted with the court's decision in the Estate of Joyce Hall v. Commissioner. Similarly, in the Estate of Gallo v. Commissioner,112 in valuing a wine company, the court accepted the estate's expert's use of guideline public companies representing a variety of brewing, distilling, and food processing companies subject to similar market forces.

Righter is an older case that demonstrates a restrictive view of what constitutes a guideline public company. As has been seen in more recent cases, the court has often used the broader concept of shared economic influences as a criterion of what constitutes a usable guideline public company.

Finally, after selecting the appropriate guideline companies, care must also be used in determining the guideline level of value(i.e., marketable shares should not be compared directly with nonmarketable shares and minority shares cannot be directly compared with majority or control shares without proper adjustments).

Common Discounts

Discounts for Lack of Control

All else being equal, shares with decision-making power in a corporation are usually considered more valuable than shares that lack these prerogatives. However, majority ownership is not necessarily a guarantee of increased value. The statutes of each state have some influence over the degree of control a particular block of stock possesses. Some states require supermajority votes to authorize actions such as mergers, sales, or liquidations. The articles of incorporation or bylaws of a company may require similar supermajority approval. Any ownership position of a corporation that is less than 100% comes with disadvantages. The business decisions made by a shareholder without 100% ownership may be the subject of contention with minority shareholders through dissent or oppression statutes. In a state with supermajority requirements, control shares are often worth more if the block of shares are at or exceed the supermajority threshold. Conversely, if ownership of a minority share prevents the controlling shareholder from achieving the supermajority threshold, it may not be discounted as heavily as a smaller block of shares as it has the ability to block a corporate action.

There are inherent risks in making an investment that does not come with control. These include the chance that:

• Poor decisions by the majority could lead to losses for the company.
• A change in direction will take place that the minority shareholder does not support.
• The majority shareholders could victimize the minority shareholders in any number of ways, including cancellation of dividends, freeze-outs, squeeze-outs, or other actions that are unfair to the minority shareholders.

These risks will be discussed further in Chapter 3 of this book, but the bottom line is that minority shares are typically worth less than controlling shares. However, it is worth noting that in some circumstances, the aggregate minority could exceed the value of the enterprise.

The first case we have found in which a minority discount was judicially recognized was the 1935 tax case Cravens v. Welch.113 In this case, the taxpayer was looking to deduct the losses from the value of his minority interest shares in a close corporation from his income. The shareholder determined that the value of the stock at the applicable date was $2.25 per share, which was the pro-rata share of the enterprise value. The IRS, however, claimed that the value was $1.21 per share because a minority interest was being valued. The court held in favor of the IRS and the minority discount, in all likelihood to support the conclusion of the government witness.114 Whereas in this instance the minority discount was beneficial to the IRS, the concept of the minority discount has remained and has since become a mechanism by which a shareholder can reduce the taxable value of his or her minority shares.

In the case of Sol Koffler v. Commissioner,115 the court discussed the lack of control discount when comparing minority shares of a private company to their publicly traded equivalent. The court stated:

Almost any available block of publicly-traded stock sold in day-to-day transactions, whether over the counter or on one of the exchanges, is a minority interest which could not determine dividend or other company policy. But the important consideration is that there is a day-to-day market for such stock, and in the absence of some unusual circumstance a purchaser can convert his investment to cash at any time. He would have no such assurance with respect to the minority block of ALW stock.

Another court described the adjustment as reflecting “the minority shareholder's inability to compel liquidation and thereby realize a pro rata share of the corporation's net asset value.”116 That distinction leads to the necessity of discounting minority shares for their lack of control and similarly, if more cash flow can be extracted from the company, adding a premium to control shares when compared with the shares of guideline public companies.

Discounts for Lack of Marketability

The fair market value of a private business or business interest may suffer due to a lack of marketability. While a minority discount adjusts for lack of control over an entity, a marketability discount compensates for the inability to convert the interest immediately into cash.117

The International Glossary of Business Valuation Terms defines marketability as “the ability to quickly convert property to cash at minimal cost.”118 The owner of a publicly traded security may execute a trade and liquidate the asset within three business days. The sale of minority shares in a privately held company may take time and expense in identifying likely and able buyers and negotiating a transaction. In this notional market, the inability to liquidate one's position immediately requires consideration of a discount for lack of marketability.

