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Business Valuation and Taxes Procedure, Law, and PerspectiveDavid Laro Judge, U.S... Business Valuation and Taxes Procedure, Law, and PerspectiveDavid Laro Judge, U.S... Library of Congr

Business Valuation and Taxes Procedure, Law, and Perspective

David Laro

Judge, U.S Tax Court

Shannon P Pratt

CFA, FASA, MCBA, CM&A, MCBC

John Wiley & Sons, Inc.

Business Valuation and Taxes

Business Valuation and Taxes Procedure, Law, and Perspective

David Laro

Judge, U.S Tax Court

Shannon P Pratt

CFA, FASA, MCBA, CM&A, MCBC

John Wiley & Sons, Inc.

This book is printed on acid-free paper ∞

Copyright © 2005 by John Wiley & Sons, Inc., Hoboken, New Jersey All rights reserved.

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Laro, David, 1942–

Business valuation and taxes : procedure, law & perspective /

David Laro, Shannon P Pratt.

p cm.

Includes bibliographical references and index.

ISBN-13 978-0-4716-9437-3 (cloth)

ISBN-10 0-471-69437-1 (cloth)

1 Business enterprises—Valuation—United States 2 Business

enterprises—Taxation—Law and legislation—United States I Pratt,

Shannon P II Title.

HF5681.V3L37 2005

346.73'065—dc22

2004013842 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

Dedication by David Laro

To my wife, Nancy, and our family—

Rachel, David, and their children, Sophie and Asher Marlene, Andrew, and their sons, Alexander and Benjamin

Dedication by Shannon Pratt

To my wife, Millie, and our family—

Mike, Barb, and their sons, Randall and Kenny Georgia, Tom, and their children, Elisa, Katie, and Graham Susie, Tim, and their children, John, Calvin, and Meg Steve, Jenny, and their children, Addy and Zeph

About the Authors

The Honorable David Laro was appointed by President George H W Bush to the United

States Tax Court, confirmed by the Senate, and invested as a federal judge in November 1992

He formerly practiced law in Michigan for 24 years, specializing in tax law

Judge Laro is a graduate of the New York University School of Law (LLM in Taxation,1970), the University of Illinois Law School (JD, 1967), and the University of Michigan(BA, 1964)

Before joining the U.S Tax Court, Judge Laro was chairman and CEO of a publiclytraded international company In 1985, he co-founded Republic Bancorp, a Michigan bank

holding company that was rated recently by Fortune magazine as the fifth-best corporation in

America at which to work He was the founder and chairman of the board of directors of public Bank Ann Arbor, a position he held until he became a federal judge Judge Laro hasalso held several public offices, including a Regent of the University of Michigan, a member

Re-of the State Board Re-of Education in Michigan, and chairman Re-of the State Tenure Commission inMichigan He formerly served as director of the Ann Arbor Art Association and as a member

of the Holocaust Foundation in Ann Arbor

As adjunct professor of law at Georgetown University Law Center, Judge Laro teaches aclass in business planning He is also a visiting professor at the University of San DiegoSchool of Law, where he teaches business valuation and tax litigation He lectures on tax pol-icy at Stanford Law School and is a member of the National Advisory Committee for NewYork University School of Law

A frequent guest speaker, Judge Laro lectures for the American Bar Association, theAmerican Society of Appraisers, the American Institute for Certified Public Accountants, andother professional organizations and associations In addition, he has authored numerous arti-

cles on taxation printed in the American Bar Association Journal, the University of Illinois

Law Review, and other publications He is a fellow of the American College of Tax Counsel.

