Nelson v. Commissioner, T.C. Memo. 2020-81
Volume 1- Discount for Lack of Control
There are numerous significant valuation issues highlighted in the recently decided Nelson v. Commissioner. For the sake of brevity, no doubt, the valuation discussion in Nelson omits many details that serious a student of valuation would dearly like to know. Because of this, any observations I make must be made with the disclaimer that, if I had key financial information, the comment might have been different.
The valuation topics I will focus on are:
There are several other interesting legal and valuation issues in the case but I will leave these for others to discuss. As a matter of fact, Steve Akers and Ron Aucutt of Bessemer Trust have recently published an excellent article on this case: “Nelson v. Commissioner, T.C. Memo. 2020 81 — Valuation: Formula Transfers, Minority and Marketability Discounts, Multi Tiered Discounts.” If you are interested in my blog you will certainly want to read Steve and Ron’s paper as well.
The value disputed in this case is derived from Warren Equipment Co. (WEC), a Delaware holding company owning 100% of the stock of Warren Cat, a Caterpillar equipment dealership in West Texas and Oklahoma which made up 51% of WEC’s combined value. WEC also owned several other companies providing equipment and services to the oil and gas exploration and production industry. CSI, which manufactures natural gas-powered compressors equipped with Caterpillar gas engines, comprised 40% of WEC’s value.
The history of the Warren family with Caterpillar and CSI goes back to 1971 when Johnny Warren was named general manager of CSI. CSI was owned by Treanor Equipment Co., a Caterpillar dealer covering several counties in West Texas. Mr. Warren purchased CSI in 1975 to found Warren Equipment Company. In March of 1985, Johnny Warren was named Dealer Principal for Treanor Equipment Company. The following year, the authorized Cat Dealer for the Amarillo and Lubbock territory was acquired.
After Johnny’s death in 1999, his son-in-law, Jim Nelson, was named as the dealer principal for Warren Cat. In 2002, WEC acquired the assets of a Caterpillar dealer in Oklahoma, giving Warren Cat the territory it now holds. Also, in 2002, the WEC dealerships were combined into a new organization, Warren Power & Machinery, L.P., but continued to do business as Warren Cat.
 We presume WEC also acquired the assets of Treanor Equipment Company but the record is unclear.
On the valuation date, 27.7% of the stock of WEC was held by Longspar Partners, Ltd., a Texas limited partnership. Mary Nelson (Johnny’s daughter) and husband Jim Nelson each held a 50% general partnership interest for a combined 1% of Longspar. Mary also owned 93.88% of Longspar as a limited partner. Various trusts held the balance of the LP interests. WEC stock comprised 99% of Longspar’s net asset value (NAV).
On December 31, 2008, Mary made a gift such that $2,096,000 in LP interests were to be transferred to the Nelson 2008 Descendants Trust. On January 2, 2009, she sold, via a note, LP interests having a fair market value of $20,000,000. (Both transfers used a valuation date of December 31, 2008). The final values were to be determined within 90 days by appraisals to be performed by Ms. Barbara Rayner (WEC) and Mr. Roy Shrode (Longspar).
When the IRS challenged the appraisals as underestimating fair market value, the taxpayers asserted the position that, even if the IRS-determined values held, the transfers were of dollar amounts not fixed percentages of Longspar. Accordingly, while the percentage interests transferred would decrease, the dollar amount would remain constant. Thus, the taxpayers would owe no additional taxes. But, the IRS claimed the defined value mechanism used by the taxpayers was defective and, in fact, the transfer was for a fixed percent of Longspar-not a fixed dollar amount. The Court ruled in favor of the IRS:
They are bound by what they wrote at the time. As the texts of the clauses required the determination of an appraiser within a fixed period to ascertain the interests being transferred, we conclude that Mrs. Nelson transferred 6.14% and 58.35% of limited partner interests in Longspar to the Trust as was determined by Mr. Shrode within a fixed period.
Having lost the argument over the defined value transfer, the case became a battle of the experts over various valuation issues. At times, the Court disregarded the testimony of all of the experts and proffered its own valuation opinions.
The taxpayer’s appraiser of WEC, Ms. Rayner, using a “sum of the parts” approach, opined as to the controlling interest values of all of the WEC entities. The values were determined on a debt free basis for each subsidiary with debt deducted at the holding company level in determining the final value of the equity of WEC.
