In the last several years we’ve seen a number of New York cases valuing minority interests in real estate holding companies in which the courts rejected a discount for lack of marketability (“DLOM”) on the theory that the underlying real estate assets are readily marketable and/or a discount already is reflected in the market exposure period assumed in the real estate appraisal. The cases that come to mind are Vick v. Albert, a 2008 appellate ruling in a partnership buy-out case (read here my post on Vick); Giaimo v. Vitale, a trial court decision last year involving the buy-out of a minority shareholder in two closely held C corporations (read here my post on Giaimo); and Chiu v. Chiu, a trial court ruling earlier this year involving the buy-out of a minority membership interest in a limited liability company (read here my post on Chiu).
If you thought such cases established a general exception to the applicability of DLOM for real estate holding companies, think again. In a decision issued last week by the Appellate Division, First Department, on appeal from the trial court’s ruling in the above-mentioned Giaimo case, the court modified the valuation by directing a 16% DLOM based on the “build up” method advanced by the purchasing shareholder’s expert appraiser. While the facts and circumstances are unique to some degree in every valuation case, the decision in Giaimo v. Vitale, 2012 NY Slip Op 08778 (1st Dept Dec. 20, 2012), will make it harder to argue in other cases that the corporate “wrapper” can be ignored when assessing DLOM for real estate holding companies.
Last week’s Giaimo decision is important for a second reason, namely, its affirmance of the trial court’s application of a discount for the present value of built-in capital gains tax (“BIG”) assuming a 10-year sale horizon for the realty assets owned by the subject C corporations. The appellate panel rejected both the selling shareholder’s position, that no BIG discount should be applied under the fair value standard, as well as the purchasing shareholder’s request to deduct 100% of the BIG tax assuming a liquidation as of the valuation date.
I won’t here relate the background of the Giaimo case or describe in any detail the rulings by the hearing officer or the trial court. My prior post does all of that and more. My focus here is solely on the two primary issues on appeal — there were several others — involving DLOM and BIG.
The Marketability Discount
Unlike in many other states, DLOM is recognized in New York’s fair-value jurisprudence as an appropriate consideration in valuing ownership interests in closely held business entities, that accounts for the greater time and risk associated with the sale of corporate shares for which there is no public market. It must not be confused with a minority discount for lack of control, the application of which is prohibited in fair value determinations. (For more on the distinction, read here.)
The two corporations at issue in Giaimo owned 18 Manhattan tenement apartment buildings and one land parcel which the hearing officer valued, based on the reports and testimony of the parties’ real estate appraisal experts, around $85 million. The hearing officer recommended, based on the testimony of the selling shareholder’s business appraisal expert, that no DLOM should be applied in determining “fair value” because to do so would assign the seller’s interest an illiquid minority interest value instead of his proportionate share of a financial control level of value. The trial court disagreed with the hearing officer’s reasoning, finding that it was contrary to binding precedent established in Friedman v. Beway Realty Corp., 87 NY2d 161 (1995), but agreed that no DLOM should be applied based on the hearing officer’s findings that the subject portfolio of properties had unique attributes rendering shares in the holding corporations readily marketable.
The purchasing shareholder’s appeal brief (read here) argued that the Beway case and others involving valuation of shares in real estate holding companies mandate application of DLOM, and that the hearing officer neither made nor, on the record presented, could have made a finding that the corporations’ shares — as opposed to the realty — were readily marketable. Since the seller’s expert expressed no opinion as to the amount of the DLOM, the purchaser further argued, the court should adopt a 20% DLOM consistent with case law and the purchaser’s expert’s opinion based on restricted stock studies, acquisition discount studies, merger arbitrage spreads, and the “build up” method which estimates transaction costs and the time required to finalize a stock sale.
The selling shareholder’s opposing brief (read here) argued in support of the trial court’s exclusion of DLOM, contending that there was no evidence presented that the corporate shares are any less marketable than the portfolio of their assets which were in “great demand.” The seller further argued that a marketability discount was already incorporated in the exposure-to-market assumptions included in the real estate appraisals. The seller also relied on the First Department’s 2008 decision in Vick v. Albert where the court stated that the “unavailability of the [marketability and minority] discounts is particularly apt here, where the business consists of nothing more than ownership of real estate.”
The First Department’s decision last week agreed with the trial court’s holding that “the method of valuing a closely held corporation should include any risk associated with the illiquidity of the shares.” It also agreed with the trial court’s rejection of the seller’s argument that Vick v. Albert “limits the application of marketability discounts only to goodwill, or precludes such discounts for real estate holding companies such as the corporations at issue here.” Agreeing with the purchaser, however, the First Department concluded that the trial court “erred . . . in assessing that the marketability of the corporations’ real property assets was exactly the same as the marketability of the corporations’ shares.” The court explained further:
While there are certainly some shared factors affecting the liquidity of both the real estate and the corporate stock, they are not the same. There are increased costs and risks associated with corporate ownership of the real estate in this case that would not be present if the real estate was owned outright. These costs and risks have a negative impact on how quickly and with what degree of certainty the corporations can be liquidated, which should be accounted for by way of a discount.