At the request of the American Bar Association and the Central Eastern European LawInitiative, Judge Laro contributed written comments on the Draft Laws of Ukraine, Ka-zakhstan, Uzbekistan, Slovenia, and the Republic of Macedonia, and on the creation of spe-cialized courts in eastern Europe As a consultant for the Harvard Institute for InternationalDevelopment and Georgia State University, Judge Laro lectured in Moscow to Russian judges

on tax reform and litigation procedures Judge Laro has also lectured to judges and tax cials in Azerbaijan on tax reform

offi-Judge Laro’s noteworthy tax decisions include Simon (depreciation of antique musical strument), Mandelbaum (lack of marketability discount), Wal-Mart (inventory shrinkage),

in-ACM Partnership (corporate tax shelter), Lychuk (capitalization issues), and Bank One

(valua-tion of financial derivatives)

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Judge Laro’s family shares his interest in tax law His wife is a certified public accountant.Both of his daughters and one son-in-law are tax attorneys For variety, his other son-in-law is

a urologist Judge Laro enjoys spending time with his family, especially his grandchildren,Sophie, Alexander, Benjamin, and Asher

Shannon Pratt’s reputation for knowledge and experience in the field of business valuation is

legendary and unparalleled He is the best-known authority in the field of business valuationand has written numerous books that articulate many of the concepts used in modern businessvaluation around the world

He is chairman and chief executive officer of Shannon Pratt Valuations, LLC; PublisherEmeritus for Business Valuation Resources, LLC; and a member of the board of directors ofPaulson Capital Corp., an investment banking firm specializing in small-firm IPOs and sec-ondary offerings.1

Dr Pratt holds an undergraduate degree in business administration from the University ofWashington and a doctorate in business administration, majoring in finance, from IndianaUniversity He is a Fellow of the American Society of Appraisers, a master certified businessappraiser, a chartered financial analyst, a master certified business counselor, and a certifiedmergers and acquisitions advisor

His professional recognitions include being designated a life member of the American ciety of Appraisers and also a life member of the Business Valuation Committee of the Amer-ican Society of Appraisers, past chairman and a life member of the ESOP AssociationAdvisory Committee on Valuation, a life member of the Institute of Business Appraisers, therecipient of the magna cum laude in business appraisal award from the National Association

So-of Certified Valuation Analysts, and the recipient So-of the Distinguished Achievement Awardfrom the Portland Society of Financial Analysts He served two three-year terms (the maxi-mum) as a trustee-at-large of The Appraisal Foundation

Besides lecturing, writing, and teaching courses for such organizations as the AmericanSociety of Appraisers, the Alliance of Merger & Acquisition Advisors, the American Bar As-sociation, and several state bars, Dr Pratt is author of the following books published by John

Wiley & Sons, Inc.: Business Valuation Discounts and Premiums; Business Valuation Body of

Knowledge: Exam Review and Professional Reference, 2nd edition; Business Valuation Body

of Knowledge Workbook; Cost of Capital: Estimation and Applications, 2nd edition; Cost of Capital Workbook; and The Market Approach to Valuing Businesses He is also the author of The Lawyer’s Business Valuation Handbook, published by the American Bar Association He

is coauthor of Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th edition, and Valuing Small Businesses and Professional Practices, 3rd edition (both pub- lished by McGraw-Hill), Guide to Business Valuations, 14th edition (published by Practition- ers Publishing Company), and Guide to Canadian Business Valuations.

He was a founder of Willamette Management Associates, and served as a managing tor of that firm through December 2003 For more than 35 years, Dr Pratt has performed val-

1 Due to judicial ethical considerations, Judge Laro is not able to and therefore does not endorse, promote, or ommend any commercial or business services Shannon Pratt or others have created or with which they are in- volved, some references to which are included in this book for informational purposes only.

rec-uation engagements for mergers and acquisitions, employee stock ownership plans (ESOPs),fairness opinions, gift and estate taxes, incentive stock options, buy-sell agreements, corpo-rate and partnership dissolutions, dissenting stockholder actions, damages, and marital disso-lutions, to name a few He has testified in a wide variety of federal and state courts across thecountry and frequently participates in arbitration and mediation proceedings Beginning in

