The professional valuator seeking guidance for developing and defending a discount for lack of marketability (DLOM) can be driven to distraction reading the many articles and case analyses that appear after a court renders an opinion that touches on the DLOM. This discussion will explore how the courts have responded to the various approaches to developing a DLOM and focus on the lessons that appraisers can derive from studying court decisions.

Many people from a number of professions look to court opinions for insight as to how things are changing in the legal space as it affects their profession. "What does this decision mean for my tax clients, my medical malpractice insurance, my next valuation report?" and so on. While common, this sort of reading that looks for general direction from the courts may inadvertently lead to incorrect conclusions.

The attorney is trained from day one in law school to approach the matter differently. Law students are taught to ask and be prepared to answer three questions:

What were the facts of the case?

In their perusal of legal opinions, law students quickly learn a few lessons that can be of value to appraisers who read cases. First, the "facts" of any case are what the court decides the facts are. A trial court, such as the Tax Court, is referred to throughout legal writing as "the finder of fact." Moreover, the trial court has the power to determine who will be allowed to offer evidence and testimony as to the facts and who will be allowed to offer their opinions, if they are experts. This is no less true when a DLOM is at issue in a case than it is in a murder trial. Who will be believed is also entirely the province of the court.

Because of this power to determine the facts of a case, the court, especially the Tax Court, can make its own determination as to the DLOM (and valuation, and minority discount, and a host of additional details) and not follow any expert witness's testimony, report, analysis, or conclusion. The trial court, such as the Tax Court, is the "trier of fact," and may reject testimony, in whole or in part, according to its own judgment:

"We evaluate expert opinions in light of all the evidence in the record and may accept or reject expert testimony, in whole or in part, according to our own judgment." Green v. Commissioneri

"However, we are not bound by the opinion of an expert witness, especially when such opinions are contrary to our judgment" IT&S v. Commissioner.ii

"While we may accept the opinion of an expert in its entirety, Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we may be selective and use only part of such an opinion, Parker v. Commissioner, supra. We may also reach a determination of value based on our own examination of the evidence in the record." Mellinger v. Commissioneriii

What did the court decide?

The decision of any court can be, and sometimes is, interpreted beyond the boundaries of the actual written decision of the court. However, the establishment of judicial doctrine seldom turns on a single case unless that case is heard in the U.S. Supreme Court. Typically, doctrine evolves over time, as other courts cite precedents and follow them or differentiate the current case due to facts or laws. The valuator, therefore, must be careful to determine exactly what the court decided.

For example, in many cases before the Tax Court, the court decides issues of fact, such as the value of an interest, the value of a minority discount, the value of a DLOM, and sometimes issues of law, such as whether post-death factors influence the valuation of a conveyed interest. Typically, the court's decision is stated in a straightforward manner:

Heck. "We rejected the valuation report submitted by the Commissioner's expert in light of his reliance on a single comparable company in employing the market approach."iv

Janda. "Accordingly, we apply a discount of 40 percent both for lack of control and marketability to the prediscount fair market value of the Company stock as determined by petitioners' expert."

Mellinger. "Based on our examination of the entire record in this case, we conclude that the marketability discount should be 25 percent."v

What reason(s) did the court cite for its decision?

In many cases, the most important detail for the appraiser is why the court found as it did. Often times this can be difficult to follow in cases with multiple issues of fact and law, but most judges are quite good about separating their reasoning on each issue. The reasoning behind many court decisions on the DLOM is quite informative to the appraiser developing a DLOM or preparing to defend a DLOM in court:

Gallo (1985). In Gallo, a federal estate tax case, both parties relied on a published restricted stock study, and the taxpayer's expert also employed a custom pre-IPO study. The court found the DLOMs calculated by the two taxpayers' experts appropriate. The taxpayers in Gallo also retained an appraiser solely for calculating a DLOM, but the court found that the DLOM of the other two appraisers to be more reliable " integral portions of comprehensive analyses, were more reliable in the present case." The court also rejected a theory of the IRS's expert that the hypothetical purchaser of the shares in question would be a member of the family (due to the intent of the family to keep ownership in the family), noting, "Respondent is desperately reaching for some support for the unsupportable."