However, the issue of applying a discount for lack of marketability for a controlling interest is unsettled. Some Tax Court decisions reference such a discount, and others argue no such discount is required as enterprises are not typically sold through the public exchanges. The authors believe that discounts for lack of marketability for controlling interests are applicable in some circumstances. Those circumstances are fact sensitive.

After addressing the marketability of the company as a whole, applicable shareholder-level discounts may need to be applied. Because public minority stock can be sold relatively quickly and easily (many times on a public exchange, such as the New York Stock Exchange, where there are potentially thousands of buyers), minority shares of a private company suffer by comparison. The universe of buyers for private minority stock is typically much smaller. Restricted stock studies have revealed the significant differential in value between freely tradable shares and those that are restricted from trading on an open market for a certain time period.119

Investors prefer liquidity to illiquidity. A liquid asset may be sold quickly for a variety of reasons: lack of confidence in management, a belief that value will decrease, or the possibility of a need for cash. With an illiquid asset, it may be difficult or expensive to obtain cash, so investors may be forced to hold the asset even if value is declining or management policies are poor.120

As discussed earlier, the court in Mandelbaum v. Commissioner121 addressed the applicability of the marketability discount on minority shares of private company stock gifted over the course of several years. In quantifying the discount, the court reviewed the factors shown previously in Exhibit 2.1 and adjusted benchmark percentages for lack of marketability based on the results.

Blockage Discounts

A blockage discount may be appropriate when a block of public stock is so large in relation to its total trading volume that it could not be offered for sale without depressing the market. Essentially, a discount is needed because the market would be flooded by the sale and supply would outweigh demand.122 The discount may be calculated based on the estimated amount of time it would take to sell the entire quantity in smaller lots. This may be applicable to large blocks of public shares123 or holdings of other types of assets like an art collection, that if sold en masse could have a depressing effect on the marketplace.124 In the public marketplace there is a debate as to whether a specific block of stock should be discounted for blockage or, when appropriate, afforded a premium for control.

Estate of O'Keeffe v. Commissioner125 was a case valuing artwork rather than stock, but for demonstration purposes it clearly illustrates why a discount for blockage may be appropriate. The court looked at the individual market values of each piece of a large art collection and concluded that, if all the artwork entered the market at the same time, it would depress the marketplace. Therefore, the value of the collection as a whole was less than the aggregate total of each individual piece of art. The court divided the collection into two groups and allowed the application of a 25% discount for the more salable group and a 75% discount for the less salable group.

Key-Person Discounts

While the hypothetical natures of buyers and sellers are generally relied upon in a determination of fair market value, in certain circumstances it is important to consider the actual position of a particular individual, sometimes the position that a decedent held within a company and the effect of his or her death.

Key-person discounts reflect the reliance of a company on a particular individual. This could be for a variety of reasons, including thin management, a wealth of personal relationships that benefit a business, knowledge and experience in the marketplace, or any other factors that, absent key-person life insurance, might make any individual very difficult to replace. It has been suggested that the magnitude of this discount may be quantified by identifying the cash flows with and without the continued presence of the key person. Several identifiable factors may influence the application of a key-person discount, including:126

• Services rendered by the key person
• Extent of the corporation's dependence on that person
• If the key person is still active, the likelihood of his or her loss
• Depth and quality of other management personnel
• Availability of adequate replacement
• Key person's compensation and probable compensation for a replacement
• Value of irreplaceable factors and skills lost
• Risks associated with operation under new management personnel
• Lost debt capacity

There are also potential offsets to the loss of a key person. These are:

• Life or disability insurance proceeds payable to the company that are not specifically designated for other purposes, such as repurchase of a decedent's stock
• Amount of compensation saved if the replacement's probable compensation is lower than that of the key person
• Covenants not to compete
• Depth in middle management

The Tax Court case Estate of Feldmar v. Commissioner127 addressed the implications of a key man for the value of a company's stock. A company selling nontraditional insurance products had been founded by the decedent and relied on his unique marketing skills. The court recognized that the value of the corporation would be less without that individual than it would be with the continued presence of that individual, and a reasonable investor would require a discount to make up for the loss of the key person in buying the company. The respondent claimed that the life insurance policy made up for the loss of the key person. The court, however, viewed the policy as a nonoperating asset. The respondent also claimed that management could be replaced by the salary that was now available due to the decedent's death, but the court found the current management of the company incapable of carrying on without the key individual. Ultimately, the court discounted the value of the corporation by 25% to account for the loss of the key person.

