Originally published on Forbes.com.
Nearly five years ago I wrote about the Tax Court decision in Estate of Natale B. Giustina as an illustration of what a great valuation deal you can get using a family limited partnership. The Giustina Land and Timber Company Limited Partnership owned assets, mostly tracts of timber land, worth approximately $150 million, net of a 40% discount to reflect delay in selling the land. At issue for the estate was valuation of a 41.128% interest in the partnership. So for talking purposes let’s call it a gross asset value of $60 million. The IRS argued for a value of $33,515,000. The estate had claimed $12,678,117 on the Form 706, but had another appraiser who arrived at $12,995,000. The Tax Court settled on $27,454,115, but did not allow any penalty even though the estate had come in at less than half of that.
An Appeal
Even though the Tax Court had ended up closer to the IRS value, I still thought the estate had done pretty well. Particularly if you compared it to Natale Giustina having owned a proportionate share of the assets outright. The estate was not satisfied with the result though and took the case up to the Ninth Circuit. The Circuit sent it back down to the Tax Court and, as instructed, they took another look. The result? The final, final valuation is $13,954,730. That is better than a 75% discount from asset value.
There were two elements that the Tax Court had to reconsider. One was the discount rate used on cash flows. The estate’s expert had used an 18% discount rate that was arrived at by combining a 4.5% risk free rate (Mr. Giustina died in 2005 when money still earned interest), a 3.6% risk premium for the timber industry, a 6.4% risk premium for small companies and a 3.5% premium for the “unique risk of the partnership”. In its original decision the Tax Court had scaled that last one back to 1.75% because an investor could partially eliminate the risk by diversifying. The Ninth Circuit didn’t buy that. Looking at the numbers in the decision, it looks like that adjustment was worth about $2.5 million at the end, but I may be missing something.
The Big Adjustment
The big adjustment is the one that I find most encouraging as a planner and most disturbing intellectually. Remember that there is an agreed value to the underlying assets of the partnership – about $60 million. And it is real stuff. Land and trees. Sure it can take you a while to turn it into cash, but that is already reflected in a 40% valuation discount. The estate’s valuation does not consider that. The Tax Court thought it should be given a 25% weight positing that a buyer could enter into a coalition with other owners to force liquidation. The Ninth Circuit did not buy that at all.
The Ninth Circuit has directed us to revise our valuation of the 41% limited-partner interest. The first revision we make is to change the weight we accorded the value of the partnership’s assets. In our first opinion, we assigned a 25% weight to this value and a 75% weight to the present value of the cashflows from the continued operation of the partnership. The Ninth Circuit has instructed us to “recalculate the value of the Estate based on the partnership’s value as a going concern.” In our view, the going-concern value is the present value of the cashflows the partnership would receive if it were to continue its operations. Therefore, we implement the Ninth Circuit’s instruction by changing the weight we accord the present value of cashflows from 75% to 100%. This causes our adjusted valuation of the 41% limited-partner interest to be entirely based on the partnership’s value as a “going concern”.
A Little Disturbing
What is intellectually disturbing about this is that the operation is owned entirely by members of the same family. Nothing prevents them from turning on the spigot at any point in time. The limited partnership interest has a relatively low value because it was designed to have a relatively low value. And, of course, that is what is interesting and exciting about this decision, it really confirms the value of the family limited partnership as a device for moving assets to the next generation. Given that it favors people who tend to take a long view, maybe it is not such a bad thing.
The ironic thing about this case is that the family, at the partnership level, could probably get a whopping big charitable conservation easement deduction, by agreeing to continue the same type of sustainable forestry that supports the low value for estate tax purposes. That would more or less make up for not getting much in the way of basis step-up for the underlying assets.
Other Coverage
Lew Taishoff referred to a vinyl album by The Sherwoods called Into The Woods for a title. Covering the original decision in 2011, he had used “Such Rarefied Heights of Pure Mathematics“.
And the 25% possibility that the FLP would dissolve, itself dissolves when Judge Morrison examines Laraway’s and his kinfolks desire to keep their forests primeval and chop them down slowly, replanting as they go. Laraway and kinfolk must approve any buyer; any buyer who claims to love trees but wants to sell out the Giustina arboreal splendor would be shown to the door.
Owen Fiore has a nice summary.
Reviewing these three opinions will allow readers to better understand how the mixing of valuation methodologies takes place in the litigation context. Robert Reilly of Willamette Management Associates was the estate’s expert and John Thomson of Klaris Thomson Schroeder was the IRS independent appraiser – both of these appraisers are well-known and have lots of experience in estate tax valuation cases.