Business Valuation and Taxes Procedure Law and Perspective phần 1 pptx

Business Valuation and Taxes
Procedure, Law, and Perspective
David Laro
Judge, U.S. Tax Court
Shannon P. Pratt
CFA, FASA, MCBA, CM&A, MCBC
John Wiley & Sons, Inc.
Business Valuation and Taxes
Business Valuation and Taxes
Procedure, Law, and Perspective
David Laro
Judge, U.S. Tax Court
Shannon P. Pratt
CFA, FASA, MCBA, CM&A, MCBC
John Wiley & Sons, Inc.
This book is printed on acid-free paper. ∞
Copyright © 2005 by John Wiley & Sons, Inc., Hoboken, New Jersey. All rights reserved.
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Library of Congress Cataloging-in-Publication Data:
Laro, David, 1942–
Business valuation and taxes : procedure, law & perspective /
David Laro, Shannon P. Pratt.
p. cm.
Includes bibliographical references and index.
ISBN-13 978-0-4716-9437-3 (cloth)
ISBN-10 0-471-69437-1 (cloth)
1. Business enterprises—Valuation—United States. 2. Business
enterprises—Taxation—Law and legislation—United States. I. Pratt,
Shannon P. II. Title.
HF5681.V3L37 2005
346.73'065—dc22
2004013842
Printed in the United States of America
10987654321
Dedication by David Laro
To my wife, Nancy,
and our family—
Rachel, David, and their children, Sophie and Asher

Marlene, Andrew, and their sons, Alexander and Benjamin
Dedication by Shannon Pratt
To my wife, Millie,
and our family—
Mike, Barb, and their sons, Randall and Kenny
Georgia, Tom, and their children, Elisa, Katie, and Graham
Susie, Tim, and their children, John, Calvin, and Meg
Steve, Jenny, and their children, Addy and Zeph
About the Authors
The Honorable David Laro was appointed by President George H. W. Bush to the United
States Tax Court, confirmed by the Senate, and invested as a federal judge in November 1992.
He formerly practiced law in Michigan for 24 years, specializing in tax law.
Judge Laro is a graduate of the New York University School of Law (LLM in Taxation,
1970), the University of Illinois Law School (JD, 1967), and the University of Michigan
(BA, 1964).
Before joining the U.S. Tax Court, Judge Laro was chairman and CEO of a publicly
traded international company. In 1985, he co-founded Republic Bancorp, a Michigan bank
holding company that was rated recently by Fortune magazine as the fifth-best corporation in
America at which to work. He was the founder and chairman of the board of directors of Re-
public Bank Ann Arbor, a position he held until he became a federal judge. Judge Laro has
also held several public offices, including a Regent of the University of Michigan, a member
of the State Board of Education in Michigan, and chairman of the State Tenure Commission in
Michigan. He formerly served as director of the Ann Arbor Art Association and as a member
of the Holocaust Foundation in Ann Arbor.
As adjunct professor of law at Georgetown University Law Center, Judge Laro teaches a
class in business planning. He is also a visiting professor at the University of San Diego
School of Law, where he teaches business valuation and tax litigation. He lectures on tax pol-
icy at Stanford Law School and is a member of the National Advisory Committee for New
York University School of Law.

A frequent guest speaker, Judge Laro lectures for the American Bar Association, the
American Society of Appraisers, the American Institute for Certified Public Accountants, and
other professional organizations and associations. In addition, he has authored numerous arti-
cles on taxation printed in the American Bar Association Journal, the University of Illinois
Law Review, and other publications. He is a fellow of the American College of Tax Counsel.
At the request of the American Bar Association and the Central Eastern European Law
Initiative, Judge Laro contributed written comments on the Draft Laws of Ukraine, Ka-
zakhstan, Uzbekistan, Slovenia, and the Republic of Macedonia, and on the creation of spe-
cialized courts in eastern Europe. As a consultant for the Harvard Institute for International
Development and Georgia State University, Judge Laro lectured in Moscow to Russian judges
on tax reform and litigation procedures. Judge Laro has also lectured to judges and tax offi-
cials in Azerbaijan on tax reform.
Judge Laro’s noteworthy tax decisions include Simon (depreciation of antique musical in-
strument), Mandelbaum (lack of marketability discount), Wal-Mart (inventory shrinkage),
ACM Partnership (corporate tax shelter), Lychuk (capitalization issues), and Bank One (valua-
tion of financial derivatives).
vii
Judge Laro’s family shares his interest in tax law. His wife is a certified public accountant.
Both of his daughters and one son-in-law are tax attorneys. For variety, his other son-in-law is
a urologist. Judge Laro enjoys spending time with his family, especially his grandchildren,
Sophie, Alexander, Benjamin, and Asher.
Shannon Pratt’s reputation for knowledge and experience in the field of business valuation is
legendary and unparalleled. He is the best-known authority in the field of business valuation
and has written numerous books that articulate many of the concepts used in modern business
valuation around the world.
He is chairman and chief executive officer of Shannon Pratt Valuations, LLC; Publisher
Emeritus for Business Valuation Resources, LLC; and a member of the board of directors of
Paulson Capital Corp., an investment banking firm specializing in small-firm IPOs and sec-
ondary offerings.
1

