How the book A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal came into existence:
Given Paul Hood’s experience as an attorney working with business appraisers and reviewing business appraisal reports, and the recurring frustrations caused by the seemingly divergent practices of business appraisers, he sensed the need for a resource for people like him – people who were not appraisers but who need to better understand business appraisal theory, appraisal standards, and the issues present in the business appraisal profession.
Those needs led to a book, A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal, co-authored with Tim Lee of Mercer Capital, which seeks to identify and explore these sometimes confusing and confounding issues to bring clarity to users of business appraisal services.
Paul authored Part III: Lessons from the Trenches. Meant for users of business appraisal services, this section of the book provides covers errors of omission and commission by business appraisers, identifies the ten burning issues in the business appraisal profession currently, and provides random practical valuation tips and thoughts from the perspective of a user of business appraisal services.
The excerpt below is taken from Chapter 17, Alleged Errors of Omission by Appraisers.
This chapter highlights alleged errors that have appeared in reported federal tax court decisions. The purpose of identifying these errors (or alleged errors as the case may be) is to allow appraisers and appraisal report users alike an awareness of the controversies surrounding numerous alleged errors. An awareness of and a proactive recognition of the various appraisal methods, treatments, and adjustments allows appraisers and appraisal stakeholders the opportunity of assessing the ramifications of such court decisions. It is important to note that there are always two sides to every story, and courts do not always get it right. For this reason, we have made a conscious decision to not name any appraisers in this analysis. We did not want to single out any appraiser because the errors and the subject matter themselves are far more instructive. Lest we not add to the confusion or controversy, we use the courts’ own words in many instances because they say it better than we could have.
The court’s first objection to appraisals is an overarching concern that there are diminishing returns in extensive numerical analyses in the appraisal process and that, no matter how the appraisal is fashioned, it has many areas for subjective determination along the way, which culminates in a subjective opinion. Consider what the U.S. Fifth Circuit wrote in Dunn Est. v. Comr.1:
As the methodology we employ today may well be viewed…as unsophisticated, dogmatic, overly simplistic, or just plain wrong…on the end of the methodology opposite oversimplification lies overengineering. (emphasis by the court)
Back in 1967, the Tax Court, in Messing v. Comr.2, expressed a thought that perhaps should be revisited in every valuation case:
Too often in valuation disputes the parties have convinced themselves of the unalterable correctness of their positions and have consequently failed successfully to conclude settlement negotiations — a process clearly more conducive to the proper disposition of disputes such as this. The result is an overzealous effort, during the course of the ensuing litigation, to infuse a talismanic precision into an issue which should frankly be recognized as inherently imprecise and capable of resolution only by a Solomon-like pronouncement.
Courts have also been troubled by the relevance of complex valuation techniques in the rough and tumble Darwinian real world of negotiation between buyers and sellers. In Mueller Est. v. Comr.3 , the Tax Court criticized the complex valuation approach of the IRS appraiser, noting:
In addition to our problems with the constituent elements, we question the validity of this equation as a valuation tool. We cannot imagine that any prospective buyer would use such an arbitrary, artificial, and subjective approach to formulate an initial offering price or to calculate a last best offer.
In Reynolds Est. v. Comr.4, Judge Forrester noted:
One expert admitted that his method of computation constituted “a highly theoretical exercise,” and indeed, this honest characterization applied equally well to the valuation methods utilized by the three other experts.
In Gross v. Comr.5, the Tax Court had this to say about valuation for tax purposes:
Overall, the entire valuation process is a fiction— the purpose of which is to determine the price that the stock would change hands from a willing buyer and a willing seller. However, a court is not required to presume hypothetical, unlikely, or unreasonable facts in determining fair market value. … The goal of valuation is to create a fictional sale at the time the gift was made, taking into account the facts and circumstances of the particular transaction.
Some errors that appraisers have made seem self-evident and should be easily avoided, yet the following errors have been chronicled in reported tax decisions. This chapter will focus on failures or omissions by appraisers.
