Business Valuation and Federal Taxes

SENIOR JUDGE DAVID LARO was appointed to the United States Tax Court, confirmed by the Senate, and invested as a federal judge in November 1992. He formerly practiced law in Flint and Ann Arbor, Michigan, for twenty-four years, specializing in tax law. Senior Judge Laro was chairman and CEO of a publicly traded international company, and he cofounded Republic Bancorp, a Michigan bank holding company. He is an adjunct professor of law at Georgetown University Law School and a visiting professor at the University of San Diego Law School. SHANNON P. PRATT is one of the most successful and respected authors in the field of business valuations. He has authored many industry standard books, including Cost of Capital, Fourth Edition; Business Valuation Discounts and Premiums, Second Edition; and The Market Approach to Valuing Businesses, Second Edition, all published by Wiley. Over a distinguished career of more than four decades, he has performed valuation engagements for M&A, ESOPs, and numerous other purposes. He is also Editor Emeritus of Shannon Pratt's Business Valuation Update, the premier monthly newsletter in the field of business valuation. Dr. Pratt is CEO of Shannon Pratt Valuations, a business valuation firm located in Portland, Oregon.

Foreword to Second Edition xv

Foreword: Legal Practitioner’s Perspective xvii

Foreword: Law Professor’s Perspective xix

Foreword: Business Appraiser’s Perspective xxi

Preface to the New Edition xxiii

Origin of the Book xxiii

Authors Provide Own Perspectives xxiv

Topics Covered xxiv

Acknowledgments xxvii

About the Authors xxix

Chapter 1 Standards of Business Valuation 1

Summary 1

Introduction 2

Sources for Defining Value 3

Definitions of Value 7

Premise of Value 17

Conclusion 18

Chapter 2 Subsequent Events 19

Summary 19

Key Question 19

Valuation Date 20

Subsequent Events—Exceptions 21

Conclusion 27

Chapter 3 Business Valuation Experts 28

Summary 28

Introduction 29

Proving Business Value 29

The Expert Appraiser 30

Types of Experts 31

Various Roles of Experts 32

Business Valuation Litigation Witnesses 32

Admissibility of Evidence Underlying Expert Opinions 33

Limitations to Admissibility 35

Reliability of the Expert 36

Minimum Thresholds for the Business Valuation Expert 38

Sarbanes-Oxley Act of 2002 40

Attorney Assistance to the Expert 40

Qualified Appraiser 43

Concerns about Expert Testimony 44

Court-Appointed Expert 46

Conclusion 48

Appendix: Expert Credentials and Qualifications 49

Chapter 4 Sources of Law and Choice of Courts 58

Summary 58

Structure of the American Legal System 59

Tax Law 60

Tax Litigation 62

Conclusion 66

Chapter 5 Burden of Proof in Valuation Controversies 67

Summary 67

Burden of Proof 69

Who Bears the Burden of Proof? 71

Burden of Proof: Exceptions to the General Rule 71

Chapter 6 Penalties and Sanctions 76

Summary 76

Introduction 77

Valuation Penalties 78

Preparer and Appraiser Penalties 81

General Penalties 82

Discretionary Sanctions 84

Chapter 7 How the Form of Entity Affects Valuation 86

Summary 86

Introduction 87

Corporations 88

General Partnerships 89

Limited Partnerships 89

Limited Liability Companies 91

Sole Proprietorships 91

Tax Classifications 91

Valuation Considerations 92

Entity-Level Discounts 94

Choice of Jurisdiction 95

Conclusion 97

Chapter 8 Valuation of S Corporations and Other Pass-Through Tax Entities: Minority and Controlling Interests 98

Introduction 98

Case Law Background 100

S Corporation Minority Interest Appraisals 104

Comparison of Minority Interest Theories—A Summary of the Issues 106

S Corporation Controlling Interest Appraisals 108

General S Corporation Appraisal Considerations 110

Conclusion 110

Chapter 9 Transfer Pricing 112

Summary 112

Introduction 113

Conclusion 123

Chapter 10 Customs Valuation 124

Summary 124

Introduction 125

Customs Valuation Methods and Concepts 125

Related-Party Transactions 130

Conclusion 132

Chapter 11 Adjustments to Financial Statements 133

Summary 133

Separating Nonoperating Items from Operating Items 134

Addressing Excess Assets and Asset Deficiencies 135

Handling Contingent Assets and Liabilities 135

Adjusting Cash-Basis Statements to Accrual-Basis Statements 136

Normalizing Adjustments 136

Controlling Adjustments 137

Conclusion 139

Chapter 12 Comparative Financial Statement Analysis 140

Summary 140

Comparable Ratio Analysis 142

Common Size Statements 147

Tying the Financial Statement Analysis to the Value Conclusion 147

Conclusion 148

Chapter 13 Economic and Industry Analysis 149

Summary 149

Objective of Economic and Industry Analysis 150

International Economic Analysis 150

National Economic Analysis 150

Regional and Local Economic Analysis 151

Industry Analysis 151

Conclusion 153

Partial Bibliography of Sources for Economic and Industry Analysis 153

Chapter 14 Site Visits and Interviews 159

Summary 159

Site Visits 159

Management Interviews 160

Interviews with Persons Outside the Company 160

Conclusion 161

Chapter 15 The Income Approach 162

Summary of Approaches, Methods, and Procedures 162

Introduction to the Income Approach 163

Net Cash Flow: The Preferred Measure of Economic Benefit in the Income Approach 164

