In today’s world, we acquire most of our short-term knowledge by “Googling.” When reading the recent Giustina decision, the first thing I did was Google the term, “Going-Concern Value”. The results showed the top definition: “a going concern value is the value of a business that is expected to continue operating into the future as opposed to being liquidated for its assets.”
This terminology is very relevant because the U.S. Court of Appeals for the Ninth Circuit reversed the Tax Court’s decision in Estate of Natale B. Giustina1 and remanded the decision to the Tax Court with the instruction to value the Giustina Land & Timber Co. (Partnership) as a going concern. What gave rise to these instructions was the somewhat arbitrary assumption by the Tax Court that there was a 20 percent likelihood that the timber company would be liquidated — arbitrary, because there were no plans to liquidate, and the interest in question didn’t have the power to liquidate the Partnership. Therefore, if there’s no liquidation, it’s a going concern. Google and the Ninth Circuit appear to be in agreement.
Two Different Valuation Approaches
The Partnership owned 48,000 acres of timberland and earned profits from growing trees, cutting them down and selling the logs. All parties agreed that the value of the timber was approximately $150 million. The most interesting facet of this case is the dichotomy in value between analyzing the Partnership under the net-asset method (resulting in a value of $150 million) and looking at the Partnership under the income approach (resulting in a value of $50 million). In other words, an asset-based approach results in a value 300 percent higher than an income-based approach. Keep in mind that neither approach assumes liquidation and both approaches analyze the company as a going concern.
Revenue Ruling 59-60
How do you handle establishing the value of the Partnership under a going concern premise when different approaches result in drastically different value conclusions? For the most part, the courts have been getting it right when they’ve followed the guidelines set forth under Rev. Rul. 59-60:
In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products and services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.
The original Giustina decision in 2011 reflected a seemingly reasonable approach by both appraisers — the taxpayer’s expert assigning 30 percent of weight to the income approach and 70 percent weight to the asset approach, and the Internal Revenue Service’s expert assigning 20 percent of the weight to the income approach and 80 percent weight to the asset approach.
The idea of weighting the different approaches is not only in line with the considerations outlined under Rev. Rul. 59-60, but it’s also supported by previous court decisions.
Estate of Andrews
In Estate of Andrews,1 the issue was the date-of-death values of four companies that were involved primarily in the ownership, operation and management of commercial real estate properties with some liquid assets in the form of stocks and bonds. The court pointed out that the degree to which a company is actively engaged in producing income, rather than merely holding property for investment, should influence the weight to be given to the values arrived at under the different approaches. Additionally, it also shouldn’t dictate the use of one approach to the exclusion of all others. The court stated:
We find the taxpayer’s expert’s valuation to be seriously flawed because they did not take into account each corporation’s net asset value… As discussed earlier, a prospective buyer of stock in these corporations would undoubtedly give substantial weight to net asset values.
The company in the Andrews case was a going concern, and it was correctly valued as such, with the appropriate weighting for the fact that the primary value driver was the value of the assets, not the cash flows.
Estate of Ford
We see a similar result in Estate of Ford.2 The estate held several companies that were pure holding entities and one entity, Ford Storage and Moving, which had minimal cash flows and significant investments in tangible assets.
The IRS’ expert concluded (and the court agreed) that Ford Storage and Moving was a “blend” of an operating company and a holding company. Consequently, the company was broken down into operating and non-operating assets. The non-operating assets were valued based on their current fair market values (net asset approach), while the operating assets were valued under traditional approaches, including an income approach and a market comparable approach. The two portions of the business were combined to reach a final conclusion, providing another example of a going-concern valuation that considered both an asset approach and an income approach.
A Contradictory Story
The recent result in Giustina tells a very contradictory story. After the apparently reasonable weighting by the two experts, the Tax Court stepped in and stated that an asset-based approach is only appropriate if the assets are to be sold. In other words, it equated the asset approach with a liquidation approach. Accordingly, it surmised that the weighting between the income approach and the asset approach had to mirror the percentage likelihood of liquidation. Based on its acknowledgement that there was a vast amount of value locked up in the underlying assets, the court selected an arbitrary 25 percent likelihood that liquidation would occur. The result of the shifted weighting was a significant decrease in value from $150 million, held in assets by the Partnership, to approximately $75 million. This turned everything we thought we knew about a going-concern value on its head as it, in fact, meant that an asset-based approach would only be appropriate if the assets are being sold and would no longer be appropriate under the going concern premise.
The taxpayer appealed the decision to the Ninth Circuit, which made quick work of the weighting by stating:
We conclude that it was a clear error to assign a 25 percent likelihood to these hypothetical events… the Tax Court engaged in imaginary scenarios… we therefore remand to the Tax Court to recalculate the value of the Estate based on the Company’s value as a going concern.
At the time, I wondered if the court’s intention was to simply remove the 25 percent weight and give all the value to the income approach, thereby further reducing the value of the Company. And that’s exactly what happened. The court stated:
The Ninth Circuit has instructed us to “recalculate the value of the Estate based on the Company’s value as a going concern.” In our view, the going-concern value is the present value of the cash flows the Company would receive if it were to continue its operations. Therefore, we implement the Ninth Circuit’s instructions by changing the weight we accord the present value of cash flows from 75 percent to 100 percent.
After applying the appropriate valuation discounts for lack of control and lack of marketability, the value of the estate’s 41 percent limited partner interest now stands at $13,950,000 — potentially a result over which the estate’s heirs are pinching themselves, given the $150 million value of the timber.
The implications of excluding all asset-based approaches from going-concern valuations are potentially significant. I don’t believe that the next partnership holding undeveloped land with no intent to liquidate will be valued as a going concern with sole consideration to the income approach and a near-zero value. At the same time, I do believe that this ruling will have a significant impact on the many companies that have some cash flow but derive most of their value from their underlying assets. I’m sure that mucking up the long-established going-concern premise, and drastically reducing values, was not what either the Tax Court or the Appeals Court had in mind.
Endnotes
1. Estate of Natale B. Giustina et al v. Commissioner, T.C. Memo. 2011-141.
- Estate of Andrews v. Comm’r, 79 T.C. 938 (1982).
- Estate of Ray A. Ford, v. Comm’r, No. 94-2825 (May 4, 1995).