Dr. Pratt holds an undergraduate degree in business administration from the University of
Washington and a doctorate in business administration, majoring in finance, from Indiana
University. He is a Fellow of the American Society of Appraisers, a master certified business
appraiser, a chartered financial analyst, a master certified business counselor, and a certified
mergers and acquisitions advisor.
His professional recognitions include being designated a life member of the American So-
ciety of Appraisers and also a life member of the Business Valuation Committee of the Amer-
ican Society of Appraisers, past chairman and a life member of the ESOP Association
Advisory Committee on Valuation, a life member of the Institute of Business Appraisers, the
recipient of the magna cum laude in business appraisal award from the National Association
of Certified Valuation Analysts, and the recipient of the Distinguished Achievement Award
from the Portland Society of Financial Analysts. He served two three-year terms (the maxi-
mum) as a trustee-at-large of The Appraisal Foundation.
Besides lecturing, writing, and teaching courses for such organizations as the American
Society of Appraisers, the Alliance of Merger & Acquisition Advisors, the American Bar As-
sociation, and several state bars, Dr. Pratt is author of the following books published by John
Wiley & Sons, Inc.: Business Valuation Discounts and Premiums; Business Valuation Body of
Knowledge: Exam Review and Professional Reference, 2nd edition; Business Valuation Body
of Knowledge Workbook; Cost of Capital: Estimation and Applications, 2nd edition; Cost of
Capital Workbook; and The Market Approach to Valuing Businesses. He is also the author of
The Lawyer’s Business Valuation Handbook, published by the American Bar Association. He
is coauthor of Valuing a Business: The Analysis and Appraisal of Closely Held Companies,
4th edition, and Valuing Small Businesses and Professional Practices, 3rd edition (both pub-
lished by McGraw-Hill), Guide to Business Valuations, 14th edition (published by Practition-
ers Publishing Company), and Guide to Canadian Business Valuations.
He was a founder of Willamette Management Associates, and served as a managing direc-
tor of that firm through December 2003. For more than 35 years, Dr. Pratt has performed val-
viii ABOUT THE AUTHORS
1
Due to judicial ethical considerations, Judge Laro is not able to and therefore does not endorse, promote, or rec-

ommend any commercial or business services Shannon Pratt or others have created or with which they are in-
volved, some references to which are included in this book for informational purposes only.
uation engagements for mergers and acquisitions, employee stock ownership plans (ESOPs),
fairness opinions, gift and estate taxes, incentive stock options, buy-sell agreements, corpo-
rate and partnership dissolutions, dissenting stockholder actions, damages, and marital disso-
lutions, to name a few. He has testified in a wide variety of federal and state courts across the
country and frequently participates in arbitration and mediation proceedings. Beginning in
2004, he practices valuation with Shannon Pratt & Associates.
Dr. Pratt develops and teaches business valuation courses for the American Society of Ap-
praisers, the American Institute of Certified Public Accountants, and the Association of Merg-
ers & Acquisitions Advisors, and frequently speaks on business valuation at national legal,
professional, and trade association meetings. He has also developed a seminar on business
valuation for judges and lawyers.
Besides life with his wife Millie, Dr. Pratt enjoys his model railroad, the ever-growing
collection of glasses and mugs from many places he’s visited, fine wines, and frequent visits
from their four children and ten grandchildren.
About the Authors ix
Table of Contents
Forewords xvii
Preface xxiii
Acknowledgments xxvii
1. Standards of Business Valuation 1
Summary 1
Introduction 2
Sources for Defining Value 3
Definitions of Value 7
Premise of Value 15
Conclusion 16
2. Subsequent Events 17

