As I mentioned in my last article, the recent case of James F. Kress and Julie Ann Kress, v. United States of America, (Case No. 16-C-795, United States District Court Eastern District of Wisconsin, March 25, 2019) dealt with a number of really interesting valuation issues. One of these related to the relevance of restrictions on the transfer of ownership interests included in an operating agreement in determining the appropriate discount for lack of marketability.
26 U.S.C. § 2703(a) states that in order to be considered in the determination of a discount a restriction must meet each of three tests (this is where I see the makings of a possible sequel to Monty Python and the Holy Grail!) – that the restriction (1) is a "bona fide business arrangement;" (2) is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) includes terms that are comparable to similar arrangements entered into by persons in an arms' length transaction shall be considered when valuing such property.
You will recall that in this case, the IRS challenged the values of gifts made by Mr. and Mrs. Kress of non-controlling stock in Green Bay Packaging (“GBP”), a very large manufacturer of cardboard packaging.
GBP’s bylaws stated that the Kress family shareholders could only gift, bequest or sell their shares to other members of the Kress family. One of the valuation experts in this case took that restriction into account in determining a relatively high discount for lack of marketability for the shares in question. The IRS maintained that this restriction should have been ignored.
The court accepted the Kress family argument that the restriction was a bona fide business arrangement since it ensured that the Kress family retained control of GBP, minimized the risk of disruption to GBP's affairs by a dissident shareholder, ensured confidentiality of GBP's affairs, and ensured that all sales of GBP minority stock were to qualified subchapter S shareholders.
The court said the second test was met since the statute only applied to a transfer on death and in this case the transfers were made during the donors’ lives.
However, the court said that the third test was not met - the Kress family had not shown comparability to similar terms in arms’ length transactions. As a result, the restriction could not be taken into account in determining the discount for lack of marketability.
The court, however, was still faced with the task of determining what the appropriate discount for lack of marketability should be. Each of the three experts in the case had applied different discounts as follows:
IRS expert – 11%
Kress expert #1 – 20%
Kress expert #2 – 28%
The court found the arguments for the 28% discount to be most convincing although they reduced the applicable discount by 3% to 25% since this was the expert that had taken the transfer restriction into account which, as noted above, the court held was not appropriate.
Having reread this article, I realized that my proposed sequel would not have the mass-market appeal to attract funding from a major studio. However, if anyone wants to invest in an indie film to be shown at next year’s Sundance Festival, let me know. (I won’t hold my breath.)