                               T.C. Memo. 2016-114



                         UNITED STATES TAX COURT



             ESTATE OF NATALE B. GIUSTINA, DECEASED,
          LARAWAY MICHAEL GIUSTINA, EXECUTOR, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent*



      Docket No. 10983-09.                          Filed June 13, 2016.



      D. John Thornton and Kevin C. Belew, for petitioner.

      Kelley A. Blaine, for respondent.



                 SUPPLEMENTAL MEMORANDUM OPINION


      MORRISON, Judge: This case is before us on remand from the U.S. Court

of Appeals for the Ninth Circuit (hereafter “Ninth Circuit”) in Estate of Giustina v.



      *
      This opinion supplements Estate of Giustina v. Commissioner, T.C. Memo.
2011-141, rev’d and remanded, 586 F. App’x 417 (9th Cir. 2014).
                                        -2-

[*2] Commissioner, 586 F. App’x 417 (9th Cir. 2014), rev’g and remanding T.C.

Memo. 2011-141. In our first opinion we held that the value of a 41.128%

limited-partner interest was $27,454,115.1 The Ninth Circuit held that our

valuation was flawed because we should not have considered the value of the

assets owned by the partnership. It remanded the case for us to recalculate the

value using the partnership’s value as a going concern. The Ninth Circuit also

held that we erred by failing to adequately explain our reason for reducing the

partnership-specific risk premium from 3.5% to 1.75%. To implement the remand

from the Ninth Circuit, we perform a series of tasks in this supplemental opinion:

!     We adjust our valuation of the 41% limited-partner interest to give no
      weight to the value of the assets owned by the partnership. See Discussion
      part 1, infra.

!     We further explain our original reason for reducing the partnership-specific
      risk premium from 3.5% to 1.75%. See Discussion part 2.a, infra.

!     We hold that our original reason is not valid because it is inconsistent with
      the Ninth Circuit’s opinion. See Discussion part 2.b, infra. We adjust our
      valuation of the 41% limited-partner interest to incorporate a partnership-
      specific risk premium of 3.5%.

!     We recalculate our valuation of the 41% limited-partner interest as
      $13,954,730. See Discussion part 3, infra. This is the result of: (1) giving

      1
       The interest we valued was a 41.128% limited-partner interest in Giustina
Land & Timber Co. Limited Partnership owned by Natale Giustina through a
revocable trust at his death. For simplicity, we refer to this interest as a 41%
limited-partner interest.
                                           -3-

        [*3] no weight to the value of the assets owned by the partnership and (2)
        using a partnership-specific risk premium of 3.5%.

                                       Background

Facts

        When he died in 2005, Natale Giustina owned a 41% limited-partner

interest in a partnership named Giustina Land & Timber Co. Limited Partnership.

The partnership owned 47,939 acres of timberland and had 12 to 15 employees. It

earned profits from growing trees, cutting them down, and selling the logs. It had

continuously operated this business since its formation in 1990.

        It was agreed for the purpose of this litigation that, if the partnership were to

sell off its timberlands, it would receive almost $143 million. If one adds in the

value of the nontimberland assets, the partnership would receive $150,680,000 if it

were to sell all of its assets.

        Through corporate structures, the partnership had two general partners:

Larry Giustina2 and James Giustina. The partnership had eight limited partners:

        (1) the revocable trust of Natale Giustina,

        (2) Sylvia Giustina (daughter of Anselmo Giustina, Natale Giustina’s

        brother),


        2
            Larry Giustina’s full name is Laraway Michael Giustina.
                                            -4-

[*4] (3) James Giustina (son of Anselmo Giustina),

      (4) Natalie Giustina Newlove (daughter of Natale Giustina),

      (5) Irene Giustina Goldbeck (daughter of Natale Giustina),

      (6) Dolores Giustina Fruiht (another relative),

      (7) Larry Giustina (son of Natale Giustina), and

      (8) the Anselmo Giustina Family Trust.

The limited partners were members of the same family (or trusts for the benefit of

members of the family). Section 9.3 of the partnership agreement provided that a

limited-partner interest could be transferred only to another limited partner (or to a

trust for the benefit of another limited partner) unless the transfer was approved by

the general partners. A dissolution provision in the partnership agreement, section

12.2, provided that if two-thirds of the limited partners agreed (as measured by

percentage interest), then the partnership would be dissolved, its assets sold, and

the proceeds distributed to the partners.

