5th Circuit Reverses McCord, Confirming Original Marketability Discounts
Business Valuation Advisor, Spring 2007

McCord v. Comm’r of Internal Revenue, 2006 U.S. App. LEXIS 21473 (August 22, 2006)

In one of the biggest upsets in business valuation law, the 5th Circuit Court of Appeals recently overturned McCord v. Commissioner, 2003 U.S. Tax Ct. LEXIS 16 (2003)(McCord I). Most analysts and attorneys know the 117-page McCord I for its determination of marketability discounts, where the Tax Court rejected the taxpayer’s restricted stock analysis and endorsed the criticism of pre-IPO studies.

McCord I revisited

In January 1996, the McCord family transferred all of their interests in a limited partnership to exempt and non-exempt donees by an Assignment Agreement. Rather than use percentage interests, however, they conveyed dollar amounts of the net fair market value of the partnership interests pursuant to a sequentially structured “defined value clause.” In conjunction with the Assignment Agreement, the taxpayer’s appraisal calculated that each donee would receive approximately $89,000 for each 1 percent of limited partnership interest at the time of the gifts. Approximately two months later, the donees signed a separate Confirmation Agreement, which translated the dollar value of each gift under the Assignment Agreement’s defined value formula into percentages of interests in the partnership.

A procedural anomaly

The taxpayers used the appraisal to calculate their gift tax returns, including a 35 percent discount for lack of marketability based on their expert’s analysis of restricted stock studies, as well as supporting data from pre-IPO studies. But the IRS assessed more than $4 million in deficiencies. The Commissioner’s valuation conclusion was nearly twice that of the taxpayers—and was based on its rejection of pre-IPO studies, including its expert’s opinion that a 7 percent marketability discount was appropriate.

The parties originally tried the dispute before Judge Maurice B. Foley, based primarily on stipulations and the service’s argument that the “defined value gift clause” violated public policy. But Judge Foley held that the IRS had failed to meet its burden of proof on any contested issue and could not prevail.

Two years later, however, the Tax Court’s Chief Judge retroactively took the case away from Judge Foley and reassigned it to what resembled an en banc panel. This uncommon proceeding ultimately produced McCord I from an eight-judge majority, with concurring and dissenting opinions from five other justices. The majority crafted its own interpretation of the Assignment and Confirmation Agreements.

[T]he majority in essence suspended the valuation date of the property that the Taxpayers donated in January [per the Assignment Agreement] until the date in March on which [per the Confirmation Agreement] the disparate donees acted, post hoc, to agree among themselves on the…partnership percentages that each would accept as equivalents of the dollar values irrevocably and unconditionally given by the Taxpayers months earlier.

The result was, as Judge Foley pointed out in his dissent, a “tortured” analysis of the Assignment Agreement that required the taxpayers to use the majority’s valuation to determine the dollar value of the transferred interest, but its own appraisal to determine the percentage interests transferred. “There is no factual, legal, or logical basis for this conclusion.”

The 5th Circuit agreed: This “unique methodology violated the immutable maxim that post-gift occurrences do not affect, and may not be considered in, the appraisal and valuation processes…”

As the Tax Court had correctly rejected the Commissioner’s valuation—but incorrectly applied its own “imaginative” methodology—the values left were those which the taxpayers had filed with their original return. Affirming without discussing the calculation of marketability discounts, the 5th Circuit allotted the remainder of its analysis to the Tax Court’s final legal error—its failure to apply a discount for the present negative value of the donees’ assumption of estate tax liability under IRC Section 2035.

Harsh words for the Service

In its note that the IRS deficiency notices were almost twice what the taxpayer filed, the Court observed, “this exemplified a practice of the IRS that we see with disturbingly increased frequency, e.g., a grossly exaggerated amount asserted in a notice of deficiency.” It’s anyone’s guess whether the IRS will heed such reprimand from the “taxpayer friendly” 5th Circuit. But this reversal means that McCord I has lost most of its precedential value; and though the appellate decision is binding only on the 5th Circuit, analysts and attorneys are likely to cite it as support for traditional valuation approaches.