Co-tenancy interests are common in the world of gift and estate tax. Consequently, the valuation of such interests is a recurring assignment for business valuation professionals and a frequent issue in estate and gift tax audits. Numerous articles have been published on the valuation of undivided interests,1 and, as a result, three accepted methods have arisen: (1) empirical co-tenancy discount data; (2) income approach using a partition assumption; and (3) limited partnership (LP) discount data. However, in a recent seminar and subsequent Business Valuation Update article, a new approach was proposed, the so-called “minority premium” model. Let’s first review the basics of the common approaches to valuing undivided interests and then examine the merits of the new approach.
The three most common approaches to valuing co-tenancy interests are:
1. Undivided interest studies. The most obvious source for co-tenancy valuation data is the small group of co-tenancy discount studies that have been published over the years. While the studies are the most on-point data source for valuation information, it’s important to conduct a thorough comparative analysis between the subject interest and the types of undivided interests that are included in each study. For example, if the subject interest is a cash-flowing rental apartment complex, it may not be directly comparable to studies focusing on undeveloped land assets. It’s imperative that the appraisal report show the proper nexus between the comparables used in its analysis and the subject interest. Unfortunately, it’s easy to simply apply central tendencies from these studies without truly understanding the applicability to the subject interest.
“Co-Tenancy Studies,” this page, summarizes several studies and their findings.
2. Partition analysis. If partition is a viable path for the interest holder to achieve liquidity, the valuation professional must look at the cost and time required to go through a partition action. This analysis is set up as an income approach, in which the estimated future value of the real estate at the completion of the partition action is valued together with interim cash flows. Interim cash flows include any net income generated during the period from the date of valuation through the conclusion of the partition action, as well as all costs associated with the action. The discount rate should, at a minimum, be the real estate capitalization rate plus the long-term rate of appreciation in real estate value. However, there’s theoretical support for using a higher rate to reflect the minority features of a co-tenant.2 (For an example, see “Partition Analysis,” this page.)
3. Partnership studies. Assuming there’s a co-tenancy agreement in place in which the co-tenants waive the right to partition, a strong case can be made for using LP transactions as a proxy for the valuation discounts. When developing discounts based on LP transactions, a thorough comparison should be made between a typical traded LP interest and the subject co-tenancy interest. Neither affords the holder control over the underlying assets. A limited partner has even less control than a co-tenant. On the other hand, while a limited partner has limited liability, a co-tenant has unlimited liability and is often jointly and severally obligated for any debt held by the co-tenancy. Based on the comparison, appropriate adjustments to the indicated discount should be made.
State law determines the nature of the legal interest and rights each co-tenant holds in the property.3 Some of the typical characteristics of a co-tenancy interest that the appraiser should take into account include: (1) co-tenants have unlimited personal liability; (2) co-tenants have no unilateral power or control over the property, although each co-tenant does have veto power, no matter how large or small her interest; (3) each co-tenant has an equal right to possession of the entire property; (4) co-tenants have the right to seek partition or sale of the property; and (5) co-tenants are jointly responsible for expenses.
The above characteristics make ownership in co-tenancy form unfavorable. There are many situations in our practices in which a client owns a property with an unreasonable or vengeful co-tenant, who makes the management of the property difficult or impossible. For example, an uncooperative co-tenant can refuse to: (1) sign leases, (2) pay her share of expenses, or (3) sell her interest at any price. An appraiser needs to use proper factual determinations and correctly apply the law to those facts. Specifically, when valuing a co-tenancy interest, it’s important for the appraiser to take into account who the actual other co-tenant(s) are, since, as discussed below, it’s a factor that the buyer of the subject co-tenancy interest will take into account.
Minority Premium Method
In an April 2011 presentation and a November 2011 article,4 Neil B. Mills-Mazer, an Internal Revenue Service engineer team manager, presented his views on valuation of co-tenancy interests and introduced his minority premium model. This model assumes that a majority holder would rather pay a smaller premium to the minority holder than take a larger discount in the third-party market. Mills-Mazer further develops the model by making certain assumptions about what would be an acceptable premium for a minority holder.
