VALUATION DISCOUNTS AND PREMIUMS

Fundamentals, Techniques & TheoryVALUATION DISCOUNTS AND PREMIUMSOne recent court case that allowed one of the largest blockage discounts was the Estate ofMellinger (112 T.C. 26). In this case, the Tax Court deemed it appropriate to apply a 25 percentblockage discount (as applied by the taxpayer) to large blocks of Frederick’s of Hollywoodstock, which was thinly traded.B. KEY PERSON DISCOUNTBusiness valuators would generally consider an additional discount for a company where thinmanagement and a strong company dependency on the efforts of a single individual for futureoperational and financial success would threaten the company’s long-term viability. Such adiscount is generally referred to as a key person discount.A few factors should be considered when using a key person discount:1. Key executive’s duties from both a day-to-day standpoint, as well as his or her involvement inguiding the long-term strategic course of the business2. Key executive’s reputation within the industry and the effect of that reputation on overalloperational and financial results both historically and prospectively3. Depth of overall management, experience of lower management, if any, and presence of asuccession plan4. Cost and time requirements to hire necessary replacement personnel for the key executive5. Availability and adequacy of key person life insurance to fund such a transition, if necessary—keyperson life insurance is sometimes earmarked for specific purposes beyond managementtransitiona. Funding repurchase of company stockb. Funding purchase of company utilized real property or other assets held by key personThe impact of the key person on the overall value of equity securities is often incorporated intothe future benefit stream computations or the company-specific discount and/or capitalizationrate development.The courts have often recognized the impact of key persons on value via a discount. In Estateof Paul Mitchell, T.C. Memo 1997-461, vacated and remanded 250 F.3d 696 (9th Cir. 2001), onremand T.C. Memo. 2002-98. In the earlier U.S. Tax Court case, the Tax Court recognized a 10percent discount, which equated to a $15 million reduction in value. Also in Furman v.Commissioner (1998 WL 209265) the Court accepted a 10 percent key person discount. InEstate of Stirton Oman, (T.C. Memo 1987-71), a key person discount was rejected since thedecedent’s sons were managing the Company both before and after the father’s death. In thiscase, it also appeared that the decedent’s son had been groomed for the position and thatsuccession planning had taken place.© 1995–2012 by National Association of Certified Valuators and Analysts (NACVA). All rights reserved. Chapter Seven – 47Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training. 2012.v1