Our first opinion

      In 2010 this case was tried. In 2011 we filed our first opinion. There we

declined to adopt entirely the findings of either the estate’s expert or the IRS’s

expert with respect to the value of the 41% limited-partner interest.
                                          -5-

[*5] The IRS’s expert gave a 60% weight to the value of the partnership’s assets.

We took the view that these asset values were relevant to the value of the 41%

limited-partner interest only to the extent of the probability that the partnership

would sell its assets.3 The value of the 41% limited-partner interest is the price

that would be agreed to by a hypothetical seller and buyer. Sec. 20.2031-1(b),

Estate Tax Regs. We determined that there was only a 25% chance that the

partnership would sell its assets after Natale Giustina’s limited-partner interest

was transferred to a hypothetical third party. We reasoned that there was a 25%

chance that the hypothetical buyer of the 41% limited-partner interest could

convince two-thirds of the partners to either: (1) vote to dissolve the partnership,

resulting in the sale of the partnership’s assets and distribution of the proceeds to

the partners or (2) replace the two general partners (who have the authority to sell

the assets and make distributions) to achieve the same result. We therefore gave a

25% weight to the value of the partnership assets rather than the 60% weight used

by the IRS’s expert.

      The estate’s expert gave a 30% weight to the cashflows that would be

received by the partnership if it were to continue its operations. We took the view

      3
        Our first opinion stated: “In our view, * * * the asset method is appropriate
to reflect the value of the partnership if its assets are sold.” Estate of Giustina v.
Commissioner, slip op. at 19-20.
                                         -6-

[*6] that the cashflows were relevant to the value of the 41% limited-partner

interest only to the extent of the probability that the partnership would continue its

operations.4 We determined there was a 75% chance that the partnership would

continue its operations. Therefore we used a weight of 75%, rather than the 30%

used by the estate’s expert.

      In order to incorporate the cashflows from continued operations into our

valuation, we had to determine the present value of the cashflows. We did this by

adjusting the calculations that the estate’s expert had made of the present value of

the cashflows. The estate’s expert assumed that the partnership’s cashflows would

increase 4% each year. We agreed with this assumption. The estate’s expert also

assumed that the discount rate for discounting the cashflows to present value

should be 18%. This 18% rate is the sum of: (1) 4.5% risk-free rate of return

equal to the rate of return on Treasury bonds, (2) 3.6% risk premium for timber-

industry companies, (3) 6.4% risk premium for small companies, and (4) 3.5% risk

premium for the unique risk of the partnership. We accepted all of these

components of the estate expert’s discount rate with the exception of the 3.5% risk

premium for the unique risk of the partnership. We concluded that this risk

      4
        Our first opinion stated: “In our view, the cashflow method is appropriate
to reflect the value of the partnership if it is operated as a timber company”. Estate
of Giustina v. Commissioner, slip op. at 19-20.
                                         -7-

[*7] premium should be only 1.75% (half the premium assigned by the estate’s

expert) because an investor could partially eliminate the risk by owning a

diversified portfolio of assets.

The Ninth Circuit opinion

      In 2012 we entered a decision consistent with the first opinion, and the

estate appealed. The Ninth Circuit issued an unpublished opinion reversing the

decision and remanding the case. The Ninth Circuit held that we had clearly erred

by finding that there was a 25% chance that the partnership would dissolve. The

Ninth Circuit held that a buyer who intended to dissolve the partnership would not

be allowed to become a limited partner by the general partners, who favored the

continued operation of the partnership. And the Ninth Circuit found it implausible

that the buyer would seek the removal of the general partners who had just granted

the buyer admission to the partnership. Finally, the Ninth Circuit found it

implausible that enough of the other partners would go along with a plan to

dissolve the partnership. Consequently, the Ninth Circuit directed us on remand to

“recalculate the value of the Estate based on the partnership’s value as a going

concern.” Estate of Giustina v. Commissioner, 586 F. App’x at 418.

      The Ninth Circuit also held that the Tax Court “clearly erred by failing to

adequately explain its basis for cutting in half the Estate’s expert’s proffered
                                         -8-

[*8] company-specific risk premium.” Id. The Ninth Circuit found our

explanation that an investor could diversify assets insufficient “without

considering the wealth a potential buyer would need in order to adequately

mitigate risk through diversification.” Id. at 419.

      The Ninth Circuit’s opinion ended with the words “REVERSED and

REMANDED for recalculation of valuation.” Id.

