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. [2]

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.