Summary 17
Key Question 17
Valuation Date 17
Subsequent Events—Exceptions 19
Conclusion 23
3. Business Valuation Experts 24
Summary 24
Introduction 25
Proving Business Value 25
The Expert Appraiser 26
Types of Experts 26
Various Roles of Experts 27
Business Valuation Litigation Witnesses 28
Admissibility of Evidence Underlying Expert Opinions 29
Limitations to Admissibility 30
Reliability of the Expert 31
Minimum Thresholds for the Business Valuation Expert 33
Sarbanes-Oxley Act of 2002 34
Attorney Assistance to the Expert 35
Qualified Appraiser 37
xi
Concerns about Expert Testimony 38
Court-Appointed Expert 40
Conclusion 41
Appendix: Expert Credentials and Qualifications 42
4. Sources of Law and Choice of Courts 48
Summary 48
Structure of the American Legal System 48
Tax Law 49
Tax Litigation 51

5. Burden of Proof in Valuation Controversies 55
Summary 55
Burden of Proof 57
Who Bears the Burden of Proof 58
Burden of Proof: Exceptions to the General Rule 59
6. Penalties and Sanctions 63
Summary 63
Introduction 63
What You Need to Know 64
Valuation Penalties 65
General Penalties 67
Discretionary Sanctions 68
7. Valuation and Choice of Entity 70
Summary 70
Introduction 71
Corporations 72
Limited Liability Companies 73
General Partnerships 73
Limited Partnerships 74
Sole Proprietorships 75
Valuation Considerations 75
Choice of Jurisdiction 77
Conclusion 77
8. Valuation of S Corporations and Other Pass-Through Tax Entities:
Minority and Controlling Interests 79
Introduction 79
Case Law Background 81
S Corporation Minority Interest Appraisals 83
Comparison of Minority Interest Theories—A Summary of the Issues 127
xii TABLE OF CONTENTS

S Corporation Controlling Interest Appraisals 130
Summary 131
S Corporation Valuation Issues—Partial Bibliography 131
9. Valuation of International Transactions 137
Summary 137
Introduction 138
Transfer Pricing 139
Customs Valuation 147
Conclusion 152
10. Adjustments to Financial Statements 153
Summary 153
Separating Nonoperating Items from Operating Items 154
Addressing Excess Assets and Asset Deficiencies 155
Handling Contingent Assets and Liabilities 155
Adjusting Cash-Basis Statements to Accrual-Basis Statements 156
Normalizing Adjustments 156
Controlling Adjustments 157
Conclusion 158
11. Comparative Financial Statement Analysis 159
Summary 159
Comparable Ratio Analysis 161
Common Size Statements 166
Tying the Financial Statement Analysis to the Value Conclusion 167
Conclusion 167
12. Economic and Industry Analysis 168
Summary 168
Objective of Economic and Industry Analysis 168
National Economic Analysis 169
Regional and Local Economic Analysis 170
Industry Analysis 170

Conclusion 172
Partial Bibliography of Sources for Economic and Industry Analysis 172
13. Site Visits and Interviews 178
Summary 178
Site Visits 178
Management Interviews 178
Interviews with Persons Outside the Company 179
Conclusion 180
Table of Contents xiii
14. The Income Approach 181
Summary of Approaches, Methods and Procedures 181
Introduction to the Income Approach 182
Net Cash Flow: The Preferred Measure of Economic Benefit in the
Income Approach 182
Discounting versus Capitalizing 184
Relationship between Discount Rate and Capitalization Rate 184
Projected Amounts of Expected Returns 190
Developing Discount and Capitalization Rates for Equity Returns 190
Weighted Average Cost of Capital (WACC) 194
The Midyear Convention 195
The Income Approach in the Courts 196
Conclusion 200
Appendix: An Illustration of the Income Approach to Valuation 201
15. The Market Approach 209
Summary 209
The Market Approach 210
Revenue Ruling 59-60 Emphasizes Market Approach 210
The Guideline Publicly Traded Company and the Guideline Transaction
(Merger and Acquisition) Method 211
How Many Guideline Companies? 213