                                     Discussion

1.    Adjusting the respective weights assigned to the cashflow method and the
      asset method

      The Ninth Circuit has directed us to revise our valuation of the 41% limited-

partner interest. The first revision we make is to change the weight we accorded

the value of the partnership’s assets. In our first opinion, we assigned a 25%

weight to this value and a 75% weight to the present value of the cashflows from

the continued operation of the partnership. The Ninth Circuit has instructed us to

“recalculate the value of the Estate based on the partnership’s value as a going

concern.” In our view, the going-concern value is the present value of the

cashflows the partnership would receive if it were to continue its operations.

Therefore, we implement the Ninth Circuit’s instruction by changing the weight

we accord the present value of cashflows from 75% to 100%. This causes our
                                         -9-

[*9] adjusted valuation of the 41% limited-partner interest to be entirely based on

the partnership’s value as a “going concern”.

2.    The partnership-specific risk premium

      a.       Our rationale for reducing the partnership-specific risk premium was
               that a potential buyer could be a multiowner entity whose owners
               could diversify the partnership-specific risk of owning the 41%
               limited-partner interest.

      With respect to the partnership-specific risk premium, our first task in

implementing the remand is to further explain our reason for making a 50%

reduction in the premium assigned by the estate’s expert. The Ninth Circuit held

that we erred by failing to consider whether a prospective buyer would need to be

wealthy enough to diversify the partnership-specific risk.

      We address this error on remand by providing a further explanation of our

reasoning. In our first opinion, we believed that the hypothetical buyer, see sec.

20.2031-1(b), Estate Tax Regs., would be able to diversify some of the

partnership-specific risk associated with owning the 41% limited-partner interest.5

      5
          Our first opinion said:

            The fourth component of Reilly’s [the estate’s expert’s] 18-
      percent discount rate was a partnership-specific risk premium of 3.5
      percent. Reilly explained that this risk premium was justified because
      the partnership’s timberlands were not geographically dispersed. All
      were in Oregon. He also explained that the partnership’s operations
                                                                      (continued...)
                                           -10-

[*10] Risk is not preferred by investors. Richard A. Brealey, Stewart C. Myers, &

Franklin Allen, Principles of Corporate Finance 182 (8th ed. 2006) (“Most

investors dislike uncertainty”.). They require a premium to bear it. However,

some of the risk associated with an asset (the “unique risk”) can be eliminated

through diversification (1) if the owner of the asset also owns other assets, (2) if

the risks of the other assets are not associated with the asset in question, and (3) if

the other assets are great enough in value.6


      5
       (...continued)
      were nondiversified. The partnership’s sole source of revenue was
      timber harvesting. Thus, it is apparent that a portion of the 3.5-
      percent premium reflects the unique risks of the partnership. But
      unique risk does not justify a higher rate of return. Investors can
      eliminate such risks by holding a diversified portfolio of assets. We
      conclude that the partnership-specific risk premium should be only
      1.75 percent.

Estate of Giustina v. Commissioner, slip op. at 16-17 (fn. ref. omitted).
      6
          A footnote in our first opinion stated:

      Richard A. Brealey and Stewart C. Myers explain:

      The risk that potentially can be eliminated by diversification is called
      unique risk. Unique risk stems from the fact that many of the perils
      that surround an individual company are peculiar to that company and
      perhaps its immediate competitors. But there is also some risk that
      you can’t avoid, regardless of how much you diversify. This risk is
      generally known as market risk. Market risk stems from the fact that
      there are other economywide perils that threaten all businesses.
                                                                        (continued...)
                                         -11-

[*11] In evaluating the potential buyer’s ability to diversify the risks associated

with the partnership, we assumed that the buyer could be an entity owned by

multiple owners. Examples of such an entity include a publicly-traded timber

company, a real-estate investment trust, or a hedge fund. The unique risk

associated with the 41% limited-partner interest would have been diversified

because the entity’s owners--wealthy or not--could hold other assets outside the

entity.7 For example, suppose that a publicly-traded timber company were the

buyer of the 41% limited-partner interest. Suppose that a shareholder of the

company owns $1,000 in stock in the company and $15,000 of other assets



      6
          (...continued)

      Brealy [sic] & Myers, Principles of Corporate Finance 168 (7th ed.
      2003) (fn. refs. omitted); see also Booth, “The Uncertain Case for
      Regulating Program Trading”, 1994 Colum. Bus. L. Rev. 1, 28
      (“Because diversification can eliminate the unique risks associated
      with investing in individual companies, the market pays no additional
      return to those who assume such risks.”).

