Tiered Discounts Theory and Tax Court Record

By William H. Frazier

William H. Frazier is a business appraiser and managing director with Weaver in Houston, Texas.

When it comes to business valuation for estate or gift tax purposes, there is perhaps no single topic that evokes stronger opinions than tiered discounts. Taxpayers love them and the IRS hates them. Situations giving rise to tiered discounts are frequently encountered in the structures used in estate planning. Appraisers must opine on the magnitude of such discounts and provide a rational explanation supporting that opinion. Unfortunately, there is virtually nothing in the financial valuation literature that speaks to this issue.

The determination of the fair market value (FMV) of fractional equity interests for estate or gift tax purposes is one of the most documented and researched topics of modern business valuation theory and practice. A not-insubstantial part of the body of knowledge of business valuations for federal estate and gift taxes relates to the subject of valuation discounts. Oft-cited textbooks on business valuation are noticeably silent when it comes to the subject of tiered discounts.

It comes as no surprise that, in gift and estate tax controversies, taxpayers’ appraisal experts argue for much higher discounts than the experts proffered by the IRS. The courts are in the unenviable position of determining a result that is most correct based upon the evidence. Much of the evidence presented by business valuation experts in these cases falls into the ipse dixit category. In fact, the only evidence cited by the courts in their tiered discount opinions is the record of other courts having previously considered the issue.

Several U.S. Tax Court cases exist that provide explanations for acceptance or disallowance of tiered discounts. Upon further examination, however, the explanations thus far proffered shed very little light on the subject.

The subject of this article is the theory of tiered discounts—not a “how to” application guide. Perhaps that will follow. The discounts provided herein for the various examples are purely arbitrary and for illustration purposes only.

The Theory of Discounts

The term “tiered discount” implies the application of two sets of discounts applied in the valuation of a noncontrolling equity interest in an investment entity whose underlying assets are composed of noncontrolling investments in one or more other asset-holding entities. So, to understand tiered discounts, we must first understand the nature of valuation discounts.

In common parlance, the word “discount” means a price reduction because of the existence of a new condition. For example, after Christmas, a clothing retailer will lower or discount the selling price of merchandise. Physically, the inventory has not changed, but because of the passage of time, its value has diminished. After a hailstorm, an automobile dealership will often sell damaged vehicles at a discount from the prices offered the day before the storm. In one case, the asset has become obsolete. In the other, the asset was damaged. In neither case is the discounted asset truly the same as the original asset.

For business valuation purposes relating to asset holding entities, discounts are applied because of the change in nature of the ownership interest—not because of a change in nature or value of the valuable asset. The decrease in value is caused by risks made manifest by the nature of the ownership interest.

It is axiomatic that a discount is always a mathematical relationship of the value of one ownership interest to another. A discount is not a commodity or thing unto itself. It is always an expression of the lowering of price relative to a previous condition. For our purposes here, we will call the value to which the discount is applied the “original value interest” and the resulting discounted value the “discounted value interest.”

As an example, one has only to look at the market prices of publicly traded stocks for evidence of this phenomenon. Stock prices are most often quoted for “round lots” of 100 shares. These shares are noncontrolling interests in the overall company. The value of the company as a whole, however, is usually worth relatively more than the aggregate value of 100 percent of the publicly traded stock. That is, on a prorata basis, the controlling interest sells at a premium to the noncontrolling interest.

The controlling interest sells at a premium because it is subject to less risk than the noncontrolling interest. The controlling interest has at its disposal all of the financial, operational, and market information about the company. The noncontrolling interest gets to see very little of these data. The controlling interest can create and implement managerial actions having a profound effect on the company’s business. The controlling interest sets the dividend policy and the compensation paid. The noncontrolling interest has no voice in any managerial action. These risks, when compensated for, give rise to the discount for lack of control. Publicly traded shares are minority (noncontrolling) interests and the risk because of lack of control is embedded in the stock’s market price.

Publicly traded stock is marketable and freely tradeable. At times corporations with publicly traded stock will raise capital in a private sale of unregistered shares of the same class as the publicly traded shares. The pricing of this so-called restricted stock almost always reflects a discount to the pricing found in the public marketplace. There are numerous empirical studies that establish this as a fact.