2004, he practices valuation with Shannon Pratt & Associates

Dr Pratt develops and teaches business valuation courses for the American Society of praisers, the American Institute of Certified Public Accountants, and the Association of Merg-ers & Acquisitions Advisors, and frequently speaks on business valuation at national legal,professional, and trade association meetings He has also developed a seminar on businessvaluation for judges and lawyers

Ap-Besides life with his wife Millie, Dr Pratt enjoys his model railroad, the ever-growingcollection of glasses and mugs from many places he’s visited, fine wines, and frequent visitsfrom their four children and ten grandchildren

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Concerns about Expert Testimony 38

8 Valuation of S Corporations and Other Pass-Through Tax Entities:

S Corporation Controlling Interest Appraisals 130

9 Valuation of International Transactions 137

14 The Income Approach 181

Net Cash Flow: The Preferred Measure of Economic Benefit in the

The Guideline Publicly Traded Company and the Guideline Transaction

Discount for Contingent Liabilities 279

Empirical Evidence to Quantify Discounts for Lack of Marketability:

Empirical Evidence to Quantify Discounts for Lack of Marketability:

24 Questions to Ask Business Valuation Experts 400

Appendix A IRS Business Valuation Guidelines 407 Appendix B International Glossary of Business Valuation Terms 412

LEGAL PRACTITIONER’S PERSPECTIVE

Judge David Laro and Dr Shannon Pratt have many years of experience looking at businessdata Dr Pratt looks at the data and its interrelationships for the purpose of evaluating the use-fulness of the data in predicting or emulating the behavior of the marketplace In that role, hehas become well-known for his common-sense explanations of the tools of the appraisal pro-fession and has become both the master teacher and the dean of the profession The books hehas authored and co-authored have become indispensable references for business amateurs—like most lawyers—who routinely encounter valuation issues

Judge Laro looks at business data in the context of the cases that we advocates present tohim We cannot hire him like many of us have engaged Dr Pratt over the years, but all of us,

as citizens, have hired him to objectively ask whether the data and analysis laid before himmakes sense and whether we advocates have used the principles developed by Dr Pratt andothers in a manner that advances the integrity of the tax system Even when the resolution ofissues is controversial, Judge Laro’s name on an opinion signals thoughtfulness, thorough-ness, and an effort to be helpful to the reading public as well as fair to the litigants in the par-ticular case

Thus, it is refreshing to see these two close observers of valuation issues collaborate onthis intriguing volume What the reader gets is something like a mural—depicting the life of abusiness appraisal from conception to preparation to the occasional ultimate use by a trier offact The coverage ranges from factors that precede but influence valuation, such as the choice

of business entity (Chapter 7), to factors that shape the end use, such as the burden of proof(Chapter 5) and penalties (Chapter 6) The respective sections of the mural are drawn withgreat care and clarity and are a wonderful addition to the scholarship in this area The reader’sopportunity to appreciate the whole panorama, however, is priceless

The authors have not tiptoed around subjects that have been controversial The

discus-sions of “the General Utilities doctrine” in Chapter 17 and discounts for lack of marketability

in Chapter 18 address areas in which the interaction of courts and appraisers has been mostlively in recent years The lawyer whose practice encounters such issues can use these discus-sions to navigate around the pitfalls that both business practice and tax controversies canplace in the way

Nor have the authors avoided areas just because they are tough Chapter 8, dealing withthe special challenges of valuing S corporations and other pass-through entities, confrontssome of the most complex and sometimes inscrutable current topics in the evolution of valua-

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tion law That chapter is at once the most eclectic and the most meticulous discussion of thesechallenges I have seen to date.