Discounting versus Capitalizing 166

Relationship between Discount Rate and Capitalization Rate 166

Projected Amounts of Expected Returns 172

Developing Discount and Capitalization Rates for Equity Returns 172

Weighted Average Cost of Capital (WACC) 176

The Midyear Convention 177

The Income Approach in the Courts 179

Conclusion 185

Appendix: An Illustration of the Income Approach to Valuation 186

Chapter 16 The Market Approach 195

Summary 196

The Market Approach 196

Revenue Ruling 59-60 Emphasizes Market Approach 196

The Guideline Public Company and the Guideline Transaction (Merger and Acquisition) Method 197

How Many Guideline Companies? 202

Selection of Guideline Companies 204

Documenting the Search for Guideline Companies 206

Choosing Multiples Based on Objective Empirical Evidence 206

What Prices to Use in the Numerators of the Market Valuation Multiples 206

Choosing the Level of the Valuation Multiple 207

Selecting Which Valuation Multiples to Use 209

Assigning Weights to Various Market Multiples 211

Sample Market Valuation Approach Tables 211

Other Methods Classified Under the Market Approach 211

Conclusion 216

Appendix: An Illustration of the Market Approach to Valuation 217

Chapter 17 The Asset-Based Approach 243

Summary 243

Adjusted Net Asset Value Method 243

Excess Earnings Method (The Formula Approach) 244

Conclusion 248

Chapter 18 Entity-Level Discounts 249

Summary 249

Trapped-In Capital Gains Discount 250

Key Person Discount 256

Portfolio (Nonhomogeneous Assets) Discount 263

Discount for Contingent Liabilities 267

Conclusion 269

Chapter 19 Minority Discounts/Control Premiums 271

Summary 271

Minority Discounts/Control Premiums 271

Conclusion 278

Chapter 20 Discounts for Lack of Marketability 279

Summary: General Introduction to Shareholder-Level Discounts and Premiums 280

Definition of Marketability 281

Benchmark for Marketability Is Cash in Three Days 281

Investors Cherish Liquidity, Abhor Illiquidity 282

Degrees of Marketability or Lack Thereof 283

Empirical Evidence to Quantify Discounts for Lack of Marketability: Restricted Stock Studies 283

Empirical Evidence to Quantify Discounts for Lack of Marketability: Pre-IPO Studies 290

Criticisms of the Pre-IPO Studies 292

Factors Affecting the Magnitude of Discounts for Lack of Marketability 294

Use of the Databases for Quantifying Discounts for Lack of Marketability 297

Discounts for Lack of Marketability for Controlling Interests 300

Option Pricing as Indicator of DLOM 305

Discounts for Lack of Marketability in the Courts 309

Conclusion 319

Partial Bibliography of Sources for Discounts for Lack of Marketability 320

Chapter 21 Other Shareholder-Level Discounts 321

Summary 321

Voting versus Nonvoting Shares 321

Blockage 324

Discounts for Undivided Fractional Interests in Property 330

Conclusion 332

Chapter 22 Personal versus Enterprise Goodwill 333

Summary 333

Definitions of Goodwill 334

Tax Implications 334

Indications of Personal versus Enterprise Goodwill 334

Landmark Cases 335

Excerpt from Personal Goodwill Appraisal Report 339

Conclusion 342

Chapter 23 Weighting of Approaches 343

Summary 343

Theory and Practice 343

Mathematical versus Subjective Weighting 344

Examples of Weighting of Approaches 345

Conclusion 347

Chapter 24 IRS Positions 348

Summary 348

Introduction 349

Rev. Rul. 59-60 350

Rev. Rul. 65-192 358

Rev. Rul. 65-193 362

Rev. Proc. 66-49 363

Rev. Rul. 68-609 366

Rev. Proc. 77-12 368

Rev. Rul. 77-287 370

Rev. Rul. 83-120 376

Rev. Rul. 85-75 379

Rev. Rul. 93-12 381

Tax Advice Memorandum 9436005 383

Rev. Proc. 2003-51 386

Rev. Proc. 2007-41 390

Rev. Rul. 2008-35 393

Chapter 25 Business Appraisal Reports 399

Summary 400

Business Valuation Report-Writing Standards 400

Elements of the Business Valuation Report 412

Organization of the Report 418

Qualities of a Good Appraisal Report 418

Conclusion 419

Chapter 26 Valuation of Options 420

Summary 420

Introduction and Background 421

General Principles of Option Valuation 422

Specific Rules for Valuing Options 427

Conclusion 433

Chapter 27 Questions to Ask Business Valuation Experts 434

Summary 434

Qualifications 434

Financial Statement Adjustments and Analysis 435

Economic and Industry Data 436

Site Visits and Interviews 436

General Questions about Methodology 436

Discount and Capitalization Rates in the Income Approach 436

Projections Used in the Income Approach 438

The Market Approach 438

Asset-Based Approach 438

Entity-Level Discounts 438

Minority Interest Discounts/Control Premiums 439

Discounts for Lack of Marketability 439

Voting/Nonvoting Stock 439

Questions about Contradictory Prior Testimony 439

Appendix A International Glossary of Business Valuation Terms 441

Appendix B Bibliography 447

Books 447

Articles and Papers 448

Periodicals 450

Mergers and Acquisitions Databases 451

Discount for Lack of Marketability Databases 452

Table of Cases 453

Index 461