Current Issues in Valuation Relating to Estate & Gift Tax

John GlennPresident

The Mentor Group, Inc.Direct - 760-325-6411

Brad M. Cashion, CFAManaging Director

The Mentor Group, Inc.Direct - 760-898-3334

February 4, 2009

Agenda

• Types of DiscountsLack Of Control

Lack of Marketability

Multi-Level Entities

Built-in Capital Gains

Blockage

• IRS Issues – Common errors the service

sees in valuation reports

• Valuation for Charitable Gifts

• Valuation of Life Insurance Policies

The New World We Work In….Application of Discounts

• Benchmarking – using empirical market data for studies

• Quantitative Methods

• Guideline Transaction Methods

• Discounts must be supported through qualitative and quantitative analysis

• Discounts must be supported by a “sanity check” using an internal rate of return calculation

Discounts for Lack of Control

• Must match source of market data with the type of asset held by the entity

• Closed End Funds – Must use specific CEFs that match type of assets owned

• RELP – good for entities that own real estate

• Income Method – Discounted cash flow and capitalization of earnings

Discounts for Lack of Marketability

• Benchmarking – using market studies and apply the “Mandelbaum factors”

• Quantitative Methods– Put Option Calculation– LEAPs– QMDM– Guideline Transactions – 2 step process

Mandelbaum Factors that Affect Marketability Discounts

1. Private vs. Public Sales Comparables

2. Financial Statement Analysis – Financial Strength

3. The Entity’s Dividend or Distribution Policy

4. The Entity’s Position in the Industry and its Economic Outlook

5. Management Strength of the Entity

6. Amount of Control being Transferred

7. Restriction on Transferability

8. Expected Holding Period of the Investment

9. The Entity’s Redemption Policy

10. Costs Associated with Selling the Interest Being Valued

Computation of Discounts for Entities that Own Various Types of Assets

1. Real Estate Holding Entities

Market data used to compute the discounts must be based on transaction data from entities that own real estate.

Some of the factors we must consider are:a. The size of the interest being valuedb. The amount of debt in the entityc. The income generated from the real estated. The cash distributions paid to the ownerse. The growth prospect for the real estate

2. Case Studies –

a. 25% LLC Int. – 100% Marketable Securities – 28.52% Discountb. 15% LLC Int. – 65% Marketable Sec. & 35% Private Equity – 31.38% Discountc. 25% LLC Int. – 60% Real Estate & 40% Marketable Sec. – 34.66% Discountd. 49% LLC Int. – 100% Real Estate (apartment) – needs $ for rehab – 41.7% Discounte. 33% LLC Int. – Land for development – 53.8% Discount

Computation of Discounts for Entities that Own Various Types of Assets

2. Entities Owning Real Estate & Marketable Securities

Different discounts must be applied to the real estate assets as compared to the marketable securities assets. (Refer to discounts outlined in previous slide)

Some of the factors we must consider are:

a. The size of the interest being valuedb. The amount of debt in the entityc. The income generated from the assetsd. The cash distributions paid to the ownerse. The growth prospect for the assetf. The % of asset allocation to the real estate and to the marketable securitiesg. The type of marketable securities – equities vs. debt securities

Computation of Discounts for Multi-Level Entities

• These are entities that own fractional LP or LLC interests in other entities.

• Care must be given to not double count the discounts. Discounts can only be taken at each entity level after analysis of the specific facts.

• Facts that drive multi-level discounts

a. Asset Allocation – are the same assets included at each entity level

b. Entity Management – are the managers the same or different at each entity level

c. Governance – does the interest have the same voting and ownership rights at each entity level

Computation of Built-In Capital Gains Discounts

There is 3 thoughts on how to deal with Built-In Gains

1. Assume the assets will not be sold and no discount for the tax should be taken

2. Assume the assets will be sold over time and the time value of the tax should be deducted

3. Assume the assets will be sold as of the date of valuation and take 100% of the tax due as a discount. (Jelke vs. CIR, No. 05-15549 case)

The valuation thought process should consider how a rational hypothetical buyer would value the interest

IRS Update – Common Errors in Valuation

1. The math does not add up correctly2. Were the discounts applied properly3. Did the appraiser reconcile and explain what method or why

weights were applied to compute the conclusion4. Is the appraiser acting as an obvious advocate5. Was selective data used without justification – using data

after the valuation date6. Was professional judgment relied upon to the exclusion of

the facts7. Are the guideline companies truly comparable8. Is the future ignored in favor of the past9. Were the income statements properly adjusted – Non-

business expenses, salaries at market10. Was the tax status considered properly – S Corp vs. C Corp11. Was the wrong premise of value used – Liquidation vs.

going concern

Valuations for Charitable Giving

Reg§1.170A-13(c)(3)(A) Need for a Qualified Appraisal:

1. No earlier than 60 days before contribution and no later than due date of return

2. Content: Description of assetDate of Contribution

Name & Qualifications of AppraiserAppraised ValueMethods to Determine ValueForm 8283 Completed

To reduce the chance of an audit, it is highly recommended to attach the appraisal to the return.

Valuation of Life Insurance Policies

New Calculations to support Fair Market Value

“PERC” Calculation outlined in Rev. Proc. 2005-25 as the safe harbor calculation does not consider fair market value

The Mentor Group Approach – use of scenario analysis assuming varying life expectancies

Evolution of Valuation Models

Use of Static Models – DCF, Single point valuation multiples

Use of Dynamic Models – Monte Carlo Simulation

What To Remember From This Presentation

• Discounts must be computed using the correct market data and a quantitative method to support the final discount.

• There are several factors that must be evaluated for each entity that affect the size of the discounts.

• The analysis of entities owning different asset classes must consider the asset allocation percentages to compute the final discounts.

• Multi-Level entity structures must be analyzed carefully so there is no double counting of discounts.

• There are 3 different viewpoints on how “built-in” capital gains are to be computed, but the trend is towards taking the full discount.

• Once the total discounts have been computed, an “internal rate of return (IRR)” calculation must be computed to support the size of the discounts.

• Valuations for charitable giving are on the top of the IRS list to audit, and a full report to support the value of the gift is needed