Estate of Giustina v. Commissioner, slip op. at 17 n.5.
      7
       Alternatively, one could think that the entity, not its owners, could
diversify the risks of holding the 41% limited-partner interest. For example,
suppose that the hypothetical buyer is a publicly-traded timber company. Such a
company could purchase the 41% limited-partner interest while holding other
substantial assets. These other assets could have returns that are unaffected by the
partnership-specific risk. Thus, these other assets could provide diversification of
the partnership-specific risk.
                                        -12-

[*12] unrelated to timber. The shareholder would be unconcerned by the

individual risk associated with the purchase of the 41% limited-partner interest by

the publicly-traded timber company in which he or she had a $1,000 stake. That

risk would be diversified by the shareholder’s $15,000 stake in other assets.

      On the basis of our assumption that an entity with multiple owners could be

the hypothetical buyer of the 41% limited-partner interest, we believed that a

hypothetical buyer would not require a premium for all the partnership-specific

risk associated with owning the interest.8 We also clarify that the only reason we

believed that the 3.5% premium should be halved was that it did not account for

the possibility that the hypothetical buyer of the 41% limited-partner interest could

diversify the risk.

      b.     The assumption in our first opinion that the hypothetical buyer of the
             41% limited-partner interest could diversify the partnership-specific
             risk of the 41% limited-partner interest should no longer be made.

      The text in part 2.a above is a more extensive explanation for our halving

the 3.5% partnership-specific risk premium. It includes an explanation of how the


      8
        The estate’s expert opined that a 3.5% premium was appropriate for the
partnership-specific risk of owning the 41% limited-partner interest. Estate of
Giustina, slip op. at 16. The theory of asset diversification might suggest that the
entire 3.5% premium should be eliminated. The reason we did not completely
eliminate the 3.5% premium is that we believed that in practice (as opposed to
theory) a buyer might still be averse to the partnership-specific risk.
                                         -13-

[*13] potential buyer could diversify the partnership-specific risk. This

explanation partially resolves our duty to implement the remand of the Ninth

Circuit. But we have more work to do. We should also consider whether our

reasoning is still valid after the Court of Appeals opinion.

      The Court of Appeals opinion, in discussing the possibility that a

hypothetical buyer could force the sale of the partnership’s assets, held that the

hypothetical buyer must be a buyer to whom a transfer of a limited-partner interest

is permitted under section 9.3 of the partnership agreement. By the same token, in

evaluating the hypothetical buyer’s ability to diversify risk, we should consider

only a buyer whose ownership of a limited-partner interest is permitted by section

9.3 of the partnership agreement.

      Under section 9.3 of the partnership agreement, a limited-partner interest

can be transferred only to another limited partner (or a trust for the benefit of

another limited partner) or a person receiving the approval of the two general

partners. Other than Natale Giustina, there were seven limited partners. All seven

are individuals and trusts. None is an entity with multiple owners such as a

publicly-traded corporation, a real-estate investment trust, or a hedge fund. The

record does not support the notion that any of the limited partners (or any trust for

the benefit of the limited partners) has enough assets to diversify the risks of
                                         -14-

[*14] owning an additional 41% limited-partner interest. The limited partners

appear to be family members (or trusts for the benefit of family members) who

probably have most of their wealth tied up in the family timberland business in the

form of their partner interests in the partnership.

      Under section 9.3 of the partnership agreement, a limited-partner interest

can be transferred to a person other than a limited partner (or trust for the benefit

of a limited partner) only if that person is approved by the two general partners.

The two general partners are Larry Giustina and James Giustina (through

corporate structures). For 25 years, Larry Giustina and James Giustina had run the

partnership as an operating business. The record suggests that these two men

would refuse to permit someone who is not interested in having the partnership

continue its business to become a limited partner. Thus, we believe that they

would not permit a multiple-owner investment entity to become a limited partner.

