Biltmore House case: lessons learned
Part One: The Asset Approach
I wrote a brief quick-reaction piece last week to the Biltmore House case (Cecil v Comm'r TCM 2023-24). It's published in Wealthmanagement's newsletter. I'm writing a longer article on Cecil now, so I wanted to add a few thoughts here.
Here's a link: Tax-Affecting Allowed in Biltmore House Case
Lots of commentary is expected on Cecil, mostly because of its treatment of tax affecting: the case has been awaited (for years) as a possible source of clarity on this issue. More on that later.
Here, though, I want to focus on the Tax Court's decision to exclude the Asset Approach from consideration.
Gifts of Shares in Biltmore Company
The case revolves around gifts made by William A.V. Cecil, Sr., and Mary Ryan Cecil, of class A (voting) and class B (generally non-voting) shares in the Biltmore Company (TBC) in November 2010. William’s mother was Cornelia Cecil?nee?Vanderbilt, the only child of George W. Vanderbilt, who built the Biltmore House in the Blue Ridge Mountains in Asheville, N.C., between 1889 and 1895.
Today, TBC owns the Biltmore House, a national tourist attraction, and its surrounding acreage, and operates a significant and profitable (1,300 employees) travel, tourism and historic hospitality business.
The Cecil family owned all of the shares of TBC and had adopted formal written policies aimed at perpetuating family ownership and management of the company and its historic assets.
The Asset Approach
The Asset Approach is one of the three generally recognized valuation approaches (income, market, and asset). For holding companies, with mostly passive investments, it's usually the preferred method. As an example, for a family LLC with real estate or securities, most appraisers would use the net asset value (NAV) method. This method is part of the Asset Approach and involves adjusting assets to their FMV and then taking discounts as appropriate for the subject interest being valued.
But for operating companies? At Pluris, we tend not to use it when valuing a non-controlling interest. That's not a foregone conclusion - we will first investigate with company management or ownership representatives to see if there's a realistic chance of a liquidation or asset sale in the foreseeable future. But if we don't believe a non-controlling shareholder would have reasonable prospects for accessing the asset values, then we tend to focus on the income and market approaches. I believe this is more or less standard in the valuation profession.
The Appraisal Institute generally supports this practice, for example in USPAP Standards Rule 9-3. The Rule provides that the Asset Approach should be used only when the interest being valued has the ability to “cause liquidation”.?Rule 9-3 is cited by the Tax Court in Cecil.
Why did this matter so much in Cecil?
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The Tax Court's memo opinion isn't particularly clear on the financial success of TBC, although it notes that revenues were $70 million annually and that the company had a consistent track record of being profitable.
I'm guessing it isn't VERY profitable, though, at least by traditional ROI measures. We know this because all the appraisers involved (IRS and taxpayer) arrived at values roughly in the $10-30 million range when valuing the business as a going concern, based on income and market approaches. The Asset Approach, though, comes in around $140 million before discounts. In other words, TBC's shareholders would be a great deal better off, financially, by liquidating.
But they won't do that, says the Tax Court. The court heard and saw a great deal of evidence that the Cecil family not only has no interest in selling TBC's assets, but has also taken steps to perpetuate family control and ownership of this historic estate. From the memo opinion:
In that TBC is an operating company whose existence does not appear to be in jeopardy, and not a holding company, we believe that TBC’s earnings rather than its assets are the best measure of the subject stock’s fair market value.
The court also found the IRS’ asset approach value to be inconsistent with appraisal standards as the holder of any of the gifted interests lack control and, thus, the ability to cause liquidation. The court here gave weight to the voting trust and shareholders’ agreement and testimony from family members. The IRS wanted the court to ignore family testimony as self-serving, but the court found their testimony to be credible.
The court held that the liquidation of TBC is unlikely, as any one holder of the subject interests would have to:
The Tax Court cites only Ford, a 1993 case involving a mix of holding companies and an operating company (with a holding company "portion" to its valuation) in support of its holding on the Asset Approach. Giustina is a more recent case on point. That one also involved some back and forth between the higher and lower courts: First, the Tax Court considered both asset and income methods, and applied a 25 percent weight on the Asset Approach method, on the theory that there was a 25 percent chance the company would liquidate. On remand from the 9th Circuit, the Court ended up rejecting the Asset Approach value altogether. The same topic was addressed in Jones, where the Court again ended up with rejecting the Asset Approach. The catch: both of these were timber cases. But both cases have this in common with Cecil: the value of the company's assets was multiples above the value of the company's operations, so the company was "worth more dead than alive."
Generally, most recent cases involving operating companies suggest that (A) courts tend to view the Asset Approach as a liquidation value method and (B) decisions turn against the approach when valuing any interest that lacks the ability to force a liquidation. An interest side-question is what will happen when the Tax Court next gets to value an operating company with significant non-operating assets. Those assets are treated as an add-back by most appraisers, but the same issue is involved: absent the ability to force a liquidation (and assuming that current management doesn't intend to liquidate those assets, the value of those assets would be inaccessible to a non-controlling shareholder.
More on tax-affecting later, in Part Two.