The discussion of discounts explains only the “what” of the historical record of certain transactions. “Why” a particular discount came to be is explained by the give and take between the buyer and seller, each of whom is attempting to maximize economic return on the investment. The buyer and seller of a negotiated transaction, each having unique views of risks and reward, develop an opinion of value, but this value is unique to that person and is defined in valuation parlance as “investment value.” For federal estate and gift tax purposes, however, the definition of value that must be used is FMV. This is the condition of value that results from the negotiations between the seller and buyer. The resulting price is FMV.

Financial value is defined as the present value of expected future economic income. Mathematical present value tables date back thousands of years. The theory of discounts is actually a subset of the theory of value. After all, a discount is merely a term we use to describe the value differential between two separate ownership interests in the same underlying asset.

The basic formula for present value of a finite, continuous stream of income is: P = D/(1+ r)n, where D is the annual expected income or cash flow; r is the discount rate (which is the measure of risk); and n is the time element or holding period. There are many other formulas for different types of financial constructs, such as debt, perpetuities, and annuities. But they all center around the same three elements of value: income, risk, and time (holding period).

In mathematical terms, then, a discount is the monetary differential in value of two ownership interests with the same proportional ownership of a valuable asset but with different characteristics relative to liquidity or control. Those differences can be experienced as a lengthy and uncertain holding period, income volatility, and financial risk that comes from the lack of information.

When the academics study “illiquidity” (and there is a vast amount of economic literature on this subject), the concepts of lack of control and lack of marketability are usually considered together. The risk associated with lack of control is often defined as “asymmetric information” and is considered a subset, or one of the constituent components, of illiquidity. In valuations for estate and gift taxes, however, a need developed for the determination of discounts for minority interests because of the distinct valuation implications of lack of control separate and apart from the cost of lack of marketability. The Tax Court has noted that it is often difficult to distinguish between the two because there is considerable overlap in causation. See Estate of Andrews v. Comm’r, 79 T.C. 938 (1982); Estate of Heck v. Comm’r, 83 T.C.M. (CCH) 1181 (2002).

There are two primary methodologies for the estimation of discounts: empirical studies and quantitative methods. More detailed information on this topic may be found in Shannon Pratt, The Lawyer’s Business Valuation Handbook (3d ed.), recently published by the American Bar Association and the American Society of Appraisers.

Regarding the lack of control discount, the most commonly used methodology is the study of the pricing of closed-end funds. These funds usually trade at a discount to net asset value (NAV), and that discount is usually associated with the lack of control. There are no academic studies supporting this claim, but closed-end funds have been accepted as proof of the discount for lack of control in innumerable Tax Court cases—perhaps because valuation practitioners and the IRS have suggested nothing better.

Restricted stock studies provide a historical record of the pricing in the sale of illiquid (restricted) stock relative to publicly traded counterparts and is the most widely used empirical evidence for the discount for lack of marketability. A far greater amount of attention has been placed on the discount for lack of marketability by the valuation community, perhaps because, relative to the discount for lack of control, the value consequences are so much greater. There are also mathematically oriented methodologies, such as option pricing models, and specialized valuation systems, such as the quantitative marketability discount method and the nonmarketable investment company evaluation method.

The empirical studies are backward looking and provide the “what” of the discounts. The causal relationship between individual transactions and the magnitude of discounts is explained only in very general terms. For the restricted stock studies, it is true that some statistical significance between discounts and such factors as stock price volatility, block size, and dividends has been found, but the correlations are generally weak.

As far as the Tax Court is concerned, discounts are best determined by a careful consideration of all relevant factors. The 1995 Tax Court case of Mandelbaum provides an excellent framework of nine different factors that logically affect the discount for lack of marketability. Bernard Mandelbaum et al. v. Comm’r, 69 T.C.M. (CCH) 2852 (1995). It is clear that the Tax Court is impressed by a thorough, careful analysis of these and other factors. It also is clear that the court is unimpressed by mere mentions of averages of studies without a studious comparison of the characteristics of the subject entity with the commonly analyzed factors.