The appellate court next determined the amount of the DLOM, noting that “[s]ince the entire record is included on appeal, it is sensible and economical for us to decide this issue rather than remand the issue to the motion court for further consideration.” The court summarized the purchaser’s expert’s opinion as to DLOM based on the various studies supporting a range of 8% to 30%, but ultimately directed a 16% DLOM based on the expert’s “build up” methodology. Here’s what the court said:
[Purchaser's expert] also employed a build-up method related to anticipated costs of selling the corporation that included real estate related costs and due diligence costs arising in the sale of closely held corporations. . . . . We find that the build up method, which makes calculations based upon expected projected expenses of selling a company holding real estate, best captures the DLOM applicable in this particular case. We conclude that a 16% DLOM against the assets of both corporations is appropriate and should be applied.
The BIG Discount
For those of you who may be unfamiliar with the BIG discount applicable to the valuation of shares in subchapter C corporations, here’s the description I wrote in a prior post on the subject:
Under changes made by the Tax Reform Act of 1986, proceeds from the sale of appreciated assets held by a C corporation upon liquidation are subject to gains tax at the corporate level. A buyer of C corporation shares therefore is willing to pay less for the shares than if the same assets were held by a subchapter S corporation. A C corporation can avoid capital gains taxes at the corporate level upon sale of all its assets by converting to a subchapter S corporation. [IRC §1361 et seq]. However, this option is of limited use since, among other things, the corporation must retain the appreciated assets for ten years from the date of conversion in order to avoid the tax. [See IRC §1374(d)(7)].
In Giaimo, the trial court adopted the hearing officer’s recommendation to apply a so-called “Murphy discount” — named after Murphy v. United States Dredging Corp., 74 AD3d 815 (2d Dept 2010) (read here my prior post on Murphy) – under which the court deducted approximately $20 million from the combined enterprise value of the two corporations, the fully depreciated realty assets of which had only a nominal cost basis, equivalent to the present value of gains tax that would be due on the appreciated value from the sale of the realty assets assuming a 10-year holding period.
According to the hearing officer’s findings, the present value approach was based on the absence in the market of comparable realty assets outside a corporate “wrapper” such that a willing seller would not agree to accept a 100% BIG and a willing buyer would not demand a 100% BIG. The trial court’s decision also noted that there was no evidence that the corporations “have any financial reason to sell properties in the foreseeable future.”
The purchaser primarily argued on appeal that, under the First Department’s prior ruling in Wechsler v. Wechsler, 58 AD3d 62 (1st Dept 2008), the trial court was required to deduct 100% of the BIG tax that would be triggered on the assumed sale of the realty assets as of the valuation date. Wechsler was a matrimonial case in which the court applied a 100% BIG discount to the value of the husband’s holding company that owned a securities portfolio. The purchaser also relied on federal gift and estate tax cases cited with approval in Wechsler in which courts also applied a 100% BIG discount.
The seller argued that the lower court erred by applying any BIG discount. In contrast to the fair market value standard applicable in Wechsler, the seller reasoned, the statutory fair value standard applicable in Giaimo requires determination of the shareholder’s proportionate share of the enterprise value as a going concern. In other words, the court should not consider the tax consequences of the sale of any assets unless there is evidence that the corporation was actually undergoing liquidation on the valuation date. The seller also argued that Murphy was wrongly decided and, in any event, distinguishable because, unlike in Giaimo, the corporation in Murphy had previously sold its real properties, acquired others, and engaged in 1031 exchanges. The seller also cited out-of-state cases involving buy-outs of oppressed or dissenting minority shareholders where BIG discounts were rejected as inconsistent with the policies underlying the fair value standard.
The First Department satisfied neither party by affirming the trial court’s deduction of assumed, future gains tax discounted to present value. Here’s what the court had to say about the seller’s argument that the BIG discount is inconsistent with fair value:
It is recognized by courts of this State that embedded capital gains taxes in assets held by “C” corporations will affect what a hypothetical willing purchaser, with a reasonable knowledge of the underlying facts, will pay for the corporate stock (see Murphy v United States Dredging Corp., 74 AD3d 815 [2nd Dept 2010]; Wechsler v Wechsler, 58 AD3d 62 [1st Dept 2008], appeal dismissed 12 NY3d 883 ).
The court was equally dismissive of the purchaser’s argument for a 100% BIG discount:
We also reject respondent’s assertion that this Court’s decision in Wechsler always requires that the BIG discount be calculated at 100% of the projected tax as of the date of valuation. In Wechsler we expressly left open issues about whether calculation methods employed by other courts to capture embedded capital gains were also proper (58 AD3d at 69). Applying a 100% discount in this case necessarily implies that following the hypothetical sale, the purchaser would immediately liquidate all of the real estate and realize the full capital gains impact. Not only is this contrary to a basic underlying assumption of fair valuation that the business will continue as an ongoing concern, but also to the motion court’s finding that there is no financial reason in the foreseeable future for the properties to be sold.
The court then expressed its agreement with the lower court’s determination of the BIG discount, as follows:
The BIG discount, as applied by the motion court, takes into account that the real estate will continue to be held by the corporations and will not immediately be sold even if the corporate stock is sold. Consequently, the reduction of BIG to present value appropriately adjusts for embedded capital gains taxes that will not be paid until some time in the future.
No doubt about it: Giaimo is an important decision that, along with Murphy, should be carefully studied and understood by appraisal professionals and lawyers involved in the valuation of closely held real estate holding companies of all types, and especially C corporations with embedded gains on realty assets.
My thanks to Mitchell Geller of Holland & Knight LLP, which represented the purchasing shareholder in Giaimo, for providing me with copies of the appellate briefs.