Such an entity seeks to increase the returns on its investments. Brealey, Myers, &

Allen, supra, at 182 (“Most investors like high expected returns”.). If such an

entity owned the 41% limited-partner interest, it would attempt to have the

partnership discontinue its operations and dissolve. (At dissolution it would get

41% of the value of the partnership’s assets, or 41% of $150.68 million. In

contrast to the $150.68 million that would be received by all the partners from
                                        -15-

[*15] dissolving the partnership, the value of the cashflows from the partnership’s

continued operations would be only $33.8 million (according to the estate’s

expert), $51.7 million (according to our first opinion), or $65.76 million

(according to the IRS’s expert). These values are 22%, 34%, and 44%,

respectively, of the $150.68 million that would be realized by dissolving the

partnership.) More generally we find that no buyer that Larry Giustina and James

Giustina would permit to become a limited partner would be able to diversify the

partnership-specific risk.

       As a result of our finding above, we determine that a hypothetical buyer of

the 41% limited-partner interest would be unable to diversify the individual risks

associated with the partnership. Without diversification, the buyer would demand

the full 3.5% risk premium assigned to the interest by the estate’s expert. In our

first opinion, we determined that the discount rate should be 16.25%, which

corresponds to a direct capitalization rate of 12.25%. We now determine that the

discount rate should be 18%, which corresponds to a direct capitalization rate of

14%.

       In our first opinion we determined that the present value of the partnership’s

cashflows was $51,702,857. Increasing the discount rate from 16.25% to 18%
                                                       -16-

[*16] causes this value to decrease to $45,240,000. The mechanics of this

recalculation are illustrated by the table below:

               Valuation of all partnership interests on a marketable basis using the cashflow method

                                               Estate’s expert’s
                                                calculations in
                                               exhibit 10 of his     As adjusted by Tax       As adjusted by Tax
                                                    report           Court (first opinion)    Court (on remand)

 Normalized pretax income                          $6,120,000              $6,120,000              $6,120,000

 Normalized net income (normalized                  4,590,000               6,120,000               6,120,000
  pretax income reduced 25% by
  estate’s expert for income tax)

 Total adjustments to estimated                       !30,000                 !30,000                   !30,000
  cashflows

 Normalized net cashflows                           4,560,000               6,090,000               6,090,000

 Projected normalized net cashflows                 4,743,000               6,333,600               6,333,600
  (normalized net cashflows increased
  by long-term growth rate of 4%)

 Direct capitalization rate                               14%                  12.25%                      14%

 Total equity value on a marketable,               33,800,000              51,702,857              45,240,000
  noncontrolling ownership interest
  basis (estate’s expert’s estimate is
  rounded)


3.      Conclusion

        In our first opinion we valued the 41% limited-partner interest at

$27,454,115. After making the two changes discussed in this supplemental

opinion (eliminating any weight attributed to the value of the partnership’s assets

and applying the 3.5% partnership-specific risk premium), our valuation changes

to $13,954,730. This change is explained in the table below:
                                                     -17-

 [*17]          Valuation of the 41.128% limited-partner interest: comparison of approaches

                               Reilly             Thomson              Tax Court              Tax Court
Methods and adjustments   (estate’s expert)     (IRS’s expert)       (first opinion)     (opinion on remand)

 Asset-accumulation                10% ×              ---                  ---                   ---
  method                      $51,100,000

 Cashflow method                   30% ×                 20% ×                75% ×                100% ×
                              $33,800,000           $65,760,000          $51,702,857           $45,240,000

 Capitalization-of-                30% ×              ---                  ---                   ---
  distributions method        $52,100,000

 Price-of-shares-of-
  other-companies                  30% ×                 20% ×             ---                   ---
  method                      $59,100,000           $99,550,000

 Asset method                    ---                     60% ×                25% ×                  0% ×
                                                   $150,680,000         $150,680,000          $150,680,000

  Total                       $48,610,000          $123,470,000          $76,447,143           $45,240,000

 Discount for lack of                  35%                  25%       25% (applied to             25% (or
  marketability                                                      value from cash-         $11,310,000)
                                                                   flow method only,
                                                                       for a weighted
                                                                           discount of
                                                                         $9,694,286)

 Discount for lack of
  control                               0%                  12%                   0%                   0%

  Total after
   discounts                  $31,597,000           $81,490,200          $66,752,857           $33,930,000

 × 41.128%                    $12,995,000           $33,515,000          $27,454,115           $13,954,730
                                       -18-

[*18] The change in valuation of the 41% limited-partner interest will affect the

deficiency. The parties will be ordered to provide their recomputation of the

deficiency under Tax Court Rule of Practice and Procedure 155.

      To reflect the foregoing,


                                              Decision will be entered

                                      under Rule 155.