Failure to Comply with USPAP
Some appraisers must comply with USPAP in all appraisals.6 In Kohler v. Comr.7, the Tax Court determined that the IRS appraiser failed to comply with USPAP:
We have several significant concerns about the reliability of [the appraiser’s] report. These concerns lead us to place no weight on [the appraiser’s] report as evidence of the value of the Kohler stock the estate held. We have previously discussed the lack of customary certification of [the appraiser’s] report and that his report was not prepared in accordance with all USPAP standards. We also have already noted that [the appraiser] admitted that his original report submitted to the Court before trial overvalued the estate’s Kohler stock by $11 million, or more than 7 percent of the value he finally decided was correct. This is not a minor mistake. When we doubt the judgment of an expert witness on one point, we become reluctant to accept the expert’s conclusions on other points. Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo. 2003-200, affd. 122 Fed. Appx. 88 (5th Cir. 2004).
In Furman v. Comr.8, the IRS appraiser put himself and the IRS into a bit of a tough spot concerning his appraisal credentials:9
[The appraiser] represents that he has certain qualifications and credentials to perform business valuations that he does not in fact have, including courses on valuation that he has not successfully completed. [The appraiser’s] report also suggests that he is a member of the American Society of Appraisers, to which he has never belonged.
In Ford Est. v. Comm.10, the taxpayer’s appraiser was not a full-time appraiser and was not a member of any appraisal organization, and the Tax Court ultimately held against the taxpayer.
Too Much Involvement by Counsel in the Appraisal Report Preparation
In Noble Est. v. Comm., the Tax Court excluded from evidence a rebuttal report because the Tax Court, citing Daubert, felt that there was too much involvement in the preparation of the report by the taxpayer’s counsel. It is imperative that the appraisal report be the sole work of the appraiser. However, we see a definite role for counsel in the fact-finding part of the appraisal engagement and in the review of a draft appraisal.
Standard of Value
Many estate and tax planners are aware of only one standard of value: fair market value. However, there are other standards of value, for example, fair value. Occasionally, an appraiser utilizes a standard that is either not fair market value or is a variation of fair market value that deviates from or conflicts with the classical definition of fair market value required for federal tax purposes.
In Knight v. Comr.11 , the Tax Court summarily dismissed the IRS appraiser’s use of the fair value standard of value, noting:
Respondent’s expert, [the appraiser], testified about the “fair value” but not the “fair market value” of the partnership interests at issue in these cases. We have not considered his testimony in deciding the fair market value of the gifts.
In Bailey Est. v. Comr.12 , the Tax Court criticized the appraiser’s deviation from the fair market value standard:
[The appraiser’s] downward adjustment of the California motel’s value on account of the alleged need of decedent’s estate to make a “distress sale” to settle the estate (an otherwise unsubstantiated factual premise) is inconsistent with the concept of fair market value as determined by reference to a hypothetical willing buyer and willing seller.
Given that valuation for federal transfer tax purposes is made as of a specific date, it is axiomatic that an appraiser use the date of death, the alternate valuation date, or the date of transfer, whichever is applicable. Additionally, all of the applicable business appraisal standards require the appraiser to state an as-of date in the appraisal report.13 Nevertheless, there are reported decisions in which this mistake has been made. This mistake actually can be made where the appraiser is not told of a decision to employ the alternate valuation date under IRC Sec. 2032 and instead sticks with the date of death as the valuation date.
In Kaufman Est. v. Comr.14, the court rejected the appraisal of an expert that was as of the date of another appraisal on which sales of interests in the subject entity were based (and on which the federal estate tax return valuation was based in part) because that was not the federal estate tax valuation date.
In Magnin Est. v. Comr.15 , the Tax Court noted the following excuse for not using the correct valuation date, which the Tax Court ultimately rejected:
[The appraiser] used a valuation date of January 31, 1952, instead of October 31, 1951, because he claims that he would have had to rely on information that was 9 months old.