Selection of Guideline Companies 217
Documenting the Search for Guideline Companies 219
Choosing Multiples Based on Objective Empirical Evidence 219
What Prices to Use in the Numerators of the Market Valuation Multiples 220
Choosing the Level of the Valuation Multiple 220
Selecting Which Valuation Multiples to Use 222
Assigning Weights to Various Market Multiples 224
Sample Market Valuation Approach Tables 224
Other Methods Classified under the Market Approach 224
Conclusion 229
Appendix: An Illustration of the Market Approach to Valuation 230
16. The Asset-Based Approach 260
Summary 260
The Adjusted Net Asset Value Method 260
Excess Earnings Method (The Formula Approach) 261
Conclusion 265
17. Entity-Level Discounts 266
Summary 266
Trapped-In Capital Gains Discount 267
Key Person Discount 271
Portfolio (Nonhomogeneous Assets) Discount 276
xiv TABLE OF CONTENTS
Discount for Contingent Liabilities 279
Conclusion 281
18. Discounts for Lack of Marketability 282
Summary: General Introduction to Shareholder-Level Discounts and Premiums 283
Definition of Marketability 283
Benchmark for Marketability Is Cash in Three Days 284
Investors Cherish Liquidity, Abhor Illiquidity 285
Degrees of Marketability or Lack Thereof 285

Empirical Evidence to Quantify Discounts for Lack of Marketability:
The Restricted Stock Studies 286
Empirical Evidence to Quantify Discounts for Lack of Marketability:
Pre-IPO Studies 291
Criticisms of the Pre-IPO Studies 294
Factors Affecting the Magnitude of Discounts for Lack of Marketability 295
Use of the Databases for Quantifying Discounts for Lack of Marketability 299
Discounts for Lack of Marketability in the Courts 302
Conclusion 309
Partial Bibliography of Sources for Discounts for Lack of Marketability 310
19. Other Shareholder-Level Discounts 311
Summary 311
Minority Discounts/Control Premiums 311
Voting versus Nonvoting Shares 317
Blockage 318
Discounts for Undivided Fractional Interests in Property 321
Conclusion 323
20. Weighting of Approaches 324
Summary 324
Theory and Practice 324
Mathematical versus Subjective Weighting 325
Examples of Weighting of Approaches 326
Conclusion 327
21. Valuation of Options 328
Summary 328
Introduction and Background 329
General Principles of Option Valuation 330
Specific Rules for Valuing Options 334
Conclusion 339
22. IRS Positions 340

Summary 340
Introduction 341
Table of Contents xv
Rev. Rul. 59-60 342
Rev. Rul. 65-192 350
Rev. Rul. 65-193 354
Rev. Proc. 66-49 354
Rev. Rul. 68-609 358
Rev. Proc. 77-12 359
Rev. Rul. 77-287 361
Rev. Rul. 83-120 367
Rev. Rul. 85-75 371
Rev. Rul. 93-12 372
Tax Advice Memorandum 1994-36-005 374
Rev. Proc. 2003-51 378
Conclusion 382
23. Business Appraisal Reports 383
Summary 384
Business Valuation Report-Writing Standards 384
Elements of the Business Valuation Report 392
Organization of the Report 397
Qualities of a Good Appraisal Report 397
Conclusion 399
24. Questions to Ask Business Valuation Experts 400
Summary 400
Qualifications 400
Financial Statement Adjustments and Analysis 402
Economic and Industry Data 402
Site Visits and Interviews 402
General Questions about Methodology 402

