Fred E. Chilkowitz, CPA, ABV, ASA and Kathryn E. DeMello
03.16.2017 | Client Alert
Numerous Tax Court decisions have addressed valuation adjustments for noncontrolling interests in closely held companies in the determination of fair market value, particularly the discount for lack of control and the discount for lack of marketability. In Estate of Kollsman v. Commissioner, T.C. Memo 2017-40 (February 22, 2017), the Court was presented with the need to quantify different valuation adjustments in the context of paintings, including discounts for the risk of cleaning the paintings and artist attribution.
However, other key topics that were presented in the case are relevant in the determination of the fair market value of any asset, including:
“Reasonable knowledge of relevant facts” under the definition of fair market value.
Use of market comparable sale prices when available.
Treatment of post-valuation date events.
Summary of Core Facts
In the Kollsman case, at the time of her death on August 31, 2005, the decedent owned two 17th‑century Old Master paintings that are referred to in the case as Maypole and Orpheus. The fair market values of the two paintings as opined by the expert hired by the Estate and included in the estate tax return were in sharp contrast to the fair market values opined by the IRS expert, as follows:
|Value of Maypole||Value of Orpheus
As of the valuation date, both paintings were covered with a heavy layer of surface dirt which could be attributed in part to the paintings being exposed to decedent’s tobacco smoking. The expert retained by the Estate placed significant weight on the “dirty” condition of both paintings as of the valuation date and the risks involved in cleaning the paintings. However, less than a month after decedent’s death, the Estate’s executor and residual beneficiary consulted with a leading fine art restoration and framing company and was later informed that the paintings should be cleaned and that the cleaning was “reasonably safe.” The paintings were successfully cleaned in December 2005.
In addition, Maypole was sold in January 2009, less than three and one-half years after the valuation date, for approximately $2,400,000. The sale took place after it was consigned to the company that employed the Estate expert, and sold for a price that was almost five times higher than the value opined by the Estate expert. Regarding Orpheus, the painting was considerably bowed at the top and bottom and there was also a question concerning artist attribution, specifically whether the painting should be attributed to Jan Brueghel the Elder or the lesser-regarded Jan Brueghel the Younger, with the IRS expert concluding to the former and the Estate expert concluding to the latter.
Estate Expert’s Opinion
The Court found the valuation opinions of the Estate expert to be “unreliable and unpersuasive” for several reasons, including:
- Conflict of Interest: The Estate expert provided his fair market value estimates simultaneously with a solicitation to auction the paintings if they were to be sold.
- Exaggeration of Dirty Condition and Cleaning Risks: The Estate expert asserted that the poor conditions of the paintings as of the valuation date inhibited concluding to the inherent value of the paintings. The Estate expert also opined that cleaning the paintings posed considerable risk. However, a prominent restoration company advocated cleaning the paintings and did not see any notable risk. The Estate expert could not recall raising his cleaning risk concerns with the Estate during discussions to auction the paintings.
- Contradiction of the “Reasonable Knowledge of Relevant Facts” Presumption Under Fair Market Value: The Court stated this presumption under the “hypothetical willing buyer and seller” principle applies to publicly known facts, as well as unknown or non-publicly known facts that could be discovered through a reasonable investigation during the negotiation process. The Court believed that this investigation would include an opinion from a conservator due to the dirty condition of each painting and noted that two employees of the restoration company provided their perspectives on cleaning the paintings shortly after the valuation date.
- Lack of Market Comparable Data: The Court found it “remarkable” that the Estate expert’s opinion was not supported by the comparable sales price data analysis that is frequently deemed significant when valuing art.
- Post-Valuation Date Events: The Court acknowledged that “[i]n general” post-valuation date events are not to be considered when valuing property for Federal tax purposes, but added that relevance is also a consideration. As a result, the sales price of a painting after the valuation date can be relevant assuming the market conditions are also considered. The Court found fault with the Estate expert’s efforts to explain the reasons for the significant increase in value from his concluded value after the valuation date, which included the cleaning of the painting and the change in market demand.