Retrospective appraisals can be especially tricky in that some of “the future” will have already occurred by the time the appraiser starts his work. In BTR Dunlop Holdings, Inc. v. Comr.16, the Tax Court noted:
In addition, petitioner’s experts made extensive adjustments based on hindsight as to matters occurring subsequent to the valuation date. Some of these adjustments were based on interviews with petitioner’s employees and representatives 10 years after the valuation date and in anticipation of trial.
In Titus Est. v. Comr.17, the Tax Court pointed out a problem often encountered in rebuttal reports or in appraisals prepared in cases more contemporaneously than an initial appraisal:
We have afforded the Apr. 7, 1988, supplemental report little weight because of the extensive use of hindsight based upon information which clearly would not have been available to a buyer or seller on Apr. 18, 1983.
The Subject Property Interest
Like the valuation date, it seems implausible that an appraiser could err in the property to be valued. Appraisers are usually required to describe the subject property in the appraisal report. Nevertheless, this mistake can arise in many different contexts and circumstances, as the following cases demonstrate. In True Est. v. Comr.19, the Tax Court stated:
Finally, we disagree with [the appraiser] that Dave True’s 68.47-percent interest ? should be treated as a noncontrolling interest.
In True Est. v. Comr.20, the Tax Court also noted:
Because Eighty-Eight Oil routinely allowed its partners to maintain disproportionate capital accounts, the two approaches are fundamentally inconsistent. To the extent that the partnership agreement defines the interest being transferred, we doubt that [the appraiser] has valued the correct interest.
In Godley Est. v. Comr.21, the Tax Court observed:
He failed to recognize that the hypothetical buyer investing in GMA would not merely be buying the accounts receivable on a particular date, but instead would be buying the income stream attributable to 10 percent of the rental income of each of the four housing partnerships, minus expenses associated with managing the housing partnerships.
The first rule of an expert witness is supposed to be that the expert witness, who offers no factual information such as documentation or eyewitness accounts that might be helpful to the trier of fact, offers a considered opinion that is based upon the facts as known or as reasonably knowable. If a court suspects any expert witness of bias, such a suspicion can eviscerate or seriously erode the expert witness’s credibility. Appraisers are supposed to be unbiased and are not supposed to be advocates.23
In Hearst Corp. v. U.S.24, the United States Court of Federal Claims articulated the following impression about the appraisers for both sides:
As is typical in litigation that involves battles by experts in analysis of complex matters, the information provided by the valuation witnesses of both parties was skewed to advance the objectives of their respective clients.
Even a competent appraiser can get lulled into the minefield of bias, especially when working for one side in a litigated matter. Appraisers who are brought in to defend or justify another appraiser’s conclusion of value can easily be inclined, even subconsciously, to skew their conclusion of value toward that of the appraiser whose opinion they were hired to defend. In Mueller Est. v. Comr.25, the Tax Court had this to say about a preeminent business appraiser:
The conflict arose when [the appraiser] strayed from the standard of objectivity and “cast aside his scholar’s mantle and became a shill” for respondent.
In Auker Est. v. Comr.26, the Tax Court wholly disregarded an appraiser’s opinion concerning blockage, stating:
We decline to accept the opinion of a man whose only appearance in this case seems to be as a spokesman for the interests of his clients and the estate.
In Knight v. Comr.27, the Tax Court concluded that the appraiser was not objective:
We conclude that [the appraiser] was acting as an advocate and that his testimony was not objective.
Sources of Data
Appraisers often are required to cite the sources of data in their reports. It is important that these cited materials be complete, up to date, and objective. In Lauder Est. v. Comr.29, the Tax Court stated the following in a footnote:
It is worth noting that in analyzing the general economy, [the appraiser] represented that there were certain negative economic indicators by November of 1976 relying on an untitled “article” in the November 29, 1976, issue of Barron’s. We found that the quote relied on came instead from an editorial commentary entitled “How’s Business? Not as Bad as the Misleading Indicators Suggest”. The editorial commentary does not provide sufficient information to support [the appraiser’s] representation. Further, characterizing it as an article without providing us with a title appears to be misleading.