Discount and Capitalization Rates in the Income Approach 402
Projections Used in the Income Approach 404
Market Approach 404
Asset-Based Approach 405
Entity-Level Discounts 405
Minority Interest Discounts/Control Premiums 405
Discounts for Lack of Marketability 405
Voting/Nonvoting Stock 406
Questions about Contradictory Prior Testimony 406
Appendix A IRS Business Valuation Guidelines 407
Appendix B International Glossary of Business Valuation Terms 412
Appendix C Bibliography 419
Appendix D Table of Cases 426
Index 431
xvi TABLE OF CONTENTS
Foreword
LEGAL PRACTITIONER’S PERSPECTIVE
Judge David Laro and Dr. Shannon Pratt have many years of experience looking at business
data. Dr. Pratt looks at the data and its interrelationships for the purpose of evaluating the use-
fulness of the data in predicting or emulating the behavior of the marketplace. In that role, he
has become well-known for his common-sense explanations of the tools of the appraisal pro-
fession and has become both the master teacher and the dean of the profession. The books he
has authored and co-authored have become indispensable references for business amateurs—
like most lawyers—who routinely encounter valuation issues.
Judge Laro looks at business data in the context of the cases that we advocates present to
him. We cannot hire him like many of us have engaged Dr. Pratt over the years, but all of us,
as citizens, have hired him to objectively ask whether the data and analysis laid before him
makes sense and whether we advocates have used the principles developed by Dr. Pratt and
others in a manner that advances the integrity of the tax system. Even when the resolution of
issues is controversial, Judge Laro’s name on an opinion signals thoughtfulness, thorough-

ness, and an effort to be helpful to the reading public as well as fair to the litigants in the par-
ticular case.
Thus, it is refreshing to see these two close observers of valuation issues collaborate on
this intriguing volume. What the reader gets is something like a mural—depicting the life of a
business appraisal from conception to preparation to the occasional ultimate use by a trier of
fact. The coverage ranges from factors that precede but influence valuation, such as the choice
of business entity (Chapter 7), to factors that shape the end use, such as the burden of proof
(Chapter 5) and penalties (Chapter 6). The respective sections of the mural are drawn with
great care and clarity and are a wonderful addition to the scholarship in this area. The reader’s
opportunity to appreciate the whole panorama, however, is priceless.
The authors have not tiptoed around subjects that have been controversial. The discus-
sions of “the General Utilities doctrine” in Chapter 17 and discounts for lack of marketability
in Chapter 18 address areas in which the interaction of courts and appraisers has been most
lively in recent years. The lawyer whose practice encounters such issues can use these discus-
sions to navigate around the pitfalls that both business practice and tax controversies can
place in the way.
Nor have the authors avoided areas just because they are tough. Chapter 8, dealing with
the special challenges of valuing S corporations and other pass-through entities, confronts
some of the most complex and sometimes inscrutable current topics in the evolution of valua-
xvii
tion law. That chapter is at once the most eclectic and the most meticulous discussion of these
challenges I have seen to date.
Whether the reader practices before the Tax Court or not, and whether the reader handles
valuation matters routinely or only occasionally, this volume will be a most valuable resource.
Ronald D. Aucutt, Esq.
McGuire Woods, LLP
xviii FOREWORD
Foreword
LAW PROFESSOR’S PERSPECTIVE
To write about valuation is a humbling task. No matter how ambitious and dedicated an author

may be, eventually he or she is forced to acknowledge that even a lifetime of work would
leave some aspects of the subject untouched. This offering from Judge David Laro and Dr.
Shannon Pratt fills in some persistent gaps in the business valuation literature, as well as pro-
vides a surprisingly fresh treatment of perennial themes.
The range of the book is impressive. It covers such basics as the definition of fair market
value for federal tax purposes and the features that distinguish it from fair value and intrinsic
value. But it also digs into practical and procedural questions that many other valuation trea-
tises leave out. And it analyzes several important evolving issues, such as valuing S corpora-
tion stock and selected international problems (transfer pricing and customs valuation), which
require close attention from seasoned professionals and novices alike.
Business valuation experts often find themselves talking about synergies, and this work
defines the term by example. Take the chapter on expert witnesses. Judge Laro’s discussion of
the relationship of the valuation professional to the litigation process provides a wealth of in-
sight, from his unique and invaluable vantage point. But the chapter does not stop there. In its
appendix, it is backed up by the Pratt organization’s excellent directories of the many profes-
sional designations for appraisers and the associations that issue them. The reader gets both a
guiding narrative from the judge, and hard data to help put his counsel into practice—the trea-
sure map and the decoder ring in one package, as it were.
The chapter on the lack-of-marketability discount is another dynamic combination. Here
one finds not only a summary of the traditional rationales for the discount and the studies on
which its amount can be based, but also a thorough summary of the classic tax valuation cases
in which it has been applied. The blend of appraisal theory with tax scholarship is impressive
and useful.
Too often the best practitioners of a craft are so busy that they lack the time to pass their
knowledge on. Some are stingy with their wisdom, and others are not very good at teaching.
When the authors of this book sit down to write, however, the results are a thing of beauty.
Enjoy, and learn from, every page.
John A. Bogdanski
Professor of Law
Lewis & Clark Law School