Other cases have addressed this issue as well, including the previously mentioned Sol Koffler v. Commissioner, in which the court applied a 15% thin management discount.

Trapped-in Capital Gains Discounts

In a case where a company holds assets that have appreciated substantially over time, there may be capital gain that will eventually trigger a capital gains tax upon sale. Recently the courts have allowed for discounts that adjust for the need to pay eventual taxes. The main argument against the trapped-in capital gains discount is that the asset is not necessarily going to be sold. However, the repeal of the General Utilities Doctrine (the general rule was that a corporation recognized no gain or loss on the distribution of appreciated property to its shareholders128) brought renewed attention to this issue. One of the more recent cases on the subject is Eisenberg v. Commissioner.129

In its decision, the court also looked to a recent decision addressing similar issues, Davis v. Commissioner,131 which examined whether the corporation's built-in capital gains tax should be accounted for in the valuation of stock. Both experts in that case recommended that the built-in capital gains tax be taken into account, regardless of whether liquidation or sale of the corporation or its assets was contemplated.

SUMMARY

This chapter has addressed the history and development of fair market value and its well-established definition. Fair market value is a legal construct related to tax, regulatory, and judicial issues, especially federal estate and gift taxes. Its use and associated assumptions grew as federal taxation became more widespread. We have analyzed court cases that have shaped the definition of fair market value and seen that largely, although certain overarching guidelines apply, the facts and circumstances of each case have often influenced the outcome of a fair market value assessment. The standard of fair market value is often applied in contexts other than tax, for example, in marital dissolutions.

To better guide the application of fair market value, the IRS has established regulations and revenue rulings (the best-known of which is Revenue Ruling 59-60) with which valuations should comply. The Estate and Gift Tax Regulations establish the general requirements of fair market value, all of which are applied as hypothetical constructs:

• The price at which a property would change hands
• A willing buyer
• A willing seller
• Neither being under any compulsion
• Both having reasonable knowledge of the relevant facts
• Specific value as of a specific valuation date
• Applicability of subsequent events

Within these general hypothetical considerations, specific issues develop, including the natures of the buyer and seller and the marketplace created:

• Synergistic buyers
• Valuing individual classes of stock together or separately
• Applicability of restrictive agreements
• Subsequent events and postvaluation-date information
• Applicability of entity- and shareholder-level discounts

In determining fair market value, the courts consistently value the stock that is in the hands of the shareholder, whether for purposes of estate, gift, or income tax. The ultimate value represents a value in exchange and lack of control and lack of marketability discounts are commonly applied, as are control premiums (if appropriate and depending on the cash flow used). However, the courts have not been fully consistent across jurisdictions in their treatment of the issues discussed. Circumstances and practical considerations may make each case unique, and therefore each judge or jury decides on a specific fact pattern.

The fair market value standard forms the basis of understanding the fair value standard in dissent and oppression. Furthermore, the concepts applied in fair market value are used in many states for value in divorce. Therefore, Chapter 3, “Fair Value in Shareholder Dissent and Oppression,” and Chapter 5 , “Standards of Value in Divorce,” build on the concepts discussed in this chapter.

1 Auker v. Commissioner, T.C. Memo. 1998-185.

2 ASA College of Fellows Opinions, “The Opinion of the College on Defining Standards of Value,” 347 Valuation, No. 2 (June 1989), at 6.

3 John A. Bogdanski, Federal Tax Valuation (New York: Warren, Gorham & Lamont, 2002), at 1–25.

4 James C. Bonbright, Valuation of Property (Charlottesville, VA: Michie Company, 1937), at 983.

5 Bank One v. Commissioner, 120 T.C. 174; 2003 U.S. Tax Ct. LEXIS 13; 120 T.C. No. 11.

6 IRS Treasury Regulations, Estate Tax Regulation § 20.2031-1. IRS Treasury Regulations, Gift Tax Regulations 25.2512-1, define the term similarly.

7 Jay E.Fishman, Shannon P. Pratt, J. Clifford Griffith, and James R. Hitchner, Guide to Business Valuations (Fort Worth, TX:Thomson Reuters, February 2012), at 2–35. This is the definition recommended by a task force comprised of members of the AICPA, ASA, IBA, NACVA, and CICBV and adopted by their respective organizations.

8 Synergies were considered in the fair market value cases BTR Dunlop Holdings Inc., et al. v. Commissioner, TC Memo 1999-377.

