In the last post, we linked to Peter Mahler’s review of the recent New York case Giaimo (Matter of Giaimo (EGA Associates, Inc.), 2011 NY Slip Op 50714(U) (Sup Ct NY County Apr. 25, 2011).
This is a statutory fair value determination pertaining to two C corporation real estate holding companies. The matter involved litigation between siblings, Robert and Janet Giaimo.
Justice Marcy Friedman’s decision was based on her analysis of the Report & Recommendation by Special Referee Louis Crespo dated June 30, 2010.
The following summary is repeated from the previous post for convenient background.
Summary of the Issues
The Special Referee first determined the market values of the various apartment buildings, siding mostly with Robert’s real estate appraiser, but making adjustments in the appreciation rates that lowered value overall.
There were two important valuation issues and some related issues pertaining to Edward’s estate (and that of the siblings’ mother, as well). While important to the parties, they are not significant for this post.
The first valuation issue related to the issue of the applicability of a marketability discount (also called the discount for lack of marketability or DLOM). The Special Referee concluded that no marketability discount should be applied, and Justice Friedman agreed, although not for the same reasons. (I discussed this portion of the opinion in the first post on Giaimo.)
The second issue was whether, in a fair value determination in New York, it was appropriate to consider the entire built-in gain (embedded capital gains, or BIG) in each of the C corporations. The issue was significant because the book values of the two corporations were minimal in relationship to the appreciated values of the apartment buildings and a combined federal, state and New York City capital gains tax of nearly 46%.
Janet’s counsel (and business appraisal experts) argued that the entire BIG should be applied as a liability in determinations of net asset value. Robert’s counsel argued that none of the BIG should be considered as a liability, but his business appraisal expert testified as to the appropriate methods for consideration if the court determined that a BIG deduction was appropriate.
The court agreed with the special referee’s application of a so-called “Murphy Discount,” which was decided while the Special Referee was preparing his report (Matter of Murphy (United States Dredging Corp.), 74 AD3d 815 (2d Dept 2010). The concluded BIG liability was about 50% of the combined embedded gains in the two corporations.
I know what Robert’s expert concluded, because I was that expert.
Partial Consideration of Built In Gain Liability
The Mahler blog post summarized the result in Justice Friedman’s opinion:
Justice Friedman next turns to Janet’s argument that Referee Crespo erred by not calculating the BIG discount at 100% assuming liquidation upon the valuation date. Janet argued that the Manhattan trial court was bound to follow the Manhattan (First Department) appellate court’s ruling in Wechsler v. Wechsler, 58 AD3d 62 (1st Dept 2008), a matrimonial “equitable distribution” case in which the court applied a 100% BIG discount, rather than the Brooklyn (Second Department) appellate court’s Murphy decision upon which Referee Crespo relied. Justice Friedman notes that the Murphy decision expressly distinguishes Wechsler on grounds equally applicable in Giaimo, namely, there was no issue presented or expert testimony in Wechsler about reducing the BIG taxes to present value. ”Given the lack of precedent in this [First] Department on the issue of whether the BIG should be reduced to present value,” Justice Friedman writes, “the support for that approach in the Second Department, and the factual support in the record for the 10 year projection, the Court does not find that the Special Referee committed legal error in following the present value approach.”
Justice Friedman rejected Robert’s contention that therer should be no BIG deduction, stating that Robert relied largely on cases from other states that refuse to consider the BIG unless the corporation was actually underoging liquidition at the valuation date.
These cases treat an assumed liquidation as inconsistent with valuation of the corporation as an ongoing concern. While the reasoning has much to recommend it, New York follows the contrary view that it is irrelevant whether the corporation will actually liquidate its assets and that the court, in valuing a close corporation, should assume that a liquidation will occur.
Some additional background is appropriate. First, both experts for Janet concluded that 100% of the embedded BIG liability should be considered (i.e., deducted) in their determinations of net asset value. I concluded that 40% of the BIG liability should be considered as a liability. This conclusion was supported by a series of calculations and market evidence regarding the 2007 market for apartment buildings in Manhattan.
I wrote an article in 1998, following the issuance of the Davis case in U.S. Tax Court. The article, “Embedded Capital Gains in C Corporation Holding Companies,” was published in Valuation Strategies, November/December, 1998.
An important conclusion of the article was that, in fair market value determinations involving C corporation asset holding companies (like EGA and FAV), the usual negotiations between hypothetical buyers and sellers would result in a conclusion of consideration of 100% of the BIG liability. This is true when buyers have the choice of buying assets inside a corporate wrapper and purchasing identical assets in “naked form,” or without any issues of BIG. The article shows that the only way that buyers can get equivalent investment returns between the two choices, buying an asset in a corporate wrapper that has embedded BIG and purchasing the “naked asset,” is by charging the full amount of the embedded capital gain. And the article makes no assumption about the potential ability of a buyer to convert the C corporation to an S corporation and hold for ten years until the embedded BIG “goes away.” Simply put, buyers who have the alternative choice of acquiring identical “naked assets” won’t agree to that concept. [emphasis added]
Janet’s counsel cross-examined me fairly hard on this issue, attempting to show that I was inconsistent between the article and the treatment in Giaimo. However, a critical assumption is made in reaching the article’s conclusion of charging 100% of the embedded BIG in C corporation asset holding companies:
When analyzing the impact of embedded capital gains in C corporation holding companies, one must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities. One must also consider the realistic option that potential buyers of the stock of those entities must be assumed to have – that of acquiring similar assets directly, without incurring the problems and issues involved with embedded capital gains in a C corporation.
- In Murphy, a case involving a real estate holding company with an embedded BIG of $11.6 million, the court allowed a discount of $3.4 million, or about 29.3% of the BIG. This was based on a present value calculation assuming liquidation of the underlying properties in 19 years assuming no growth in value. The implied discount rate was 6.7%. (Matter of Murphy (United States Dredging Corp.), 74 AD3d 815, 2010 NY Slip Op 04794 (2d Dept June 1, 2010))
- The properties would grow in value at an expected rate of 2.5%.
- The properties would be liquidated at the end of a ten year holding period. This was based on assumptions in the underlying real estate appraisals.
- The discount rate used was 10% based on a small premium to the discount rates used in the real estate appraisals.
- The combined capital gains tax rate (federal, state and city) was 45.63%.
Given these assumptions, the present value of the expected future embedded capital gains tax represented 49.4% of the embedded BIG at the valuation date. Just to be clear, that means that for each dollar of embedded capital gain, the analysis suggests reducing net asset value by 49.4 cents. My conclusion, based on this analysis and others presented in court, was that the liability should be 40 cents of each dollar of BIG.
The Special Referee concluded that the appropriate BIG should be about 50% based on an analysis similar to that outlined above. Expected growth was 3% per year (not compounded), for ten years, and with a 10% discount rate.
This finding was affirmed by Justice Friedman’s opinion.
Giaimo is an interesting case that addresses two important issues in statutory fair value determinations in New York.
- The marketability discount issue was decided by Judge Friedman in a manner in which she did not have to tackle the precedent established in Beway. She determined that the Special Referee had sufficient economic evidence based on the marketability of the properties and the market for the properties in EGA and FAV to substantiate his opinion of no marketability discount.
- The Special Referee’s determination of the BIG liability was clearly in line with both the precedent treatment in Murphy and the economic reality of the marketplace for apartment dwellings in Manhattan at the valuation date.
It remains to be seen if there will be an appeal in the matter.