The skirmishes over value had to do with whether Ms. Rayner determined “controlling” interest or “noncontrolling” interest values. Ms. Rayner claimed her valuations determined controlling interests to which discounts for lack of control could be applied. Mr. Mark Mitchell, the IRS’ expert appraiser, disagreed claiming the valuations determined noncontrolling interest values for which no discount for lack of control was appropriate.
Ms. Rayner valued the 100% controlling equity interest in Warren Cat by the net asset value method of the asset approach. Ms. Rayner asserted that if control of the dealership was transferred, as was envisioned in her theoretical construct, the Caterpillar restrictions of the dealership agreement would be triggered. Those restrictions mandated that any sale of the dealership must be at NAV.
Mr. Mitchell noted that Warren Cat’s results indicated excess economic returns and the presence of intangible asset value. He concluded that Ms. Rayner’s failure to include that intangible asset value in her analysis resulted in a fair market value for Warren Cat on a noncontrolling interest basis and, therefore, precluded the use of a minority interest discount. The Court, however, disagreed with Mr. Mitchell’s assessment noting that it had disallowed just such an analysis of intangible asset value in two prior cases having to do with automobile dealerships.
I disagree with the Court’s use of prior case law on automobile dealership intangible value here. An owner of a dealership will have a multitude of competitors -those with the same brand and those offering comparable automobiles of a different brand. There are only 46 Caterpillar dealerships in the US and there is only one Caterpillar company. Caterpillar dealerships rarely sell. 
One of the reasons they rarely sell is that the owners usually have the ability to earn large profits (Mitchell’s “excess economic returns”) but Caterpillar does not allow dealers to capitalize on this when dealerships are sold because dealerships must be sold at NAV. (A very much intended inducement by Caterpillar for their dealerships to become family legacies.) Therein lies the problem for Mr. Mitchell’s argument. The restriction imposed by Caterpillar (and other equipment dealers) means a willing (or unwilling) seller is limited to NAV. According to this line of thinking, we must presume a sale to determine fair market value, and, if NAV is the required methodology, the intangible asset argument becomes moot.
Having valued minority interests in a couple of Caterpillar dealership before, I know there is a significant amount of cash flow generated by the profitable sale of equipment and parts and from servicing equipment. The capitalized value of this cash flow is not captured in tangible net asset value. So, unless Warren Cat was underperforming, fair market value based on NAV would greatly understate the value of Warren Cat to its owners.
In a discussion with Gil Matthews (well-known business appraiser of the Simplot saga), Gil was adamant that using the NAV approach was the wrong measure of fair market value in Nelson. There was no reason or need to use a methodology which artificially brought in the Caterpillar restriction. The Company was not for sale. Further, no rational seller would sell its franchise unless they were under duress and/or the company was underperforming.
A better valuation approach would have been to value Warren Cat on a minority interest basis using the discounted cash flow method of the income approach (DCF). There is no need to presume a hypothetical sale of the 100% equity interest in Warren Cat since it is a 27.7% minority interest in WEC that Longspar holds.
One reason the IRS may not have wanted to go down that road is that, since Warren Cat is a limited partnership, it would have drawn the issue of “tax affecting” into the discussion. In the recent case of Aaron Jones v. Commissioner, the IRS, to its detriment, tried to avoid tax affecting and was soundly defeated on this issue by the taxpayer’s approach which embraced tax affecting.
In that case, the Court (also Judge Pugh) held that a minority limited partnership interest in a timber company that held timberlands and generated annual cashflows from timber harvesting operations must be valued only by the income approach since there was no likelihood of a sale or liquidation of the company. This conclusion apparently rejected even the notion of a hypothetical sale.
So, why, for a company such as Warren Cat which is only an operating company, would the use of the asset approach make sense? In my opinion, it does not. There was another, better way to skin this cat.
I would also note that the valuation dates were in the midst of the Great Recession. The mother ship, Caterpillar, recorded an earnings decline of 75% in 2009. Perhaps, the downturn had already impacted Warren Cat’s earnings as well but there is nothing in the record which speaks to this. So, my comments rest on the assumption that Mr. Mitchell was correct about the presence of significant intangible value in Warren Cat. After all, no one denied this. The IRS and the Court merely said it must be ignored for valuation purposes.
The Court cannot be faulted for the use of the NAV-based valuation methodology in Nelson. This was the taxpayer’s expert’s approach and neither the IRS nor its expert challenged it. This was the only evidence presented as to the value of Warren Cat. Yet another reason why appraisers should not base valuation methodology on the findings of a single court case.
 An exception to this would be the 1980s transfers of dealerships serving the recession-plagued oil and gas producing regions.