9 Late in this chapter, we will discuss the issue of potential synergies as they relate to the application of fair market value in the United States.

10 United States v. Fourteen Packages of Pins, 25 F. (at 1182, 1185 (D.C. PA, 1832)

11 Id.

12 W. Elliot Brownlee, Federal Taxation in America: A Short History, 2nd ed. (Washington, DC: Woodrow Wilson Center Press, 2004), Chapter 1.

13 Id.

14 157 U.S. 429; 15 S. Ct. 673; 39 L. Ed. 759; 1895 U.S. LEXIS 2215; 3 A.F.T.R. (P-H) 2557.

15 Brownlee, Federal Taxation in America.

16 Id.

17 Amendment Sixteen, Constitution of the United States.

18 120 T.C. No. 11.

19 Chapter 18, 40 Stat.1057,§ 202(b), 40 Stat. 1060.

20 Williamsport Wire Rope Co. v. United States, 277 U.S. 551 (1928), Footnote 7.

21 T.B.R. 57, 1 C.B. 40 (1919).

22 Williamsport Wire Rope Co. v. United States.

23 Hewes v. Commissioner, 2 B.T.A. 1279, 1282 (1925).

24 Hudson River Woolen Mills v. Commissioner, 9 B.T.A. 862, 868 (1927).

25 Natl. Water Main Cleaning Co. v. Commissioner, 16 B.T.A. 223 (1929).

26 St. Joseph Stock Yards Co. v. United States, 298 U.S. 38, 60 (1936).

27 823 F.2d 483; 1987 U.S. App. LEXIS 10281; 87-2 U.S. Tax Cas. (CCH) P13,726; 60 A.F.T.R.2d (RIA) 6117.

28 Estate of McFarland v. Commissioner, T.C. Memo 1996-424.

29 Bryan A. Garner, Black's Law Dictionary, 9th ed. (St. Paul, MN: Thompson West, 2009), at 1308.

30 Id., at 1587.

31 Reiner H. Kraakman and Bernard S. Black, “Delaware's Takeover Law: The Uncertain Search for Hidden Value,” 96 Northwestern University Law Review (Winter 2002), at 521.

32 John Stewart Mill, Principles of Political Economy, 7th ed., William J. Ashley, ed. (London: Longmans, Green &Co., 1909), Book III, Chapter III.

33 John Bogdanski, Federal Tax Valuation, at 2.02[2][a].

34 287 F.41, 45 (3d Cir. 1923).

35 302 F.2d 790, 794 (2nd Cir. 1962).

36 Roger J. Grabowski, “Identifying Pool of Willing Buyers May Introduce Synergy to Fair Market Value,” Shannon Pratt's Business Valuation Update, 7 Business Valuation Resources, No. 4 (April 2001).

37 94 T.C. 193(1990).

38 Estate of Mueller v. Commissioner, T.C. Memo. No 1992-284 at 1415, 63 T.C.M. 3027-17.

39 T.C. Memo 1989-231; 1989 Tax Ct. Memo LEXIS 231; 57 T.C.M. (CCH) 373; T.C.M. (RIA) 8923.

40 Grabowski, “Identifying Pool of Willing Buyers.”

41 St. Joseph Stock Yards Co. v. United States, 298 U.S. 38, 60 (1936).

42 www.bvappraisers.org/glossary/glossary.pdf.

43 Ian Campbell,Canada Valuation Service (Scarborough, ON: Carswell, October 2004), at 4–28.

44 Shannon P. Pratt, The Market Approach to Valuing Businesses (Hoboken, NJ: John Wiley & Sons, 2001), at 142.

45 Richard M. Wise, “The Effect of Special Interest Purchasers on Fair Market Value in Canada,” Business Valuation Review (December 2003).

46 Dominion Metal & Refining Works, Ltd. v. The Queen, 86 D.T.C. 6311 (Trial Division).

47 Richard Wise, “The Effect of Special Interest Purchasers of Fair Market Value in Canada,” 22 Business Valuation Review, Quarterly Journal of the Business Valuation Committee of the American Society of Appraisers, No. 4 (December 2003).