IRS Expert’s Opinion
The Court generally accepted the IRS expert’s fair market value estimates, but made certain adjustments. Unlike the Estate expert, the IRS expert used comparable sale price data from public auctions as the basis for developing fair market value estimates and for analyzing market demand. The Estate expert acknowledged that the IRS expert’s sales data for Maypolewas “good” but disagreed on which sale was most comparable to Maypole. In addition, the Estate expert offered no rebuttal to the IRS expert’s market analysis related to Maypole. The IRS expert admittedly did not make an adjustment for the surface dirt or the bowing. The Court also found the IRS expert’s support attributing Orpheus to Jan Brueghel the Elder convincing but nonetheless felt that the dispute regarding attribution was not abated. As a result, the Court applied discounts to the IRS expert’s conclusions as follows:
|IRS Appraised Values||Discount for Risk of Cleaning||Discount for Bowing||Discount for Attribution||Tax Court Concluded Values
The Kollsman case provides an analysis of issues that frequently confront valuation experts of various disciplines, including experts that specialize in business valuation as well as the valuation of real estate and personal property, such as art. In particular, those issues include the treatment of post-valuation date events. Certain Tax Court decisions have used post-valuation date events when concluding to the fair market value of an asset, including in Estate of Noble v. Commissioner, T.C. Memo 2005-2 (January 6, 2005), where the Court’s value of a business interest in a bank was based on the actual sale price of the asset approximately 14 months after the valuation date with an adjustment for inflation, and in Estate of Newberger v. Commissioner, T.C. Memo 2015-246 (December 22, 2015), where the Court’s value of one of the pieces of artwork was based on the actual sale price of the artwork six months after the valuation date with an adjustment to reflect market conditions on the valuation date. In Kollsman, the Court did not conclude to the value of Maypole based on the post-valuation date sale event, but rather used it in the Court’s analysis and conclusion that the Estate expert’s analysis was unreliable. The AICPA’s Statement on Standards for Valuation Services No. 1 is clear on this topic:
The valuation date is the specific date at which the valuation analyst estimates the value of the subject interest and concludes on his or her estimation of value. Generally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date. An event that could affect the value may occur subsequent to the valuation date; such an occurrence is referred to as a subsequent event. Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions. Moreover, the valuation report would typically not include a discussion of those events or conditions because a valuation is performed as of a point in time—the valuation date—and the events described in this subparagraph, occurring subsequent to that date, are not relevant to the value determined as of that date.
In addition, it should be noted that in Kollsman the Court’s treatment of “reasonable knowledge of relevant facts” was not the same as the IRS’s position in Estate of Kessel v. Commissioner,T.C. Memo 2014-97 (May 21, 2014), where the IRS requested summary judgment to deny a refund to an estate that had paid the amount of tax due on assets purportedly held in an investment account at Bernard L. Madoff Investment Securities, LLC. In Kessel, the IRS argued “that a hypothetical willing buyer and willing seller of the Madoff account would not reasonably know or foresee that Mr. Madoff was operating a Ponzi scheme at the time Decedent died.” However, the Court in Kessel disagreed with the IRS since there was suspicion “years before Mr. Madoff’s arrest” as the returns on investments were “simply too good to be true.” The Court determined that access to this information by a hypothetical willing buyer and willing seller and the degree to which this information affected the fair market value of the assets reported in the account on the valuation date were disputed material facts, and the IRS’s motion for summary judgment on this point was denied.
Further decisions in Kessel were unknown at the time of the Kollsman decision. However, it bears repeating that in Kollsman the Court addressed the disputed material facts about the dirty condition of each painting by noting that the hypothetical willing buyer would ask the hypothetical willing seller for information that may not be publicly-available as well as conduct a reasonable investigation into the values of the paintings, which at a minimum would include seeking an opinion from a conservator.
Questions? Contact Fred E. Chilkowitz, CPA, ABV, ASA.