The Tax Court does not always approve of the empirical studies, however. In the case of Nelson, the court rejected the taxpayer’s expert’s discount for lack of marketability specifically because the expert’s analysis depended solely upon empirical studies. Nelson v. Comm’r, 119 T.C.M. 1554 (2020). In referring to three prior cases, the court stated: “And in those cases we have repeatedly disregarded experts’ conclusions as to discounts for long-term stock holdings when based on these studies.” Here the court was referring to the fact that the restriction period for restricted stocks is relatively short compared to the very long expected holding period of an interest in a closely held entity. The court was more impressed by the respondent’s expert’s analysis, which considered quantitative models in addition to the empirical studies.

Interestingly, the subject of this particular discount represented a tiered discount. Discounts were being applied to a noncontrolling interest in a family limited partnership whose primary source of value was a noncontrolling interest in a family-owned operating company. The NAV of the partnership was the value of the interest held in the operating company after discounts for lack of control and lack of marketability. Although the court sided with the respondent’s expert, it assigned a slightly higher discount for lack of marketability. The court noted that the expert contended that the partnership’s discount should be incrementally lower than the discount found for the interest held in the operating company because the marketability of that company’s shares was already considered in the FMV of the partnership’s holding in the company. The court found the contention reasonable, but, because no support was provided by the expert, the court determined a slightly different result.

Tiered Discounts

As evidenced in Nelson, the term “tiered discount” implies the application of two sets of discounts in the valuation of a noncontrolling equity interest in an investment entity whose underlying assets are composed of noncontrolling investments in one or more other asset holding entities.

Each business entity, regardless of whether it is an operating or a holding entity and regardless of the legal form (corporation, limited partnership, LLC, etc.), contains two levels of ownership. We will use the term “enterprise level” to describe the asset holding level and “shareholder level” to describe the level holding fractional equity interests of the entity.

Because the topic of tiered discounts is a process of related investments, there must be a beginning and an endpoint. The process begins with a source of value held in an entity. This we describe as the “source asset holding entity.” In our opinion, the discounts are determined in a logical, hierarchical order. That is, the appropriate discount at the source asset level is first determined. Then, because the value in the investment entity is a derivative of and dependent upon values determined at the source asset level, the investment entity discount is determined last.

In a tiered investment structure, regardless of the number of tiers, there can be only one source (or “valuable”) asset holding entity. The asset values of any additional tiered entities will always be a derivative of the source entity enterprise level. Thus, for additional (investment) entities in the tiered structure, the enterprise level of that entity will be described as holding an investment asset. The FMV of the shareholder level of that entity would be found by applying any applicable discounts to the investment asset value or NAV of the entity.

Like a river that flows downstream from its source, the tiered discount begins with a valuable asset that is the source of wealth for one or more chained or “tiered” investment entities. The valuable asset can be an operating asset, such as a for-profit corporation or income-producing real estate. It also might be an intangible asset, such as a stock portfolio, royalty interest, or even art.

If the source asset value is the beginning of the tiered discounting process, the end is found at the fractional equity interest that is the subject of the valuation exercise. This is the interest that has been transferred for gift or estate tax value purposes and for which the FMV must be determined.

The existence of two tiers does not imply that discounts are appropriate at both levels. A discount is appropriate only if a pricing adjustment is required because of a change in the nature of the ownership, which also represents a change in the level of risk.

A frequent complaint of the IRS relative to tiered discounts is typified by its stance in Astleford: “In valuing the 50-percent Pine Bend general partnership interest, respondent’s expert concluded that because the Pine Bend partnership interest was simply an asset of AFLP, discounts he applied at the AFLP level . . . obviated the need to apply an additional and separate discount at the Pine Bend level.” Astleford v. Comm’r, 95 T.C.M. (CCH) 1497 (2008). The Tax Court, in answer to this claim, defended its opinion that a second layer of discounts should be applied to the Pine Bend partnership interest by citing four cases in which it had applied tiered discounts. The court also cited two other cases where such discounts were disallowed. We shall discuss this in more detail later.

The Type 1 Tiered Discount

We use the term “type 1 tiered discount” to exemplify discounts taken for which there is (1) direct, comparable market evidence for the valuation discount taken to determine the FMV of the source asset entity’s shareholder level FMV; (2) a fractional, noncontrolling share of the source asset holding entity’s equity that is held by a separate investment entity; and (3) there is a transfer of a fractional, noncontrolling interest in that investment entity for which FMV must be determined.