48 T.C. Memo 1992-284; 1992 Tax Ct. Memo LEXIS 310; 63 T.C.M. (CCH) 3027.

49 T.C. Memo 1999-377; 1999 Tax Ct. Memo LEXIS 432; 78 T.C.M. (CCH) 797.

50 Roger J. Grabowski, “Identifying Pool of Willing Buyers.”

51 Roger J. Grabowski,“Fair Market Value and the Pool of Willing Buyers.” Unpublished paper.

52 Id.

53 7 06 F.2d 1424; 1983 U.S. App. LEXIS 28894; 83-1 U.S. Tax Cas. (CCH) P13, 518; 51 A.F.T.R.2d (RIA) 1232. This case was heard in the United States Federal District Court, in front of a jury.

54 Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981).

55 706 F.2d 1424; 1983 U.S. App. LEXIS 28894; 83-1 U.S. Tax Cas. (CCH) P13, 518; 51 A.F.T.R.2d (RIA) 1232.

56 249 F.3d 1191; 2001 U.S. App. LEXIS 9220.

57 IRS Revenue Ruling 93-12.

58 Z. Christopher Mercer, Quantifying Marketability Discounts (Memphis, TN: Peabody, 1997), at 178.

59 T.C. Memo 1995-255; 1995 Tax Ct. Memo LEXIS 256; 69 T.C.M. (CCH) 2852.

60 Giustina v. Commissioner, T.C. Memo 11-141.

61 Davis v. Commissioner. 1998 U.S. Tax Ct. LEXIS 35, Daily Tax Report (BNA) No. 126, at K-17 (T.C. June 30, 1998).

62 658 F.2d 999; 1981 U.S. App. LEXIS 17205; 81-2 U.S. Tax Cas. (CCH) P13,436; 48 A.F.T.R.2d (RIA) 6159; 48 A.F.T.R.2d (RIA) 6292.

63 680 F.2d 1248; 1982 U.S. App. LEXIS 17696; 82-2 U.S. Tax Cas. (CCH) P13,475; 50 A.F.T.R.2d (RIA) 6153.

64 658 F.2d 999; 1981 U.S. App. LEXIS 17205; 81-2 U.S. Tax Cas. (CCH) P13,436; 48 A.F.T.R.2d (RIA) 6159; 48 A.F.T.R.2d (RIA) 6292.

65 Bogdanski, Federal Tax Valuation, at 2.01[2][b].

66 Jay Fishman and Bonnie O'Rourke, “Value: More Than a Superficial Understanding Is Required,” 15 Journal of the American Academy of Matrimonial Lawyers, No. 2 (1998).

67 Id.

68 287 F.41, 45 (3d Cir. 1923).

69 1B.T.A. 653,655 (1925).

70 44 T.C. 801,813 (1965).

71 Campbell, Canada Valuation Service, at 4–32.

72 U.S. Code Title 26, Section 2703(b).

73 Stephen C. Gara and Craig J. Langstraat, “Property Valuation for Transfer Taxes,” 12 Akron Tax Journal, Vol. 125(1996), at 139.

74 T.C. Memo 1994-527; 1994 Tax Ct. Memo LEXIS 535; 68 T.C.M. (CCH) 985.

75 92 T.C. 312; 1989 U.S. Tax Ct. LEXIS 24; 92 T.C. No. 19.

76 48 T.C.M. (CCH) 733 (1984).

77 U.S. Code Title 26, § 2701.

78 Stephen C. Gara and Craig J. Longstraat, “Property Valuation for Transfer Taxes,” at 12 Akron Tax J 139.

79 Bogdanski, Federal Tax Valuation, at 2.01[3][a].

80 346 F.2d 213; 1965 U.S. App. LEXIS 5425; 65-2 U.S. Tax Cas. (CCH) P12,321; 15 A.F.T.R.2d (RIA) 1430.

81 IRS Revenue Procedure 66-49.

82 Bogdanski, Federal Tax Valuation, at 2.01[3][a].

83 Id., at 2.01[3][a], 2–47.

84 41 A.F.T.R.2d 1477 (Ct. Cl. Tr. Div. 1978) (not officially reported), at 1490.

85 The court also applied a discount for lack of control for unrelated reasons.

86 Couzens v. Commissioner, 11 B.T.A. 1040; 1928 B.T.A. LEXIS 3663.

87 Gallagher Estate v. Commissioner, T.C. Memo 2011-148.

88 The Court's characterization, at 15.

89 20 A.F.T.R.2d 5946 (1967).

90 41 A.F.T.R.2d 1477 (Ct. Cl. Tr. Div. 1978) (not officially reported), at 1490.