Berg (1991). In Berg, an estate tax case, the taxpayer put forth the argument that the court had found a particular DLOM in Estate of Andrews and other cases similar to that put forward by the petitioner. The court disagreed, noting, "First, the facts of each case are distinguishable from those of the instant case. Second, the valuation of the appropriate discounts must take into account all relevant facts and circumstances of the particular corporation at issue. Northern Trust Co. v. Commissioner, supra. This and other courts have decided many cases involving discounts. The fact that petitioner found several cases which approve discounts approximately equal to those claimed in the instant case is irrelevant. Therefore, in deciding the appropriate discounts in the instant case we will take into account all relevant facts and circumstances of petitioner's interest in Vaberg, and do not consider the amount of discount applied in other cases cited by petitioner as persuasive." The court noted that the taxpayer's experts were not professional valuators and untrained in business valuation.

The IRS expert in Berg offered in evidence discounts for Real Estate Investment Trusts (REITs): "Because of his analysis of specific factors related to the value of the decedent's interest in [subject company], [IRS expert's] methodology is convincing and superior to that of petitioner's expert witnesses. In addition, due to the greater experience, education, and professionalism in appraising business interests by [IRS expert], we place greater weight on respondent's appraisal."

Mandelbaum (1995). The findings in Mandelbaumvi have led some appraisers to the position that only the factors given by the court as influencing the DLOM (the so-called "Mandelbaum factors") should be considered in developing a DLOM. This may be due to Judge Laro's careful setting out of ten "...elements of value that are used by an investor in making his or her investment decision." These are elements that the court used in adjusting the DLOM, but as the judge himself noted, this was a "nonexclusive list." Furthermore, the court began its calculations with the taxpayers' restricted stock studies, noting, "We find that the 10 studies analyzed by [taxpayer's expert] are more encompassing than the three studies analyzed by [IRS's expert]. Because [taxpayer's expert's] studies found that the average marketability discount for a public corporation's transfer of restricted stock is 35 percent, and that the average discount for IPO's is 45 percent, we use these figures as benchmarks of the marketability discount for the shares at hand." (See the DLOM Discussion, "Defending Your DLOM" for a list of the many factors various courts have applied in determining a DLOM.)

Davis (1998). In Davisvii, a federal gift tax case, the experts for both parties employed published restricted stock studies and one published pre-IPO study in developing their DLOM. (Note: while the Davis decision is well-known for its recognition of a required offset for capital gains tax for which the willing buyer may be responsible, we will focus only on the DLOM.) The court criticized two of the taxpayer's experts for failing to specify " their respective expert reports and rebuttal reports how each used the restricted stock and IPO studies as well as factors specific to [the company] and each of the blocks of stock in question in order to arrive at a 35 percent lack-of-marketability discount." However, the court continued to note, "Nonetheless, we found those reports and the additional testimony at trial of [taxpayer's expert] to be quite helpful in ascertaining the lack-of-marketability discount that we shall apply in this case." The Tax Court's detailed approach to each issue in determining the case led Christopher Mercer to warn appraisers that, "Appraisers are increasingly being called to task by the Court to provide the detailed explanations that make it possible for the Court to render reasonable opinions."viii

Janda (2001). In Jandaix, a gift tax case, the taxpayer's expert relied on the Quantitative Marketability Discount Model ("QMDM" or "Model") in determining the DLOM. While the IRS expert challenged the use of the QMDM generally, the court cited Estate of Weinberg, "slight variations in the assumptions used in the [QMDM] model produce dramatic difference in results" and concluded that, "The effectiveness of this model therefore depends on the reliability of the data input into the model." The court went on to say, "We have serious reservations with regard to the assumptions made by [the taxpayer's expert]," noting that a number of factors specified by the author of the Model had not been included in the expert's analysis. The court concluded, "We have grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65 percent."

