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Recent Tax Court Decision - Discount for Lack of Marketability

Business Advisors|Business Valuation |Tax

By Dan Riske

One business valuation concept discussed frequently is the discount for lack of marketability (“DLOM”).  The Estate of John F. Koons III v. Commissioner is a recent case that directly analyzed the DLOM. 

John F. Koons III (“Koons”), the decedent stockholder in the case, owned a 50.5% ownership interest in an LLC which owned cash of approximately $320 million and two small operating businesses.  Two important events took place shortly before Koons’ death in March 2005 that were considered in the tax court’s decision in the case:

  1. Stock redemption agreements were signed by Koons’ children that, upon completion, would cause Koons to be an approximate 71% owner of the LLC.  The redemptions were ultimately completed after the date of Koons’ death; and
  2. The LLC entered into a stock purchase agreement (“SPA”) with PepsiAmericas, Inc. (“PAS”) to sell off its soft drink bottling and vending machine businesses to PAS.  The terms of the SPA also required the LLC to hold $10 million in liquid assets (i.e., cash, marketable securities, etc.) and maintain a positive net worth of at least $40 million until January 10, 2012. 

The IRS expert in the case estimated a 7.5% DLOM attributable to the interest while the taxpayer expert estimated a 31.7% DLOM.  The tax court agreed with the IRS expert’s lower DLOM.  The following key factors were considered in the tax court’s decision:

  1. Stock redemptions – The IRS expert believed that because the stock redemptions were signed (but not yet fully completed) on the date of death and the redemption price for the shares could easily be determined (since the LLC’s assets were mainly cash), Koons’ interest would be a controlling 71% on the date of death.  The tax court agreed with this even after considering the terms of the LLC’s operating agreement which limit member distributions.    
  2. Asset composition – The tax court agreed with the IRS expert that the LLC’s assets would likely remain liquid in the future given the LLC’s current cash holdings and the fact that Koons is the 71% majority voting member and has the ability to require the LLC to hold mainly liquid assets.
  3. SPA requirements – The taxpayer expert believed it was illegal for the LLC to distribute all of its assets until after January 10, 2012.  However, the SPA only required the LLC to maintain certain liquid asset levels and a minimum net worth; only a small portion of the LLC’s overall assets would be restricted.  Therefore, the IRS expert opined, and the tax court agreed, that most of the LLC’s assets were able to be distributed by Koons on the valuation date. 

The tax court believed that a majority owner with the power to distribute most of the LLC’s assets would not sell its membership interest for less than his pro-rata share of the LLC’s assets.  Therefore, the court established a “minimum value” of $140 million for Koons’ majority interest.  The value was determined by taking the LLC’s net worth (about $318 million), less the $40 million net worth required in the SPA, and multiplying by the 50.50% interest [(318 – 40)*50.5% = $140.4].  The taxpayer expert’s final value of $110 million was therefore rejected while the IRS expert’s value of $149 million was above the minimum threshold established by the tax court.

Final Thoughts

There are many available methods to help determine the DLOM, but no one particular method will keep the IRS and tax courts from questioning the final determination.  According to Mike Gregory, IRS Engineering Territory Manager and Champion for the DLOM Job Aid for IRS Valuation Professionals, “The federal courts have indicated their interest in data, and in the use of data for the logical development of a DLOM.  This suggests the use of raw data, multiple approaches, reconciliation of the approaches and a recommendation.”  As with any business valuation, a valuation analyst must demonstrate a clear understanding of the facts and conditions surrounding the business interest being valued and thoroughly explain all decisions used in the analysis. 

Schneider Downs has significant business valuation experience. In addition, we have tools to assist in determining discounts for lack of marketability.  For more information about Schneider Downs’ business valuation and other business advisory services, please contact Joel Rosenthal at 412.697.5387 or jrosenthal@schneiderdowns.com or Tom Claassen at 412.697.5330 or tclaassen@schneiderdowns.com.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

© 2018 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

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