Whether the reader practices before the Tax Court or not, and whether the reader handlesvaluation matters routinely or only occasionally, this volume will be a most valuable resource

Ronald D Aucutt, Esq.McGuire Woods, LLP

LAW PROFESSOR’S PERSPECTIVE

To write about valuation is a humbling task No matter how ambitious and dedicated an authormay be, eventually he or she is forced to acknowledge that even a lifetime of work wouldleave some aspects of the subject untouched This offering from Judge David Laro and Dr.Shannon Pratt fills in some persistent gaps in the business valuation literature, as well as pro-vides a surprisingly fresh treatment of perennial themes

The range of the book is impressive It covers such basics as the definition of fair marketvalue for federal tax purposes and the features that distinguish it from fair value and intrinsicvalue But it also digs into practical and procedural questions that many other valuation trea-tises leave out And it analyzes several important evolving issues, such as valuing S corpora-tion stock and selected international problems (transfer pricing and customs valuation), whichrequire close attention from seasoned professionals and novices alike

Business valuation experts often find themselves talking about synergies, and this work

defines the term by example Take the chapter on expert witnesses Judge Laro’s discussion ofthe relationship of the valuation professional to the litigation process provides a wealth of in-sight, from his unique and invaluable vantage point But the chapter does not stop there In itsappendix, it is backed up by the Pratt organization’s excellent directories of the many profes-sional designations for appraisers and the associations that issue them The reader gets both aguiding narrative from the judge, and hard data to help put his counsel into practice—the trea-sure map and the decoder ring in one package, as it were

The chapter on the lack-of-marketability discount is another dynamic combination Hereone finds not only a summary of the traditional rationales for the discount and the studies onwhich its amount can be based, but also a thorough summary of the classic tax valuation cases

in which it has been applied The blend of appraisal theory with tax scholarship is impressiveand useful

Too often the best practitioners of a craft are so busy that they lack the time to pass theirknowledge on Some are stingy with their wisdom, and others are not very good at teaching.When the authors of this book sit down to write, however, the results are a thing of beauty.Enjoy, and learn from, every page

John A Bogdanski

Professor of Law Lewis & Clark Law School

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BUSINESS APPRAISER’S PERSPECTIVE

I am honored that I was asked to write a foreword for a book written by two people who I lieve are among the most prolific people in our industry, the Honorable Judge David Laro and

be-Dr Shannon Pratt

I remember meeting the Honorable Judge Laro, almost a decade ago now, while he wasteaching a valuation course at the National Judicial College Prior to that, all I had ever donewas read many of his opinions I still remember walking into the classroom that day and see-ing his name tent on a desk in the front row of the room Almost immediately my stress levelrose when I realized that I would be citing many of his opinions during my program that day.All I could think about was what would happen if I misrepresented or misstated something Ifound his Honor to be extremely respectful, personable, open-minded, and eager to learn, aswell as understand, as a judge

Over time, I came to learn more about the judge and the person I believe he sets a nomenal example for us, as successful or ambitious experts, with regard to certain standards

phe-of prphe-ofessionalism, credibility, and character traits His Honor really has a way phe-of puttingthings in perspective I believe this has never been embodied more succinctly and poignantlythan in his Honor’s own words as he answered the following question that was posed to himfrom the audience at a recent AICPA Annual Valuation Conference: “Your Honor, do you be-lieve that this is the greatest job that anyone or you could have?” To this his Honor responded,

“I surely have a wonderful job and career, but it is not the greatest The greatest job I have isbeing a husband, father, and grandfather!” I commend you for your work as a person and aprofessional and thank you for your guidance and friendship through the years, and the oppor-tunity to be a little part of it all

Then there is Dr Pratt He needs little if any discussion in the valuation industry I have ten referred to him in my presentations as the “godfather” of valuations Dr Pratt has traveledthe country helping so many of us in our careers He has provided us guidance throughout theyears through his writings, speeches, and subscriptions I doubt that the industry would be at thematurity level it is without his works He has always forced us to challenge our conventionalwisdom and thoughts to find the better way to do things He too has set an example to many of

of-us without asking of-us for much in return (Okay, maybe jof-ust putting up with some of his dled salesmanship.) He has formalized many of the processes and theories that we currently ap-ply in our practices He took positions at times when others would not—a true pioneer!This book, like its two authors, is a unique work that provides practical sense andguidance in our profession It is the first of its kind that presents methodology issues ofvaluation, as well as procedural issues and what I would call the environmental factors

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