Heck (2002). In Heckx, another federal estate tax case, both experts cited many of the same empirical studies (not specified), but the court took the IRS expert to task for failing " make clear, in either his primary or rebuttal report, the basis for his determination that the appropriate liquidity discount is at the low end of the acceptable range of such discounts." The court found the taxpayer's expert's analysis " be both thorough and convincing, and we find that a basic discount for lack of marketability in the amount of 25 percent [the expert's DLOM] is appropriate."

Green (2003). In an estate tax case before the Tax Court, both parties in Greenxi relied on published restricted stock studies, and the IRS expert used pre-IPO studies (unspecified in the opinion) for their DLOMs. "In sum, we believe that [taxpayer's expert's] consideration of the potential loan impairment, the pending bankruptcy, and the prior transactions cause his recommended lack of marketability discount to be overstated. The remaining factors that he identified in his report support a lower lack of marketability discount." Furthermore, "In sum, we are unpersuaded that [IRS expert] has adequately supported his recommended 25 percent discount for lack of marketability."

McCord (2003) (2006). A gift tax case, McCordxii presents a challenge to the appraiser reading opinions, as the decisions of the Tax Court were appealed to, and reversed by, the U.S. Court of Appeals for the Fifth Circuit. In addition, McCord represents the rare occurrence in which the Acting Chief Judge of the Tax Court vacated the order of the trial judge and ordered a rehearing of the case, assigning it to a different judge. Seven Tax Court judges joined in the opinion filed by the new judge, while separate opinions were filed by seven other judges, concurring and dissenting with the majority opinion.

In the case of reversal for judicial error, the reader must look for the very specific reasons the appellate court gave for reversing a trial court decision. In McCord, the Circuit Court Judge's opinion makes these points clear:

"The Majority's opinion substantively treats neither the nature of the Commissioner's burden of proof nor whether he met it. Instead, the Majority confects its own methodology grounded in significant part in the donees' post-gift Confirmation Agreement. The Majority first proceeds independently to appraise the donated property, eventually reaching a value precisely halfway between those of the [taxpayers' expert] and the [IRS's expert]."

"The Majority's key legal error was its confecting sua spontexiii its own methodology for determining the taxable or deductible values of each donee's gift valuing for tax purposes here. This core flaw in the Majority's inventive methodology was its violation of the long-prohibited practice of relying on post-gift events. Specifically, the Majority used the after-the-fact Confirmation Agreement to mutate the Assignment Agreement's dollar-value gifts into percentage interests in MIL. It is clear beyond cavil that the Majority should have stopped with the Assignment Agreement's plain wording. By not doing so, however, and instead continuing on to the post-gift Confirmation Agreement's intra-donee concurrence on the equivalency of dollars to percentage of interests in MIL, the Majority violated the firmly-established maxim that a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits."

Looking to the DLOM aspects of McCord before the Tax Court that were not challenged in the appeal, this was the forum for one of Dr. Bajaj's attacks on published pre-IPO studies (specifically the Emory and Willamette studies) as empirical data on which to base a DLOM due to, among other details, a belief that "...a pre-IPO purchaser demands compensation (in the form of a lower price) for bearing the risk that the IPO will not occur or will occur at a lower price than expected." The court agreed, disregarding the taxpayer's expert's opinion " the extent [the DLOM] is based on the IPO approach." The court also took the taxpayer's expert to task for flaws in his analysis, including mischaracterizing block sizes and failing to indicate where his referenced studies drew correlations between proportional block size and the DLOM. Concluding, the court stated, "In light of those numerous defects, we give little weight to [the taxpayer's expert's] restricted stock analysis."

Lappo (2003). In Lappo, a federal gift tax case, the experts for both parties agreed that private placements of publicly traded stock were " appropriate starting place for determining marketability discount here." However, they disagreed on the private placements to be considered and what is measured by such comparisons, and disagreed "...on the inferences to be drawn from the partnership's specific characteristic."

The taxpayer's expert essentially conducted a restricted stock study from a published Management Planning study, selecting 39 transactions and working from the resulting median discount of 29.3%. The court was unpersuaded that 13 of the companies were comparable to the subject partnership and calculated the median with those companies removed, resulting in 19.45%.