91 Although, as illustrated by Tully, Gallagher, and Couszens, consideration of postvaluation date events are a function of particular facts and circumstances and, in some cases, the courts have gone to great lengths to indicate they were foreseeable and sometimes used even when it is acknowledged they were not foreseeable.

92 101 T.C. 412; 1993 U.S. Tax Ct. LEXIS 69; 101 T.C. No. 28.

93 T.C. Memo. 1996-331 (7/24/96).

94 T.C. Memo 1996-149; 1996 Tax Ct. Memo LEXIS 157; 71 T.C.M. (CCH) 2555.

95 763 F.2d 891; 1985 U.S. App. LEXIS 19780; 85-2 U.S. Tax Cas. (CCH) P13,620; 56 A.F.T.R.2d (RIA) 6492; 18 Fed. R. Evid. Serv. (Callaghan) 290.

96 Id.

97 James C. Bonbright, “The Problem of Judicial Valuations,” 27 Columbia Law Review (May 1927), at 497.

98 Id., at 503.

99 79 T.C. 938; 1982 U.S. Tax Ct. LEXIS 12; 79 T.C. No. 58.

100 658 F.2d 999; 1981 U.S. App. LEXIS 17205; 81-2 U.S. Tax Cas. (CCH) P13,436; 48 A.F.T.R.2d (RIA) 6159; 48 A.F.T.R.2d (RIA) 6292.

101 William B. Barker, “A Comparative Approach to Income Tax Law in the United Kingdom and the United States,” 46 Catholic University Law Review (Fall 1996), at 40.

102 Campbell, Canada Valuation Service, at 4–20.

103 Fishman and O'Rourke, “Value,” at 321.

104 Campbell, Canada Valuation Service, at 4–20.

105 Id.

106 Fishman and O'Rourke, “Value.”

107 T.C. Memo. No. 1962-153 at 919,21 T.C.M. 845, aff'd 332 F.2d 725 (3d Cir. 1963).

108 John Bogdanski, Federal Tax Valuation, at 2.01[2][c], 2–45.

109 92 T.C. 312; 1989 U.S. Tax Ct. LEXIS 24; 92 T.C. No. 19.

110 92 T.C. 312; 1989 U.S. Tax Ct. LEXIS 24; 92 T.C. No. 19 at 340.

111 439 F.2d 1244 (1971).

112 T.C. Memo 1985-363.

113 10 F. Supp. 94 (D.C. Cal. 1935).

114 Edwin T. Hood, John J. Mylan, and Timothy P. O'Sullivan, “Valuation of Closely Held Business Interests,” 65 University of Missouri at Kansas City Law Review, No. 399 (Spring 1997).

115 T.C. Memo 1978-159.

116 Estate of Thomas A. Fleming, et al. v. Commissioner, T.C. Memo 1997-484 (October 27, 1997).

117 Gara and Langstraat, “Property Valuation for Transfer Taxes,” at 154.

118 Guide to Business Valuations at 2–40.

119 David J. Laro and Shannon P. Pratt, Business Valuation and Federal Taxes, 2nd ed.(2011), at 283–290. John Wiley.

120 Laro and Pratt, Business Valuation and Taxes, at 285.

121 T.C. Memo 1995-255; 1995 Tax Ct. Memo LEXIS 256; 69 T.C.M. (CCH) 2852.

122 Gara and Langstraat, “Property Valuation for Transfer Taxes,” at 158.

123 Estate of Friedberg v. Commissioner, 63 T.C.M. (CCH) 3080, 3081-82 (1992).

124 Estate of O'Keeffe v. Commissioner, 63 T.C.M. (CCH) at 2704.

125 Id.

126 Steven Bolten and Yan Wang, “Key Person Discounts,” Business Valuation: Discounts and Premiums (Hoboken, NJ: John Wiley & Sons, 2003), at 3.

127 Estate of Feldmar v. Commissioner, T.C. Memo 1988-429, 56 T.C.M. (CCH) 118 (1988).

128 Pillsbury Winthrop Shaw and Pittman, LLP, “Tax Page” (http://pmstax.com/acqbasic/genUtil.shtml).

129 155 F.3d 50 (2d Cir. 1998).

130 Id., at 25.

131 1998 U.S. Tax Ct. LEXIS 35, Daily Tax Report (BNA) No. 126, at K-17 (T.C. June 30, 1998).