Financial Resources Management, Inc.,
provides authoritative valuations for all your business appraisal needs including buy/sell, estate planning, litigation, and others as well as economic analysis in commercial litigation.
Business Appraisals and Forensic Economics


As you are aware, the Giustina case [Giustina v. Commissioner, T.C. Memo, 2011-141, June 22, 2011] has been used as an example of the impact of the tax adjustment for pass-through entities (an entire history of this issue is available on request). If you review the original Tax Court opinion, two methods were ultimately used to determine the value of a noncontrolling nonliquid interest in a partnership. The entity invested in forests which it harvested for a lumber business. The Tax Court objected to the tax adjustment made by the Estate expert stating “An appraiser should not reduce cashflows by income tax while simultaneously using a pretax rate of return to discount the cashflows to present value.” That statement alone indicates that the Tax Court did not understand that the method used to develop the discount rate was based on data from AFTER TAX rates of return [as are virtually all determinations of discount or capitalization rates] (observations on before tax rates of return are not available as pass through entities are generally not publicly traded except for a few master limited partnerships). Thus, the cashflows must be reduced by the imputed tax rate owed by an owner on that owner’s share of the income. You must either use a before tax discount rate with before tax cashflows or after tax cashflows with after tax discount rate (as the estate appraiser did). That is why approximately 95 percent of business appraisers make the tax adjustment – almost always adjusting the cashflows.

That case was appealed to the Ninth Circuit (“the Ninth Circuit”) who remanded it back to the Tax Court [No. 12-71747, 2014 BL 342186 (9th Cir. Dec. 5, 2014]. On remand, they did not address the before tax-after tax issue so the Tax Court continued to make the same conceptual mistake as in the original opinion [Giustina v. Commissioner, T.C. Memo, 2016-114, June 13, 2016] . This aspect of the Ninth Circuit’s decision has been discussed at length [We are awaiting the next chapter in the discussion in the forthcoming case of Cecil vs. Commissioner].

However, there was another aspect to the Ninth Circuit’s opinion which has not been as widely discussed of which you need to be aware. The appraisers had utilized various valuation methodologies (primarily asset, earnings, and market methods) to determine indicators of value and then weighted them to determine the final valuation. The Ninth Circuit opined that because the general partners had no interest in selling the assets and would not admit someone who would want to sell the assets, no weight should be placed on the asset method, which had a value considerably higher than the other methods of valuation [which is not unusual]. As a result, on remand, the Tax Court gave no weight to the asset method (2016 opinion, supra).

The discussion in the Ninth Circuit’s opinion indicated a similar lack of knowledge of financial economics as did the tax adjustment portion of the opinion. That lack of knowledge was also present in the Tax Court’s resulting 2016 opinion (although they had little choice based on the Ninth Circuit’s opinion). While a sale may not be imminent or in the foreseeable future, the asset will be sold at some time in the future at which time the partners will divide the sale proceeds according to their interests. The problem is that we do not know when it will take place nor the price to which the assets may have increased by that time.

What we do know is the current net value of the assets [using the Adjusted Net Worth (ANW) or Net Asset Value (NAV) approach]. Based on the efficient market theories as discussed, for example, in Chapter 13 of Brealey, Myers and Allen, Principles of Corporate Finance, McGraw-Hill Irwin, 2006, the best indicator of the future price of an asset is the current value of an asset. We do not know when the asset sale will occur or at what price, but we do know that the best indicator of the present value of that price is the current value. Thus, the asset value (ANW or NAV) must be considered in the valuation process.

In preparing the final determination of value, the appraiser is to be guided by the Uniform Standards of Professional Appraisal Practice (USPAP) Standard 9-5 which states the appraiser must consider and reconcile the indications of value from the various approaches to arrive at the value consideration by evaluating the quality and quantity of data leading to each indication of value. It must be emphasized that the value conclusion is the result of the appraiser’s judgement and not necessarily the result of a mathematical process. The weighting of valuation indicators is not an exact science and is indicated in mathematical terms only to assist in interpreting the valuer’s thinking as to the relative emphasis given to each method. [It should be noted that the ruling of the Ninth Circuit and thereby the 2016 Tax Court in the case of tax adjusting and weighting itself violates Standard 9-1c of USPAP).

We have recently been preparing a significant number of appraisals involving asset rich firms and it is our practice to give weight to the asset approach consistent with USPAP Standard 9-5. I would be careful not to rely too much on the Ninth Circuit’s opinion in Giustina as a way to avoid considering asset values (and thereby reduce valuations for estate and gift tax purposes). If you have any questions or need more information, do not hesitate to contact us.