The Phone Call
The Tax Court’s decision addressing McCord v. Commissioner set off alarms that prompted an attorney, and client, to contact our firm to discuss its impact on calculating valuations. Certain it sounded a death-knell for the application for discounts, she advised me to read – and even re-read – the opinion while paying special attention to the discussion of marketability discounts and the court’s revised valuation analysis. She advocated conforming to the court’s self-crafted valuation methodology and urged our firm to follow its lead.
The Unexpected Confession
Assuring her that I had carefully read the 117-page opinion, I asked what she thought about the court’s re-valuation of the interests in question and whether she thought it would hold up on appeal. Her response greatly surprised me. After a deep breath she confessed that she “always knew it was too good to be true.” Her next statements were even more revealing. These “silly discounts” were undeserved and it was only a matter of time before someone out there proved that they were unsupportable at any level, she added.
Calmly I explained our firm’s guiding principle was to analyze the value of an interest based upon economic and financial theory as well as – and even more importantly – economic and financial reality. The courts may have shaped the theory behind the valuation of limited partnership interests but its essence is the basic theory of risk and return. No matter how the courts may choose to characterize valuation, investors recognize the universal economic truth regarding investments – the higher the risk, the higher the required rate of return.
I assured her our policy would remain intact, even in light of the McCord decision, and we would continue to phrase our opinions in a manner that was acceptable to the courts. However, as always, the bottom line of our valuations would still reflect the values determined by an analysis of risks and returns appropriate to the investment in question.
The 5th Circuit’s recent reversal of McCord does not establish the “correct” methodology by which the value of limited partnership interests should be analyzed. It does, however, establish the methodology by which value should not be analyzed. Legalities aside, the 5th Circuit held that the Tax Court’s self-created valuation methodology should be disregarded, stating:
“…the values ascribed by the Majority, being derived by its use of its own imaginative but flawed methodology, may not be used in any way in the calculation of the Taxpayer’s gift tax liability.”
In essence, the 5th Circuit determined valuation through a process of elimination. The court rejected the Tax Court’s flawed methodology but confirmed the Tax Court’s rejection of the Commissioner’s valuation, leaving only the taxpayer’s valuation.
Although we never agreed with the valuation methodology applied in the Tax Court’s decision in McCord, we were reluctant to rely on any decision dictating valuation principles. Valuation always has been – and always should be – based on tested financial theory and proven market realities. While valuation for tax purposes must be guided by the constraints of certain court-induced realities (such as the bifurcation of discounts between lack of control and lack of marketability), the fundamental basis must be risk and return.
My last conversation with this attorney (after the reversal) ended with a confident assertion by the attorney that she “knew the court screwed up when it tried to become a valuation expert” and that she never expected the “ridiculous ruling” to be upheld. Let’s all hope that the Tax Court proves to have a better memory than the client.