xix
Foreword
BUSINESS APPRAISER’S PERSPECTIVE
I am honored that I was asked to write a foreword for a book written by two people who I be-
lieve are among the most prolific people in our industry, the Honorable Judge David Laro and
Dr. Shannon Pratt.
I remember meeting the Honorable Judge Laro, almost a decade ago now, while he was
teaching a valuation course at the National Judicial College. Prior to that, all I had ever done
was read many of his opinions. I still remember walking into the classroom that day and see-
ing his name tent on a desk in the front row of the room. Almost immediately my stress level
rose when I realized that I would be citing many of his opinions during my program that day.
All I could think about was what would happen if I misrepresented or misstated something. I
found his Honor to be extremely respectful, personable, open-minded, and eager to learn, as
well as understand, as a judge.
Over time, I came to learn more about the judge and the person. I believe he sets a phe-
nomenal example for us, as successful or ambitious experts, with regard to certain standards
of professionalism, credibility, and character traits. His Honor really has a way of putting
things in perspective. I believe this has never been embodied more succinctly and poignantly
than in his Honor’s own words as he answered the following question that was posed to him
from the audience at a recent AICPA Annual Valuation Conference: “Your Honor, do you be-
lieve that this is the greatest job that anyone or you could have?” To this his Honor responded,
“I surely have a wonderful job and career, but it is not the greatest. The greatest job I have is
being a husband, father, and grandfather!” I commend you for your work as a person and a
professional and thank you for your guidance and friendship through the years, and the oppor-
tunity to be a little part of it all.
Then there is Dr. Pratt. He needs little if any discussion in the valuation industry. I have of-
ten referred to him in my presentations as the “godfather” of valuations. Dr. Pratt has traveled
the country helping so many of us in our careers. He has provided us guidance throughout the
years through his writings, speeches, and subscriptions. I doubt that the industry would be at the

maturity level it is without his works. He has always forced us to challenge our conventional
wisdom and thoughts to find the better way to do things. He too has set an example to many of
us without asking us for much in return. (Okay, maybe just putting up with some of his unbri-
dled salesmanship.) He has formalized many of the processes and theories that we currently ap-
ply in our practices. He took positions at times when others would not—a true pioneer!
This book, like its two authors, is a unique work that provides practical sense and
guidance in our profession. It is the first of its kind that presents methodology issues of
valuation, as well as procedural issues and what I would call the environmental factors
xxi
(i.e., court, audit, appeal, etc.) of a valuation matter from the perspective of both the court
and the expert. Many valuators get involved in a project from the perspective of complet-
ing the valuation engagement and it is separate and detached from the consideration of
procedural and planning factors that gave rise to the project in the first place. Additionally,
many valuators may not consider the impact of their work on further developments such as
audit, appeals, and trial. It is clear from the writing herein, and I have stated this in many
of my presentations around the country, that these aspects are not separate and, quite to the
contrary, they are pivotal to the proper documentation, understanding, and support of a
conclusion in a valuation matter. From a legal perspective it is important to understand the
theories that are to be advanced by the valuation expert, as well as to understand, from a
valuation perspective, the theories that are to be advanced by the planners, implementers,
and legal counsel that set up the case. It is these folks who typically bring us into the case,
yet it is we, as experts, who have a material impact on the success of the plans from a tax-
planning perspective, as well as the court case, if it is contested.
This book is the bridge that connects the legal assumptions and legal issues with the valu-
ation theories that valuators apply to those assumptions and issues to get to an appropriately
supportable conclusion in a matter. It provides a view from the bridge of the procedural envi-
ronment. With this information and knowledge, experienced and fledgling valuators alike are
much better prepared to embark on the journey. Thank you both again for all of your guidance
through the years and all of the hard work you have put into this manuscript, which will prove
invaluable for us in the industry!

Mel H. Abraham
CPA, CVA, ABV, ASA
Abraham Valuation Advisors
xxii FOREWORD