Typically the standard of value in the valuation of a fractional interest in an entity for estate and gift tax reporting purposes is “fair market value” which is defined by Revenue Ruling 59-60 as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
However, when the owner of the fractional interest is a non-profit entity, such as a foundation, the standard of value for financial statement reporting purposes is “fair value” rather “fair market value.” Under Statement of Financial Accounting Standards No. 157 (SFAS 157), which is now part of Accounting Standards Codification (ASC) 820, Fair Value Measurements, “fair value” is defined in paragraph 5 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
One of the key concepts in determining fair value is the transaction price between market participants which requires the valuation analyst to consider the market that would be most advantageous for the asset. The three valuation approaches utilized are the same as in determining fair market value: 1) market approach; 2) income approach; and 3) the asset approach. However, in determining fair value there are three levels of a hierarchy of inputs:
- Level 1 – quoted prices in active markets for identical assets that are available as of the date of valuation;
- Level 2 – observable market data other than quoted market prices; and
- Level 3 – unobservable inputs for the asset which include the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset.
Help Others Foundation, a non-profit entity, owns a 10% noncontrolling, nonmarketable membership interest in ABC, LLC. For financial statement reporting purposes in accordance with Generally Accepted Accounting Principles, the foundation is required to report the fair value of the interest as of its fiscal year-end, which is December 31, 2011. ABC, LLC’s sole asset is vacant land located in Yuma, Arizona and there are no liabilities. Susan Wright, ASA, has been hired to determine the fair value of the 10% interest. John Smith, MAI, prepared the property appraisal, valuing the vacant land at $10,000,000 as of December 31, 2011.
In this example, Level 1 inputs cannot be utilized as there are no quoted market prices for a fractional interest in ABC, LLC. However, Level 2 inputs can be utilized as there is observable market data in the sale of comparable fractional interests in publicly registered real estate limited partnerships that own vacant land. Twenty-three comparable transactions were found between 1994 and 2010 resulting in a median discount/net asset value ratio of 39%. Applying the 39% discount to 10% of the net asset value of ABC, LLC results in a fair value of $610,000 ($10,000,000 x 10% x (1-39%)) as of December 31, 2011 for the 10% membership interest in ABC, LLC held by Help Others Foundation.