For example, assume we have a $4 million piece of real estate with two owners: a 95 percent holder (M) and a 5 percent holder (N). Rather than taking, let’s say, a 35 percent discount to her pro-rata value in the third-party market, M would pay N a premium to the 5 percent pro-rata value to entice N to sell. Even if M paid N a 50 percent premium on N’s pro-rata value, the resulting discount to M is only 3 percent.
It helps to better understand the model if we also look at an example that has a different ownership structure. Assume we have a 75 percent majority owner (M) and a 25 percent minority owner (N). As you can see from “Two Ownership Structures,” this page, the 75/25 ownership model indicates a very different result. In that scenario, a 50 percent premium would indicate a 17 percent discount for M. As the majority interest approaches 50 percent, the discounts increase fairly rapidly. In fact, Mills-Mazer argues that the model only works for an interest that’s greater than 50 percent and that the discount indication should be given less weight as the majority interest decreases in size.
Arbitrary premium range. In his article, Mills-Mazer develops a range of so-called reasonable premiums for minority interest. This reasonable range is determined to be 20 percent to 35 percent. However, the article doesn’t present any basis for this determination. We would welcome some support of this assumption that’s based on empirical evidence, demonstrating that minority holders won’t accept less than 20 percent and don’t deserve more than 35 percent.
Minority premium. If we accept that the fair market value (FMV) of the majority interest is equal to the value of the entire piece of real estate, less the cost of procuring the minority interest, including a premium, must we then also accept that the minority interest is worth more than its pro-rata share of the appraised value of the real estate? We hope not, since such a conclusion would assume that the majority owner is always willing to pay a premium to achieve a 100 percent interest in the asset.
Hypothetical willing buyer/willing seller test. While the minority premium model initially has some intuitive appeal when looking at a 99 percent or even a 90 percent interest, it’s seriously flawed in its legal application, since it’s such a simplistic notion that doesn’t take into account all variables.
The minority premium model has received a lot of criticism that it ignores or doesn’t properly apply the FMV hypothetical willing buyer/willing seller test.5 Mills-Mazer focuses heavily on the willing seller and little on the willing buyer or the actual other co-tenant(s). He comments that if you were the 95 percent co-tenant in the above example, why would you be willing to sacrifice more than the amount for which you could buy out the other minority fractional interest holder and then own 100 percent with the ability to sell with no discount. He concludes that it would make sense for the actual minority co-tenant to take a small premium for her pro-rata value, rather than have to go through a partitioning process which could result in her receiving less than her pro rata share due to the time and costs involved.
We believe this notion is flawed, since an objective valuation using the hypothetical willing buyer/willing seller test is limited to what’s reasonably foreseeable at the date of transfer, without reference to post-valuation date events. The courts have held that speculative events aren’t considered in determining FMV, except to the extent they were reasonably foreseeable at the date of valuation.6 The recent case of Mitchell v. Commissioner7 held that an appraiser had to take into account a long-term lease on the property, rather than making the assumption that the tenant would accept any amount of money to be bought out of the lease. Thus, one of the properties was valued at nearly a 70 percent discount to the fee simple interest, due to the encumbrance of the lease. The court stated that there were no facts that the actual tenants in Mitchell would take a buy-out at any price. Similarly, it would be difficult for any appraiser to provide evidence that an actual minority co-tenant would be willing to be bought out at any premium, which is the entire premise of the minority premium model.
This line of cases discredits the minority premium model. The willing buyer/willing seller test must be applied at the date of transfer and the majority subject of the valuation would have to deal with the actual other co-tenants (who have the identical rights and control). Neither the seller nor buyer of the 95 percent interest has sufficient certainty that the majority buyer can subsequently buy out the remaining co-tenant(s). That scenario is speculative and isn’t reasonably foreseeable and, therefore, can’t be taken into account by the appraiser. The same rationale doesn’t allow the appraiser to assume that the holder of the majority interest could negotiate the buy-out of the minority co-tenant and then be able to sell a 100 percent interest.