It has been determined that Warren Cat must be valued at NAV even though that value, according to Mr. Mitchell, is far below the economic value which would have been enjoyed by the hypothetical buyer and new owner. Accepting the foregoing as the fact, would any rational seller then allow the buyer a discount from this price? Would any rational buyer even ask for one? Is it always the case that discounts from NAV must exist?
The answer is “no”-discounts do not always have to exist. There is ample evidence of market premiums with respect to NAV in asset holding entities owning such assets as oil and gas, timber and real estate (especially REITs). From Pratt’s Valuing a Business, which the Court cited often in Nelson, statements can be found documenting situations wherein minority interest values in public companies exceed the (pro-rata) transaction values of controlling interests in comparable companies. Such might be the case with Warren Cat.
One element which would cause a minority interest discount to be appropriate here rests on whether or not significant dividends were paid. It is amazing to me that there is nothing in the record about dividends paid to WEC shareholders. Appraisers and the Tax Court overlook this key variable time and time again. In valuing an FLP holding marketable securities, appraisers frequently examine closed end funds when determining the lack of control or minority interest discount. It is axiomatic that those funds with high dividends sell for low discounts and those with low dividend rates sell at high discounts.
In the valuation of CSI and two smaller companies, PSI and NorAm, Ms. Rayner used DCF of the income approach and two methods of the market approach. For the sake of brevity, I will refrain from a discussion on methodology. Suffice it say the Court accepted her DCF analysis but rejected the market approach values.
Although the Opinion does not state this, it appears Ms. Rayner weighted the DCF value 60% and the market approach 40% to arrive at an overall value of $309 million for CSI and PSI. This is an important point we will come back to later.
Regarding the DCF value, Mr. Mitchell correctly noted that Ms. Rayner made no adjustments to income or expense to be consistent with a control level valuation and neither did she make any adjustments to the capital structure that would be consistent with control. Accordingly, the DCF value was that of a minority interest to which no lack of control discount should be applied.
The Tax Court agreed that Ms. Rayner’s DCF values were of minority interests but cited passages from Pratt’s Valuing a Business: “[e]ven minority shares can have some elements of control. These elements of control may reduce, but rarely eliminate, the discount for lack of control.”
But, the Court has misinterpreted Pratt’s point. As the Court noted, Pratt was referring to three types of situations by which a minority block might have elements of control (blocking power, swing vote, and takeover protection). What Pratt was saying is that even though these minority blocks can exert some measure of control, they do not have absolute control and, therefore, some measure of discount for lack of control is warranted. That is not the situation under analysis here. No one has argued the Longspar block has blocking power, is a swing vote or acts as a “poison pill” to prevent takeover.
In Pratt’s chapter on the income approach, there is a section entitled “ Does the Discounted Economic Income Model Produce a Control or a Minority Value?” According to Pratt, if the projections used are not adjusted and merely reflect a continuation of current financial policies of the company then a minority interest value is determined. Most practitioners I know generally follow this rule.
Historically, the Tax Court is very inconsistent on this issue. Following is a list of eight Tax Court cases wherein the operating companies were valued using DCF.
In the cases cited above, all were of minority interests. In three out of the eight cases, the minority interests were apparently valued as controlling interests. In only one case, however, (Gallagher) does the appraiser specifically state that a controlling interest value resulted due to control-level adjustments being made. In one case (Simplot), the Tax Court disallowed the DLOC because it ruled that the DCF derived value was a noncontrolling interest.
A large measure of responsibility for the Tax Court’s inconsistent record on DLOC must fall upon the shoulders of the appraisal community. The judges aren’t appraisers and they must rely upon the evidence they are presented. When the evidence presented isn’t persuasive or even plausible, the judges are left to their own devices. The appraisal community needs to do more work in establishing guidelines with more specificity. The appraisal standards of the various professional societies are very generalized and high level. They simply do not address technical issues such as we find in Nelson. And, as good as they are, Pratt’s Valuing a Business or Pratt and Grabowski’s Cost of Capital can’t handle every situation. Having valuation methodology determined by the Tax Court is no way to run a railroad.
Ms. Rayner determined an overall discount for lack of control of 20%. Primarily the discount was derived from a five-year average of control premiums found in Mergerstat Review. The Court found this unpersuasive and proceeded to provide its own analysis by looking at prior court cases.
The Court concluded that Ms. Rayner’s values were primarily as of noncontrolling interests (but with elements of control for which a discount for lack of control should be reduced but not eliminated). If that is true, why was the discount, at 15%, so large? Conceptually, shouldn’t this be more like adding elements of control such that the otherwise zero discount is increased but only marginally so?