In Klauss Est. v. Comr.30, the Tax Court rejected the IRS’s sole reliance upon an article by Bajaj and Hakala, “Valuation for Smaller Capitalization Companies”, published in Financial Valuation: Businesses and Business Interests, Chapter. 12A (Hanan and Sheeler ed. 1998) for the proposition that there is no small stock premium.
Appraisers are supposed to provide sources for the data that they utilize in valuation reports.31 In Klauss Est. v. Comr.32, the court criticized the IRS appraiser for failing to include a source for an article:
Respondent attached to respondent’s opening brief an appendix which shows that large capitalization stocks have outperformed small stocks since about 1988. We do not consider the information in the appendix because respondent provided no source for it.
With respect to the increasing use of citations to web sites, a good valuation report will note the last time that the web site was checked. This is particularly important in areas of the report such as general economic conditions, and so forth.
1 301 F. 3d 339 (5th Cir. 2002).
2 48 T.C. 502, 512 (1967).
3 T.C. Memo 1992-284.
4 55 T.C. 172 (1970).
5 Gross v. Comr., T.C. Memo 1999-254, aff’d., 272 F. 3d 333 (6th Cir. 2001).
6 See, e.g., ASA BVS General Preamble (II).
7 T.C. Memo 2006-152.
8 T.C. Memo 1998-297.
9 IBA considers such behavior to be unethical. IBA Business Appraisal Standards Section 1.24.
10 T.C. Memo 1993-580.
11 115 T.C. 506 (2000).
12 T.C. Memo 2002-152.
13 2010-2011 USPAP Standards Rule 9-2(d), Standards Rule 10-2(a)(vii), the comment to Standards Rule 3-1(c) and Statement on Appraisal Standards No. 3; IBA Business Appraisal Standard s Section 1.20; ASA BVS VI Section II.A; AICPA Statement on Standards for Valuation Services Paragraphs 12, 25, 43, 52 (calculations), 68, 69, 71 (summary reports) and 77 (calculations); NACVA Professional Standards Sections 3.3(c) and 4.3(a)(4); see also the definition of “valuation date” in the International Glossary of Business Valuation Terms that was adopted by the AICPA, ASA, CICBV, IBA, and NACVA.
14 T.C. Memo 1999-119.
15 T.C. Memo 2001-31.
16 T.C. Memo 1999-377.
17 T.C. Memo 1989-466.
18 See, e.g., ASA BVS-I Section (II)(B)(1); NACVA Professional Standards Section 4.3(a)(2); AICPA Statement on Standards for Valuation Services Paragraph 52(3); IBA Professional Appraisal Standards Section 5.3(a).
19 T.C. Memo 2001-167.
20 T.C. Memo 2001-167.
21 T.C. Memo 200-242.
22 FRE 702.
23 IBA Business Appraisal Standards Sections 1.3 and 1.4; AICPA Statement on Standards for Appraisal Services, Paragraph 14; ASA BVS VIII (III)(A); NACVA Professional Standards Section 1.2(j)
24 28 Fed. Cl. 202 (Cl. Ct. 1993), vacated, 36 F. 3d 1116 (Fed. Cir. 1994).
25 T.C. Memo 1992-284.
26 T.C. Memo 1998-185.
27 115 T.C. 506 (2000).
28 ASA BVS-I Sections (V) and VIII(V)(k); IBA Business Appraisal Standards Sections 1.18 and 5.3(I); AICPA Statement on Standards for Valuation Services Paragraph 44.
29 T.C. Memo 1992-736.
30 T.C. Memo 2000-191.
31 IBA Business Appraisal Standards Section 1.18; AICPA Statement on Standards for Valuation Services, Paragraph 53; NACVA Professional Standards Section 3.3(j); ASA BVS Section VIII (V)(K).
32 T.C. Memo 2000-191.