For illustration purposes, let’s assume ABC Real Estate Development, L.P. (ABC) directly owns and operates an income-producing shopping center—Southpark Shopping Center. The limited partners were the original investors in the development.

A distinguishing characteristic of the type 1 tiered discount is that the initial discount taken at the asset level is easily established and verified from transactions observed in the secondary marketplace or active private placement marketplace. For operating entities in various sectors such as private equity, real estate, and oil and gas, secondary markets exist wherein fractional interests are bought and sold on an organized and regular basis.

The pricing information is objective and verifiable. Thus, there is proof that the noncontrolling equity interest in question can be observed to sell at a discount. Most often, the pricing information containing valuation metrics is somewhat limited, but, for private equity and real estate investments, a discount from NAV may be directly observed. This discount is a combined one as no allocation between “lack of control” or “lack of marketability” is provided.

In the illustration, the fractional interest held in the source asset entity (ABC) is transferred to an investment entity (Smith Family, L.P.). The justification for the 15 percent combined discount is taken directly from the secondary marketplace for real estate partnership interests.

The Smith family’s 16.5 percent limited partnership interest in ABC is held by their family limited partnership, Smith Family, L.P. If the FMV of John and Mary Smith’s 30 percent interest in Smith Family, L.P., were to be determined, a careful analysis must ensue.

The validity of discounts at the investment level implies that the nature of the specific equity interest has changed in the transfer from one holder to the next. At the Smith Family, L.P., enterprise level, the financial ramifications of the fractional ownership interest in ABC has been likened to the same value that interest would obtain if sold in the secondary marketplace.

Now the task is to assess what discounts might apply in the valuation of the ownership interest in the Smith Family, L.P., held by John and Mary Smith. Let us begin with the discount for lack of control.

A large degree of discounts for both lack of control and lack of marketability are associated with the financial risks (earnings or pricing volatility). The discount for lack of control of the Smith Family, L.P., shareholder level is with a view that the asset risk found at the ABC enterprise level has been mitigated to a large extent via the previous discounting. Thus, the risk of the investment asset is far lower than the asset risk of the source asset, but the risk is not zero.

Significant components of the risk of lack of control are related to the governance and management of the entity. For the type 1 tiered discount, it is a given that these elements are not related between the asset tier and the investment tier. That is, in the type 1 construct, Smith Family, L.P.’s general partners could not serve as the general partners of ABC. Further, the limited partnership agreements of the two entities could not be linked or contractually bound together.

The Smith family investment in ABC may come with significant flows of information and opportunities to converse with management. The ABC financials may be audited and ABC may have informational reporting duties to regulatory agencies such as the IRS and SEC.

In Smith Family, L.P., however, a hypothetical buyer of a noncontrolling interest may have no access to information other than annual K-1 tax statements. Control over the partnership operations’ distribution policy may be entirely out of the hands of the general partners. Distributions paid out by ABC may or may not be passed through to the Smith Family, L.P., limited partners. These are all factors that might exist at the investment entity level, which would give rise to an additional element of discount for lack of control.

Although some of the combined discount taken at the asset level must be allocated to lack of marketability, it must be recognized that the marketability of the Smith Family, L.P., interest held by John and Mary Smith is relatively more impaired. After all, the secondary market, as imperfect as it is, does represent an element of liquidity. The Smith Family, L.P., limited partnership interests are nonmarketable. Finding a buyer would involve an expensive and lengthy private placement process.

Type 2 Tiered Discounts

In the type 1 tiered discount, only two entities are involved in the discounting process. In the type 2 tiered discount, three entities are involved.

Type 2 tiered discounts might be found to exist when a fractional interest in an investment (nonvalue source) entity is held by another investment entity and a fractional, noncontrolling interest in that second investment entity is transferred to another party, requiring a valuation and the consideration of whether or not additional discounts are warranted. In this structure, the NAV of the first investment entity is at a risk-mitigated value relative to the source asset holding enterprise level NAV. The NAV of the second investment entity is found by risk-reducing whatever lack of control and lack of marketability risks exist at the FMV of the first investment entity’s shareholder level interest.

