This post discusses the “Executive Summary” and the “Introduction” to the IRS DLOM Job Aid.
Review of the “Executive Summary” Section
It should be no surprise that the IRS is focusing on the marketability discount. The DLOM is an issue in virtually every gift or estate tax matter involving minority ownership interests in businesses, partnerships, limited liability companies and more. The DLOM Job Aid begins:
In June 2008 a team was formed for the purpose of exploring and developing information to assist valuators in the Internal Revenue Service Large and Mid- Size Business (LMSB) Engineering Program in dealing with the Discount for Lack of Marketability (DLOM) as such is used in valuation reports. Among the activities to be undertaken by the team was the clarification of the definition of Discount for Lack of Marketability, exploration of the state of the art in estimating this discount, analysis of current estimating models, review of court commentaries, and documentation of any concerns with the use of the various approaches considered. The team’s focus was to identify issues around DLOM and to present techniques to assist valuators in the field. This information should be of value not only to our own personnel but also to our valuation customers.
The DLOM Job Aid is a manual for IRS employees to assist them when evaluating marketability discounts. One thing that was important in the development of the DLOM Job Aid was to understand the basic methods employed by appraisers, and their relative strengths and weaknesses. The objective of the publication was stated succinctly as:
The team researched the state of art in DLOM starting by defining DLOM and differentiating it from such related areas as Discount for Lack of Liquidity (DLOL) and Discount for Lack of Control (DLOC). We reviewed longstanding methods for estimating DLOM. We explored the models in recent professional journals, discussed the pro’s and con’s of these models, explored their strengths and weaknesses and looked for elements of reconciliation among the models where possible. As a result of this initial work, the team developed a job aid that addresses the more common approaches being used in the valuation community. Our hope was to provide a quality, timely analysis that will assist employees in the field working DLOM issues.
The Executive Summary of the DLOM Job Aid recognizes that any valuation method or model can be misused or abused. It also recognizes that new methods and models may be developed for determining marketability discounts. As a result, the DLOM Job Aid is current as of its publication and could become dated with evolving developments.
The conclusion regarding the DLOM Job aid was also stated in the Executive Summary:
This Job Aid is meant to provide a background and context for the Discount for Lack of Marketability as such is commonly applied in business valuation analyses and reports. It reviews past and existing practices and attempts to provide insight into the strengths and weaknesses of these practices. It is not meant to provide a cookbook approach to evaluating a marketability discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal. Nor is it meant to be an IRS position or cited as precedent. Any opinions expressed are suggestions of the job aid developers not the position of the IRS. It is emphasized that, all background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator. By bringing the included material together in one document, we are striving to make the job of the IRS valuation analyst easier. We do not mean to provide guidance as to reasonable levels of marketability discounts that would prevail in all situational contexts or to imply that the IRS has any policy per se in the evaluation or the determination of such discounts. (emphasis added)
The DLOM Job Aid is not meant to set any precedent for positions or for methods. The caveat above regarding the publication not providing a “cookbook approach” is clear. It is also clear that there is no objective to try to establish guidance regarding “reasonable levels of marketability discounts.” To round out the caveats, this disclaimer is found at the bottom of every page of the DLOM Job Aid:
“This Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position.”
Review of the “Introduction” Section”
The Introduction begins with a recognition that the marketability discount is a big money issue (my term for their discussion), and that this discount is one of frequent discussion in gift and estate tax cases. The Job Aid’s publication is, in part, an IRS response to the potpourri of studies, methods and models used by valuation practitioners in developing marketability discounts. For example:
Today’s valuation practitioners utilize numerous studies, methods and models as the source for DLOM as it is applied to a specific subject interest. These studies, methods and models can be complex, can indicate widely diverse conclusions, and may be appropriate in only certain limited situations.
As a veteran of more than thirty years in this business I can attest to the truth of this observation in the Job Aid. In addition, the business valuation profession has not developed any convergence regarding best practices in the development of DLOM. The spectrum of “studies, methods and models” observed in practice is wide indeed. Nor is there much focus on “acceptable” practice among business appraisers:
The business valuation profession does not identify acceptable or unacceptable methods for estimating marketability discounts, although some individual practitioners have their own preferences and frequently disagree as to the best approach.
The drafter of this portion of the Job Aid was prone to understatement.
The Job Aid is designed to identify the current state of DLOM studies and methods, as they say, “ranging from the SEC Restricted Stock study prepared in 1971 to the Liquistat database announced in 2007.” We will examine studies or methods introduced since then in this series of posts.
The analysis of studies, methods and models in the DLOM Job Aid typically do four things:
- Identify the parameters used in the method
- Evaluate (or note) the particular strengths and weaknesses of each method
- Summarize “the view of the valuation community” for each method (if, indeed, such views can be summarized)
- Discuss what the courts, principally the U.S. Tax Court, have to say about the methods, if anything.
The DLOM Team working on the Job Aid identified studies, methods and models in four general categories:
- Benchmark methods (using various studies as “benchmarks” from which to evaluate a particular subject interest, as well as using restricted stock data bases to provide “guidelines” for necessary valuation judgements)
- Securities-based methods (using option pricing models and option prices)
- Analytical methods (examining DLOM through consideration of various transactional data sets)
- Other methods (essentially the various quantitative methods or models that have been developed to date)
While this categorization scheme is useful, we will, further categorize methods based on whether they represent valuation methods under the asset approach, the income approach, or the market approach. We will also examine each method in the context of the earlier discussion of business valuation standards and the factors that influence marketability.
In our next post, we will review the factors influencing marketability as described in the DLOM Job Aid.