The IRS expert relied on an academic study by Dr. Bajaj and others, referred to in the opinion as "the Bajaj study," which concluded a DLOM of 7.2%. The court expressed its preference in the instant case, for [the IRS's expert's] "...approach (as embodied in the Bajaj study) over [the taxpayer's expert's] more narrow 'restricted stock' approach." It then remarked that, "Absent further explication of the Bajaj study by Dr. Shapiro, however, and without the benefit of other empirical studies that would tend to validate the conclusions of the Bajaj study, we are unpersuaded that a 7.2-percent discount is an appropriate quantitative starting point for determining the marketability discount applicable to the gifted interests in this case." The court went on to examine the raw data from the Bajaj study and the average discount from another study (Herzel & Smith) and averaged the average discounts from the two studies, stating, "...we conclude that a 21 percent marketability discount is appropriate before adjustments to incorporate characteristics specific to the partnership."

Adjusting his DLOM upward, [taxpayer's expert] suggested factors, including the small size of the partnership, the lack of prospects for the partnership becoming publicly held, the partners' right of first refusal (with a 15% discount), and the requirement of the general partners' consent to a transfer of a limited partnership interest. In turn, [the IRS's expert] considered that the scheduled dissolution of the partnership [in 2045] justified some additional discount, but suggested that, "...the appraised value of the partnership's real estate already incorporates a lack of marketability discount." He also argued that the provisions of the partnership agreement had little effect on marketability. The court, without providing additional detail, noted, "On the basis of all the evidence and using our best judgment, we conclude that a 3 percent upward adjustment in the marketability discount rate (as determined by reference to the previously described empirical studies) is appropriate to incorporate characteristics specific to the partnership."

True (2004). True represents a challenge to the inexperienced reader of court opinions. First, True represents six legal proceedings: four before the Tax Courtxiv, and a combined appeal from three Tax Court decisions before the U. S. Court of Appeals for the Tenth Circuitxv, as well as a previous appeal from the Tax Court to the U. S. Court of Appeals for the Tenth Circuitxvi. Beginning with the gift tax deficiency notices from the IRS for transfers of interests in the family business, the later set of cases on appeal turned on (a) whether price terms in a buy-sell agreement "...controlled for the purpose of valuing interests..." in the decedent's estate and if the Tax Court "...erred by placing too great an emphasis on whether the buy-sell agreements had a testamentary purpose rather than on whether the agreements represented an exchange for full and adequate consideration." and (b) "...whether the tax court properly valued these different interests." The Court of Appeals found that the Tax Court had not failed to consider the existence of buy-sell agreements, saying, "By applying marketability discounts to the True companies, the tax court explicitly acknowledged the True family's bona fide business purpose of keeping the companies under family control as embodied in the buy-sell agreements." The court in True also noted that, "We believe that the restricted stock studies provide more relevant data than the pre-IPO studies, because [the interests] are subject to State law transfer restrictions and because True Oil is not comparable to a company on the verge of going public."

The lessons to take away from these cases are fairly straightforward:

  1. Be sure the DLOM takes into account all relevant facts and circumstances of the particular company whose interest is in question. The DLOM cannot be taken directly from previous decisions of the court. (Berg v. Commissioner, Mandelbaum v. Commissioner, see also Peracchio v. Commissioner and Northern Trust Co. v. Commissioner)
  2. When reviewing the facts and circumstances of the company in question, be sure that the impact on the DLOM is considered for each. Appraisers can run the risk of factors they minimize being found by the court to have greater impact on the DLOM, and vice versa. (Green v. Commissioner)
  3. Be sure that the basis (or more probably bases) for your DLOM are made clear in your report. A simple review of empirical evidence and a conclusion will not be found as persuasive as a carefully and logically worked out basis for the DLOM. (Heck v. Commissioner, Lappo v. Commissioner, see also Davis v. Commissioner and Peracchio v. Commissioner)
  4. Be sure the reasoning behind your DLOM is consistent with the rest of your valuation, as the Tax Court has expressed a preference for the valuation being an integral whole. (Gallo v. Commissioner, see also Peracchio v. Commissioner)
  5. Beware of using medians, averages, and other statistics from published studies of restricted stocks and pre-IPOs. While the Tax Court has found such figures persuasive in the past (Mandelbaum v. Commissioner, see also Davis v. Commissioner and Okerlund v. United States,), it has more recently shown a preference for data closer in time to the valuation (Berg v. Commissioner, McCord v. Commissioner, see also Estate of Mildred Green, Litchfield v. Commissioner and Peracchio v. Commissioner)
  6. Beware of quoting from published empirical studies without being prepared to address the nature of the underlying data and provide other supporting evidence. The appraiser should also offer a detailed analysis of any empirical study offered to support a DLOM. (Lappo v. Commissioner, see also Okerlund v. United States)
  7. Use pre-IPO studies as empirical evidence carefully, as the court may not find them persuasive if the subject company is not comparable to a company "...on the verge of going public." (True v. Commissioner)

iEstate of Mildred Green, Deceased; Thomas R. Green, Executor; Petitioner v. Commissioner of Internal Revenue, Respondent T.C. Memo. 2003-348 citing Helvering v. Natl. Grocery Co.,where the U.S. Supreme Court stated that the court (ed: Board of Tax Appeals) "was not obliged to accept as true Kohl's statement of his intention and purposes; or to accept as sound the opinion of his experts." Shepherd v. Commissioner, Newhouse v. Commissioner

iiIT&S of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508 (1991)

iiiEstate of Harriet R. Mellinger, Deceased; Hugh V. Hunter and Wells Fargo Bank, Co-Executors; Petitioners v. Commissioner of Internal Revenue, Respondent 112 T.C. 26 (1999)

ivEstate of Richie C. Heck, Deceased; Gary Heck, Special Administrator; Petitioner v. Commissioner of Internal Revenue, Respondent T.C. Memo 2002-34

vMellinger, citation above

viBernard Mandelbaum, et al., Petitioners v. Commissioner of Internal Revenue T.C. Memo 1995-255

viiEstate of Artemus D. Davis, Deceased; Robert D. Davis, Personal Representative; Petitioner v. Commissioner of Internal Revenue, Respondent 110 T.C. 530

viiiMercer, Christopher (1998) Mercer Capital’s Vol. 10, No. 2

ixDonald J. Janda, Petitioner v. Commissioner of Internal Revenue, Respondent Dorothy M. Janda, Petitioner v. Commissioner of Internal Revenue, Respondent T. C. Memo 2001 – 204

xHeck v. Commissioner citation above

xiGreen v. Commissioner citation above

xiiCharles T. McCord, Jr. and Mary S. McCord, Donors, Petitioners v. Commissioner of Internal Revenue, Respondent 120 T.C. 13 and Succession of Charles T. McCord, Jr., Deceased; Charles T. McCord, III and Michael S. McCord, Executors; Mary S. McCord, Donors; Petitioners-Appellants v. Commissioner of Internal Revenue, Respondent-Appellee. In the U. S. Court of Appeals for the Fifth Circuit, No. 03 -60700

xiiiSua Sponte – a decision made by the court without the position being advanced by any of the parties to the litigation

xivEstate of H. A. True, Jr., Deceased; H.A. True, III, Personal Representative; and Jean D. True, et al.; Petitioners v. Commissioner of Internal Revenue, Respondent T.C. Memo 2001-167

xvEstate of H. A. True, Jr., Deceased; H.A. True, III, Personal Representative; and Jean D. True, Petitioners-Appellants v. Commissioner of Internal Revenue, Petitioners-Appellee 390 F. 3d 1210 2004

xviJean D. TRUE, individually and as personal representative of the estate of Henry A. True, Jr.; Henry A. True, III; Karen S. True; Diemer D. True; Susan L. True; David L. True; Melanie A. True, Plaintiffs-Appellants v. United States of America, Defendant-Appellee 190F. 3d 1165 1999