“Valuation report writing is a lot more challenging than we think,” says former IRS official Howard Lewis (International Society of Business Analysts and RiskGuidance Co. LLC). Speaking at the recent NYSSCPA Business Valuation Conference in New York City, he observed that valuation report writing and report review is an overlooked subject that deserves more attention.
While there is a great deal of material about report writing in BV standards, textbooks, and so on, some of the most important—and practical—lessons come from the courts. Lewis points out a number of key court cases that speak to various aspects of report writing—cases that every valuation analyst should know before writing that next report.
- Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148
This case is a great example of the need to “explain everything” when writing a business valuation report, says Lewis. He points out that the most common problem with reports is the failure to explain certain conclusions, especially discounts and multiples. “Don’t just state—explain,” he says.
At the conference, he asked attendees whether anyone knew or could explain what the Gallagher case says about report writing. No one raised a hand. “I was shocked that no one appeared to know this case,” Lewis said later. “It’s a great report-writing case.”
In a detailed, comprehensive opinion by Judge Halpern, the U.S. Tax Court in Gallagher addresses nearly every aspect of private company valuation, including the application of the guideline public company method and income approaches. It also has a particular focus on tax affecting, adjustments to financial statements and cash flow projections, calculation of the rate of return, application of subsequent events, and the determination of discounts for lack of control and lack of marketability.
“Judge Halpern had many problems with both experts not being able to explain things,” says Lewis. “The judge destroyed both sides. Read it. It will help you understand your report writing—and your testimony.”
- Estate of Winkler v. Commissioner, T.C. Memo 1989-231
An important concept about report writing is that another expert—after reviewing your report—should be able to replicate your work. It doesn’t matter whether your conclusion of value is picture-perfect. It’s like a carpenter trying to replicate a house without a blueprint. If there are not enough details about how you came to your conclusion, the court may not accept it—as the Winkler case illustrates:
Respondent’s expert appears to be extremely well qualified but he favored us with too little of his thought processes in his report.… His report briefly referred to the projected earnings approach, but the discussion was too abbreviated to be helpful. His testimony on the computer models he used … suggested that a lot of work had been done but simply not spelled out in his report. That may also be the case in his price-to-earnings computations, but the Court cannot simply accept his conclusions without some guide as to how he reached them.
- Estate of Berg v. Commissioner, T.C. Memo 1991-279
Citing cases in a valuation report is problematic for a few reasons. First of all, valuation experts are not attorneys, so to cite cases can be asking for trouble if you don’t fully understand the nuances of the case. Second, every valuation engagement is different, so a conclusion of value is predicated on the specific facts and circumstances of the subject. In the Berg case, the expert cited cases in backing up the amount of the discount he was claiming. The court wasn’t pleased:
We will not discuss these cases in any detail for two reasons. 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.… 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 [the subject entity], and do not consider the amount of discount applied in other cases cited by petitioner as persuasive.
- Louise B. Barnes v. Commissioner, T.C. Memo 1998-413
This case emphasizes the importance of including in your report all of the information that’s available. If your opponent finds more information than you, it will not be a good situation. In this case, the taxpayer’s expert used the market or guideline company approach to estimate the value of the stock, but the court noted:
He excluded three companies that [the IRS expert] used as comparables because he did not have their market trading prices as of the valuation date. In contrast, [the IRS expert] apparently easily obtained the stock prices by contacting the companies.
The court also pointed out that the IRS expert visited the companies and interviewed the management. However, the taxpayer’s expert did not do a site visit, nor did he “make any other factual investigation.”
5. Estate of Lewis A. Bailey v. Commissioner, T.C. Memo. 2002-152
“Be consistent” is the lesson in this case, which considered the valuation of a corporation that owned and operated motels for estate tax purposes. The court picked up on some inconsistencies in the expert’s report that led to the expert contradicting himself—something to avoid at all costs.
In one place in his report, the expert categorized the company as a mere holding company. In several other places, he said the company “owns and operates” motels and that the family manages the properties. This inconsistency came back to haunt him when he discussed DLOM.
From his report, we infer that [the expert] believes that management continuity would support an additional amount of marketability discount if [the subject company] were considered to be an operating company. As just noted, [the expert’s] own report (although internally inconsistent in this regard), as well as the evidence in the record, fairly supports a conclusion that [the subject company] was in fact an operating company. Hence, [the expert’s] own report supports a conclusion that his recommended marketability discount is understated insofar as it disregards continuity of management.
- Estate of True v. Commissioner, 2004 U.S. App. LEXIS 24844 (Dec. 2, 2004), affirming T.C. Memo 2001-167
This is an estate and gift case in which the court was troubled by the lack of explanations on a number of issues. It went into details about the DLOM conclusion, the weighting of factors used in the guideline company method, and a minority discount.
For the DLOM for controlling interests, the taxpayer’s expert relied on restricted stock and pre-IPO studies. The Tax Court takes issue with this:
We are troubled by the lack of any clear connection between [the expert’s] report’s general discussion of restricted stock and pre-IPO studies and the marketability discounts applied to the [subject interests]. For instance, there was no showing that the industries represented in the studies had risks and other attributes similar to the oil and gas industry. In fact, one of the pre-IPO studies specifically excluded natural resource companies from the companies being examined.
The court had more trouble with the report’s guideline company analysis:
It provided no data to support the calculations of EBDIT, EBIT, pretax earnings, and book value for either the comparable companies or [the subject company]. Further, [the expert] did not explain the relative weight placed on each factor.… Without more data and explanations, we cannot rely on the final [expert’s] report’s valuation conclusions using the guideline company method.
The analysis of the minority discount also was a target:
The final … report vaguely described studies of acquisition transactions and REITs to support the chosen discount, but it did not cite specific studies, describe the studies’ assumptions and findings, or analyze the control features of the … subject interests. We therefore disregard [the final report’s proposed minority discount].
- Kohler v. Commissioner, U.S. Tax Court, July 25, 2006
In a valuation report, you need to follow the professional standards of the appraisal organization from which you are certified and prepare the report accordingly. If you are not certified, you must, at minimum, meet the requirements of the Uniform Standards of Professional Appraisal Practice (USPAP).
This was one of the issues in the Kohler case. While the valuation reports by the Kohler experts merited high praise from the court, it was the IRS expert’s report that felt the judge’s wrath.
[The IRS expert’s] report … was not submitted in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) … and did not provide the customary USPAP certification.
Final point. At the recent NACVA conference in Las Vegas, one of the sessions spent a lot of time discussing the Richmond case (Estate of Richmond, T.C. Memo. 2014-26). While it has major valuation-related issues, one of the interesting aspects of the case has to do with the valuation report submitted with the tax return. Attached to the return was not the final report, but a draft version—and it was marked up. And, of course, it wasn’t signed. This brings up the question of whether you should submit draft reports to attorneys. The risk is that you don’t know where they will end up—and you could get a surprise call asking to explain something in a report that you never intended to get released.