Illustration of a Type 2 Tiered Discount

Let’s assume John and Mary Smith wish to transfer their nonmarketable, noncontrolling interest in Smith Family, L.P. to their own family entity, JAS Partners, LP. This will be followed by a gift of four separate limited partnership interests to trusts set up for their four children: Charles, Robert, Susan, and Ann.

The FMV of John and Mary’s 30 percent limited partnership interest in Smith Family, L.P., becomes the NAV of JAS Partners, LP. The four separate 20 percent gifted interests are candidates for discounts for lack of control and lack of marketability in the determination of FMV.

Substantiating discounts for the type 2 pattern is difficult but not impossible. The primary factors giving rise to discounts are (1) asset risk, (2) governance and management, and (3) lack of marketability. The asset risk will have been mitigated already in the source asset level discount (ABC). To the extent there is any residual asset risk, it will most likely have been mitigated by the discount taken at John and Mary’s fractional interest in Smith Family, L.P.

There often is an overlap in the management and equity owners between the two investment entities. Frequently, the management and other equity holders are of the same family. At this level, the functions of management may be very limited, and, as such, any risk because of lack of control would be slight. Further, any lack of marketability discount would be only any marginal or additional risk not already captured at the source asset or first investment entity levels.

Likely, any marginal discounts found at the shareholder level of the third-tier entity would be related to differences in the governance of the entities. But even if these can be enumerated, are they that different that they merit a separate discount?

There are no secondary markets for equity interests for which a type 2 tiered discount might be sourced. Accordingly, discounts must be applied based upon reason and logic, which will be dictated by the facts and circumstances of each situation.

Tiered Discounts in Tax Court

Evidence of tiered discounts can be found by reviewing US Tax Court cases. The support for opinions in every case is different and, so, valuation conclusions found therein should not be used directly in the valuation of any subject interest. Such cases can be very useful, however, in illustrating factual matters that influenced valuation determinations such as discounts. The examples we provide are but a few of many such examples found in reported Tax Court cases.

In Nelson (discussed previously), the Nelson family controlled Warren Equipment Co. (WEC), a large construction equipment dealer that also owned several other operating businesses. The overwhelming majority of WEC’s stock was held by Longspar, Ltd.—the Nelson family limited partnership. In determining the NAV of Longspar, the court allowed discounts for both lack of control (15 percent) and lack of marketability (30 percent). In the determination of the fair market value of noncontrolling and nonmarketable interests in Longspar, the court arrived at discounts for lack of control of 5 percent and lack of marketability of 28 percent. Nelson is also an example of a type 1 tiered discount as a minority interest buyer for the interest in WEC could be found. (Technically, that company’s franchise agreement with Caterpillar might not permit such a transfer, but that only serves to increase the magnitude of any discount.)

In Astleford (also discussed earlier), the Astleford Family Limited Partnership (AFLP) owned real estate and a 50 percent general partnership in Pine Bend Development Co. (Pine Bend), which also owned real estate. The other 50 percent GP interest in Pine Bend was held by an unrelated third party. In valuing the GP interest held by AFLP, the Tax Court determined a combined discount of 30 percent. Thus, AFLP’s NAV was composed of directly owned real estate and a discounted fractional ownership in Pine Bend. The court also determined discounts from NAV of 17.47 percent for lack of control and 22 percent for lack of marketability for the AFLP limited partnership interests.

The Astleford tiered discounts illustrate the commonly found situation in which only a part (or a “sliver”) of the NAV of the investment entity is represented by a previously discounted asset. The tiered discount evidenced for AFLP’s 50 percent Pine Bend GP interest is of the type 1 tiered discount described above. Although there is no secondary market for general partnership interests in real estate, the fact that there is such a market for limited partnership interests could be reasonably extended to the discounting analysis of the GP interest.