There is no way to sugarcoat this. The Court’s analysis is flawed because it has misconstrued the meaning and use of the term “holding company”. As one of its reasons for rejecting Ms. Rayner’s DLOC, the Court said she should have used holding companies as comparables.
This suggests there is something unique about WEC’s organizational structure. There is not. Very few large businesses with multiple operations have them all held inside of one corporate entity. There is, in fact a “holding “ entity owning the stock of subsidiaries. Most large, operating public companies are organized in this fashion. A better term would be “parent” company.
In investment parlance, a holding company is one which invests in the stock of companies owned and operated by others. The investments may be for control or they may be minority interests. These investors usually seek to have an active voice in management through board representation. Think of Berkshire Hathaway or Icahn Enterprises. Their investments are opportunistic and vary widely by industry. The individual entities are usually “silos” which have little connection to one another. It is hard to imagine that one holding company could be considered comparable to another. How would you even begin to try to compare WEC to an entity of this type?
To complicate matters further there are other types of holding companies that serve as the parent organization for a large grouping of entities which do operate together for a common purpose. If you purchase a share of Google, you are really buying stock in Alphabet, Inc.-its parent holding company. Johnson & Johnson is another “holding” company. This is a distinction without a difference. These are operating companies in the same way that WEC is.
In determining its 15% DLOC the Court cited discounts for lack of control from three prior Tax Court cases: Litchfield, Lappo and Hess. This is puzzling. The Litchfield and Lappo cases deal with small family-owned investment entities owning marketable securities and real estate.
These are not holding companies, either. They are “investment” companies. That is, these entities invest passively. In no way are they comparable to WEC. And what distinguishes these two from the myriad of other cases of FLPs owning marketable securities and/or real estate?
Hess is a good example, although I would note it is not a true holding company in the strict sense I described above. It is a parent corporation with operating subsidiaries. (The same could be said for Simplot, Gallo, Piper, Paul Mitchell, Newhouse and, no doubt, others.) But, if Hess is a good comparable, what about the seven other examples of DLOC for operating companies valued by the income approach found in the table above? Unfortunately, these cases provide a DLOC range of 0-26% . Not very helpful.
And, finally, to strike this dead horse one more time, Judge Pugh in Aaron Jones states: “Not all companies are apt to be characterized as simply an operating or a holding or investment company.” So, why here?
For valuation purposes, Mr. Shrode bifurcated Longspar’s assets into LP and GP groupings with 99% of NAV being allocated to the limited partnership interests. In total, this was correct but to base individual LP interest percentages as a subset of the 99% ownership was an error. In a sale or liquidation of the partnership, it does not matter whether one owns a GP or LP interest, they each get their pro-rata share of 100%. One percent of 99% is mathematically 1.0101%.
The Court incorporated this math error into its final value calculation. It took the NAV it determined for WEC, $60,729,000, and created a 99% cohort ($60,122,000). It then determined the value of a 1% interest in this cohort by applying discounts and multiplying by .01. This yields the$411,235 fair market value per share it determined. The correct answer should have been $415,386 per share.
Rejected but Counted
The Court rejected Ms. Rayner’s market approach value. In determining the value of CSI and PSI, this value was weighted in with the income approach value. Ms. Rayner had derived a value of $309 million. Using this value and the value of the other businesses, Ms. Rayner determined a value (in her opinion, on a controlling basis ) of $1,532 per share for WEC. Mr. Mitchell did not dispute this. His objection had to do with DLOC.
However, because the Court rejected Ms. Rayner’s market approach, the controlling interest value of CSI-PSI should have been $335 million not $309 million. This would create a controlling interest value of $1,642.75 per share.
Perhaps because the IRS did not object to Ms. Rayner’s $1,532 per share, the Court decided not to make a change. It seems that this should have at least been mentioned in the Opinion, if so. More than likely, it is simply an error in the taxpayer’s favor.
In the next episode of Trial Trails there will be further discussions on the Nelson case. I will be looking at the discount for lack of marketability (DLOM). Specifically, I will review the Court’s opinion of (1) the applicability of restricted stock and pre-IPO discount studies, (2) the tiered discount and (3) the use of the Income Approach.
 According to the SEC definition of “investment company”, Lappo certainly qualifies. Over 50% of its assets were marketable securities. Litchfield, whose assets were primarily farmland, converted from a C corporation to an S corporation to avoid the corporate level 25% tax on its income which, under IRS regulations, was classified as passive.