It’s good practice to step back from the issues and remember that valuation is nothing more than a comparison of alternative investments. In the above example, if a buyer had $3.8 million to invest, what level of discount would it take for her to purchase a 95 percent interest in a property, versus buying a 100 percent interest in a comparable property without the risks that a minority co-tenant brings? A reasonable assumption is that it would be substantially more than 3 percent. At the end of the day, the hypothetical willing buyer and willing seller have to come to a meeting of the minds to arrive at the FMV of the property, without making assumptions that change the interest that’s being transferred.
In our practices, we’ve found that having a strong quarterback, who organizes the project and all its various pieces, is an excellent way of ensuring that all parties have all the facts and are moving towards one common goal (and deadline). We find that the best quarterbacks are experienced lawyers who work with the family, the family office, the CPA, the income tax advisor, the stock broker, the life insurance agent and the valuation firm. For example, the lawyer makes sure that the appraisers have all the legal assumptions that they need to accurately perform the valuation. Some of the planning issues that a quarterback should consider when organizing a co-tenancy project are:
Multiple co-tenants. The minority premium model becomes increasingly difficult to apply when there are multiple minority co-tenants. Take, for example, a situation in which there’s a 90 percent holder and four separate 2.5 percent holders. The majority holder, based on the minority premium model, will have to negotiate with four different minority holders (and four different personalities) before acquiring 100 percent and, effectively, eliminating the co-tenancy discount.
Transfer larger percentage. The minority premium model only has common sense appeal when the majority holder has a very high ownership percentage. Therefore, estate planners should attempt to transfer more than 10 percent from the client’s estate, especially if there’s only one other co-tenant.
Tenancy in common (TIC) agreement. The TIC agreement is a mutual agreement among co-tenants, which, typically, waives the right to partition and establishes a framework for making decisions and settling disputes. Mills-Mazer asserts that a waiver of partition by a majority holder, if it’s not paid for, isn’t proper, effective or enforceable and, perhaps, is a taxable gift.
We don’t agree with these notions. Not everything is orchestrated to obtain higher levels of valuation discounts; in fact, there are numerous non-tax purposes for a waiver of partition. The threat of a partition is real and cuts both ways. The waiver of partition by the minority holder will give the majority holder, who has more dollars at stake, comfort that the minority holder won’t seek a partition during a period when the property is down in value. It can be argued that a majority holder actually gains more in this scenario. In many regards, the TIC agreement eliminates a number of problems associated with TIC ownership.
No Simple Approach
Admittedly, valuing fractional interests in real property is a challenging assignment, because direct comparables are scarce. However, the valuation community must be careful not to look, out of desperation, to a simplistic approach that doesn’t take into account all the variables.
1. For purposes of this article, we’ll use the terms “co-tenancy” and “undivided interest” interchangeably.
2. Daniel R. Van Vleet and Aaron M. Stumpf, ”Higher Discounts for Undivided Interests?” www.srr.com/article/higher-valuation-discounts-undivided-interests, Spring 2010.
3. United States v. National Bank of Commerce, 472 U.S. 713, 722 (1985).
4. Neil B. Mills-Mazer, “Valuing a Majority Fractional Interest and the Minority Premium Model,” Business Valuation Update (November 2011).
5. Treasury Regulations Section 20.2031-1(b); Treas. Regs. Section 25.2512-1(b).
6. Okerlund v. U.S., 53 Ct.Cl. 341 (2004) (ignoring possible, though unlikely, events in gift tax); Simplot v. Comm’r, 249 F.3d 1191 (9th Cir. 2001); and Morrissey v. Comm’r, 243 F.3d 1135 (9th Cir. 2001).
7. Estate of Mitchell v. Comm’r, T.C. Memo. 2011-94.