Astleford most importantly provided an opinion from the bench as to when tiered discounts apply and when they don’t. Focusing on when it has rejected tiered discounts, the court states:

We note that this Court, as well as respondent, has applied two layers of lack of control and lack of marketability discounts where a taxpayer held a minority interest in an entity that in turn held a minority interest in another entity. See Estate of Piper v. Commissioner, 72 T.C. 1062, 1085 (1979); Janda v. Commissioner, T.C. Memo. 2001-24; Gow v. Commissioner, T.C. Memo. 2000-93, affd. 19 Fed. Appx. 90 (4th Cir. 2001); Gallun v. Commissioner, T.C. Memo. 1974-284. However, we also have rejected multiple discounts to tiered entities where the lower level interest constituted a significant portion of the parent entity’s assets, see Martin v. Commissioner, T.C. Memo. 1985-424 (minority interests in subsidiaries comprised 75 percent of parent entity’s assets), or where the lower level interest was the parent entity’s “principal operating subsidiary”, see Estate of O’Connell v. Commissioner, T.C. Memo. 1978191, affd. on this point, revd. on other issues 640 F.2d 249 (9th Cir. 1981).

Astleford, 95 T.C.M. (CCH) 1497, at n.5. The court seems to imply that tiered discounts will be disallowed (1) if the lower-level interest is a significant portion of the parent entity’s assets or (2) where the lower-level interest was the parent entity’s principal operating subsidiary. There is obviously considerable overlap between the two conditions because a parent company’s principal operating subsidiary is de facto a significant portion of the parent entity’s assets.

We would note that the court’s terminology for the hierarchy of entities follows the familiar legal construct. Our presentation of the order of entities, for tiered discounting theory purposes, is based on the source of value and how it affects related ownership interests. Thus, the “parent entity” referred to by the court is the investment entity that holds an interest in the asset entity.

This message from the bench as to when tiered discounts might be disallowed is highly problematic. The implication seems to be that, because the Pine Bend interest was only a sliver of the AFLP NAV, its discounting was permissible. The logical extension of this is that if the Pine Bend interest had been AFLP’s only asset, a tiered discount would not have been allowed.

But this does not square with the court’s decisions in other cases. For example, in Nelson, the heavily discounted WEC interest was the primary asset of Longspar. In Gow, the only significant asset of the parent entity, Williamsburg Vacations, Inc., was its one-third joint venture ownership interest in Powhatan Associates. The case involved a minority ownership interest in Williamsburg Vacations, Inc. The appraisal accepted by the court included discounts for lack of control and lack of marketability for the minority interests of both entities.

In Piper, in valuing interests gifted in two similar investment entities, the court agreed to a “portfolio discount” for the unattractive nature of each company’s component assets. This is tantamount to an adjustment to NAV and is a discount for neither lack of control nor lack of marketability. A 35 percent discount for lack of marketability also was allowed for each company’s stock. There are not two layers of discounts here.

Similarly, in Janda, discounts for lack of control and lack of marketability were allowed in the valuation of the closely held holding company, which owned a 94.6 percent interest in a small community bank. The bank stock was not discounted. Thus, two discounts were allowed, but two layers of discounts were never discussed in this case.

Martin v. Commissioner is an example of a tiered structure for which discounts were disallowed by the Tax Court. The Court stated: “Thus, insofar as the gifted Arbor shares represent an interest in the seven Martin family corporations, lack of control over the family corporations and the lack of marketability of the shares of such corporations is more appropriately addressed at the level of the underlying corporations.” But what the Court said next is of great significance: “We think, therefore, that respondent’s application of a 70-percent discount at the level of the underlying corporations is a sufficient marketability/minority discount.” It is ironic that it was the IRS’s valuation expert that applied the heavy discount.

O’Connell is a case with some issues similar to Martin. In this estate tax case, the decedent owned an interest in a corporation (Capri, Inc.) that owned an interest in Glacier General Assurance Company. The court allowed a 30 percent interest for lack of marketability of the Glacier General interest. No discount was allowed for the Capri interest. The court reasoned that because it had already allowed for a discount at the Glacier General level, and because Glacier General is Capri’s principal operating subsidiary, any additional discount would serve only to increase the Glacier General discount. Mentioned but not discussed was the relevance of the large ownership interests found in this case. Capri owned a 74.3 percent and controlling ownership interest in Glacier. Even more striking is that the estate owned a 95.74 percent interest in Capri. It is somewhat of a surprise that a significant discount was allowed in this case—much less, tiered discounts.