Thursday, July 17, 2014

Timber Case Shows Value of Family Limited Partnership

Originally Published on on July 7th,2011
 There are many good business reasons to consider putting assets into a family limited partnership.  I can and have discussed them in sober detail, but I will gloss over that for now and skip to what gets people excited.  Valuation discounts.  Natale B. Giustina owned 41.128 % of Giustina Land and Timber Company Limited Partnership (GLT).  The value of that interest was the subject of the case. In cases like, this there will be multiple appraisals with the appraisers disagreeing on various points.  The Court will usually agree with one appraiser on one thing, another on something else and sometimes make something up on its own.  In this case, there was one item on which there was no disagreement.  The gross value of the partnership’s assets (mostly vast tracts of timber land-some 48,000 acres) was approximately $150,000,000.  In arriving at the $150,000,000 the timber lands value of $143,000,000 was net of a 40% discount to reflect the delay in selling the land.)  So if the case was being decided by the simple minded jurors in the Levy case, the value of the interest would be $60,000,000 and change. (Unless the land were actually sold by the time of the trial which would make the partnership interest value higher).
  The Tax Court instead considered the value on the Form 706 based on an appraisal by Columbia Financial Advisors -  $12,678,117.  The estate brought in another appraiser named Robert Reilly (no relation, that I know of, although I do have a brother by that name) who arrived at $12,995,000.  Then there was John Thomson, the IRS expert, who came in at $33,515,000.  The Tax Court, not exactly splitting the difference in this case ended up at $27,454,115 (Or as the Court modestly refers to it “the correct value”).  The as filed value was less than 50% of the “correct value”, but the Court did not allow the IRS to assess a penalty.
How can this be ?  If prior to his death Mr. Giustina had received a distribution of 19,000 or so acres that were representative of the whole and he had held those acres on the date of his death, they would have been worth at least $60,000,000.  Inside a partnership in which he was the largest partner and all seven of the other limited partners had names like Syliva B Giustina and Natalie Giustina Newlove even the IRS is only looking for about 50% and an appraisal at around 20% doesn’t rate a penalty.
Since Mr. Giustina could not force a sale of the assets, the primary valuation of the partnership was based on the discounted present value of the cash flow.  The Court thought Mr. Reilly had done the better job on estimating the cash flow:
 First, as Reilly explained on pages 17-18 of his rebuttal report, there was an internal inconsistency between Thomson’s cashflowestimates and his calculation of the effect of lack of control on the value of the 41.128-percent limited partner interest. The inconsistency led Thomson to overvalue it. Second, Thomson unrealistically assumed that the partnership’s operating expenses would remain fixed, even though he projected that its revenues would increase 3 percent annually. Third, Thomson’s estimate of annual cashflowswas extrapolated from the actual cashflow results of the most recent year. By contrast, Reilly extrapolated from the cashflow results of five consecutive years. Reilly’s use of five years of data is sounder because it reduces the effect of a temporary variation in cashflow.
The Court was not totally satisfied with Mr. Reilly’s valuation based on cash flow.  He had deducted 25% for income taxes, which was inappropriate since he had used a pre-tax rate of return to discount the cash flows.  In addition they quibbled with his discount rate. The rate was built up from four components.  A risk free rate of 4.5%, a beta adjusted risk premium of 3.6% (about half that of the S&P 500), a small stock equity risk premium of 6.4% and an additional risk premium of 3.5% because the timber was concentrated in Oregon.  He then reduced the rate by 4% for assumed growth.  The Court cut the 3.5% to 1.75%, because some of that was based on “unique risk”.   According to the Court the market does not pay for unique risk, since it can be avoided by diversification.
The Court rejected the use of the guideline company method.  The proposed companies Plum Creek Timber Co., Inc., Pope Resources LP, Deltic Timber Corp., and Potlatch Corp, were not comparable enough. Both Deltic and Potlatch have substantial operations other than owning timber land and selling timber.
In the end the Court used the discounted cash flow value prepared by Mr. Reilly, as adjusted, and a liquidation value.  It gave the discounted cash flow method a 75% weight, its prediciton on the probability that the company would continue to operate.  There was no discount for lack of control allowed, since that is reflected in the weight given to the partnership conitnuing to operate rather than liquidate.  There was a discount for lack of marketability of 25% but that was only applied to the operating value not the liquidating value.
There is something about all this that disturbs me intellectually.  The parties seem to agree that if you wanted to buy all the stuff in the Giustina partnership it would cost you $250,000,000 (remember the 40% discount on the land value).  On the other hand a valuation of a 40% interest in all that at less than $13,000,000 was reasonable, although low, the ”correct value” being $27,454,115. There has to be something bizarrely wrong about our capital markets for this to make any sense.  Fortunately, thinking about matters like that is not my job, man.  My motto in tax matters is “It is what is.  Deal with it.”  There are a host of execution issues and numerous ways to screw up family limited partnerships as I have written elsewhere, but the family limited partnership is once again proven to be a very valuable estate planning tool.

No comments:

Post a Comment