In Ludwick v. Comm’r, TC Memo 2010-104, the Service struck a major blow for its favored approach to undivided interests, not only winning acceptance of its “cost to partition” approach, but winning the argument on most of the important inputs to the model, yielding a discount that’s a fraction of what has been taken in similar cases in the past. Ludwick is a troubling departure from past valuation cases and represents a significant loss for the taxpayer.
In 2000, Andrew K. Ludwick and Worth Z. Ludwick purchased unimproved real property on the north shore of Hawaii’s big island onto which they constructed a vacation home. In 2004, the Ludwicks owned the improved property as tenants in common (TIC), each holding an undivided one-half interest therein. In December 2004, the petitioners executed agreements establishing separate qualified personal resident trust (QPRT) arrangements. In February 2005, each executed a separate gift for a one-half interest of the Property pursuant to the QPRTs, for which they reported a 30 percent discount from the fair market value of the property. While the Commissioner of Internal Revenue (respondent) argued for a discount of 11 percent, it had been willing to allow a discount of 15 percent in audit. Each side provided testimony from their respective experts on the valuation of the fractional interest in the property. Both experts agreed that disadvantages of owning an undivided fractional interest in the property, as opposed to the property in its entirety, results in incremental risk for illiquidity and a commensurate reduction in value. However, opinions widely diverged on the magnitude of the appropriate fractional discount and whether partitions are always necessary to realize liquidity for a TIC interest holder.
The petitioners’ expert relied on the following three approaches: (i) undivided interest discount approach; (ii) real estate limited partnership (RELP) approach; and (iii) cost to partition (C2P) approach. The first two approaches, which are market based in nature, were rejected by the Court. The C2P approach, the only approach selected by the Court, used significantly modified data inputs from the ones provided by the petitioners’ expert.
The Court’s reasons for rejecting the undivided interest discount data included the petitioner’s expert’s failure to:
(1) explain how the discounts were calculated, i.e., how the base value was determined;
(2) provide more than a median or mean discount, i.e., measures of the dispersion of the data; and
(3) show how specific transactions were or were not comparable to the subject interest.
The message is clear: whenever the Court is invited to consider data which it is unable to scrutinize closely, it will treat such data with a high degree of skepticism.
The Court’s reasons for rejecting the RELP data are more troubling, however. The RELP data is widely used among valuation experts. The fact that the petitioner’s expert had chosen a sample of just 10 such partnerships for his analysis may provide a clue to this puzzling decision. The Court pointed out that these partnerships held income-producing properties, while the subject property was “never intended to produce income” and that the cash flow statements of the limited partnerships were irrelevant to the analysis. While these criticisms may be fair, we believe they are insufficient to reject the approach. The fact that the subject property in Ludwick was not intended to produce income does not imply it could never do so. Furthermore, the lack of current cash flows from the subject property would tend to increase the discount, relative to discounts for RELPs. Apart from this one difference, the lack of control and lack of marketability experienced by a holder of an undivided interest would be relatively comparable to those of a limited partner in a RELP. We believe the Court’s decision here, while based on reasonable objections, risks throwing the baby out with the bath water.
Lastly, under the C2P approach, the taxpayer suffered another major setback when the Court rejected the petitioner’s expert’s discount rate (required rate of return) of 30 percent as “he presented no evidence to support that conclusion.” The Court cites Barge in its discussion of the C2P method, but does not mention or discuss other undivided interest cases which might shed further light on this method, including Busch, Williams, and Baird.
The respondent’s expert relied on the following five approaches: (i) sale transactions of undivided interests (rejected by the Court due to lack of comparability to the property as “all the sales involved commercial properties in the eastern United States”); (ii) surveys of brokers on fractional interest discounts (rejected by the Court as little rationale was provided for the discount ranges); (iii) surveys of brokers on pooled public TIC investments (rejected by the Court due to lack of support for critical qualitative assumptions); (iv) analysis of tender offers for majority interests in public companies (rejected by the Court as the discount (or premium) “depends on many factors that do not seem relevant to the discount appropriate here”; and (v) C2P approach (only approach selected by the Court).
In addition, the respondent’s expert argued that, aside from a partition action, there are other avenues that may lead to a liquidity event in the near term for a TIC interest holder. Under this premise, the Court decided that a buyer would expect a partition action necessary only 10 percent of the time. As far as we can tell, this is based on no more than the fact that the petitioner bore the burden of proof in this case and failed to provide any proof stating otherwise.
Rejecting the empirical data on discounts taken in transactions involving fractional interests in real estate or real estate holding entities leaves the Court to rely solely on the C2P method. The problem with this, from the taxpayer’s perspective, is the arbitrariness of the inputs to this model. With the natural tendency of appraisals to become more and more extreme when unchecked by real-world market data, we can easily see where this leads: to an increasing number of ‘expert battles’ where each side argues irreconcilable positions based on their own personal ‘views of the world.’ For a preview of what this implies, just review some marital dissolution cases.
Under the C2P approach, the discount rate is a critical driver of value. In Ludwick, the Court noted that the respondent’s expert used a 10 percent discount rate. The petitioner’s expert used a 30 percent discount rate, but the Court noted “he presented no evidence to support that conclusion.” However, it is unclear what evidence the respondent’s expert relied on and, in fact, the entire memorandum provides no rationale for the Court’s decision to go with a 10 percent discount rate. This, also, appears to be based on the petitioner’s burden of proof.
In summary, the rejection of all relevant real-world market data, combined with the petitioner’s burden of proof, makes Ludwick a profoundly taxpayer-unfriendly decision.
1. It is worth noting that the petitioners were subject to the burden of proof under Rule 142 (a), Gift Tax Regulations, as sec. 7491 (a), a tactic used to shift the burden of proof to the IRS, was not raised.
2. Estate of Barge v. Commissioner, T.C. Memo 1997-188
3. Estate of Busch v. Commissioner, T.C. Memo 2003-3
4. Estate of Williams v. Commissioner, T.C. Memo 1998-59
5. Estate of Baird v. Commissioner, T.C. Memo 2001-258
Ori Bash, ASA, is a Vice President at Pluris Valuation Advisors LLC and resides in our Palo Alto, California office. He performs valuation services for estate and gift tax, corporate and personal income tax, fairness opinions, financial reporting, and other purposes. Mr. Bash has valued common stock, preferred stock, debt instruments, carried interests, intangible assets, minority interests in passive asset holding entities, and fractional interests in real property. Pluris has offices in New York and Palo Alto, and specializes in illiquid, complex, and distressed securities, and business valuations.