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Business Valuation
and Federal Taxes


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Business Valuation
and Federal Taxes

Procedure, Law, and Perspective
Second Edition

DAVID LARO
SHANNON P. PRATT

John Wiley & Sons, Inc.


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Copyright # 2011 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in
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ISBN 978-0-470-60162-4; ISBN 978-1-1180-2316-7 (ebk); ISBN 978-1-1180-2317-4 (ebk);
ISBN 978-1-1180-2318-1 (ebk)
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1



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Dedication

Dedication by David Laro
To my wife, Nancy,
and our family—
Rachel and David, and their children, Sophie and Asher
Marlene and Andrew, and their sons, Alexander and Benjamin
Dedication by Shannon Pratt
To my wife, Millie,
and our family—
Mike and Barb, and their sons, Randall and Kenny
Georgia and Tom, and their children, Elisa, Katie, and Graham
Susie and Tim, and their children, John, Calvin, and Meg
Steve and Jenny, and their children, Addy and Zeph


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Contents

Foreword to Second Edition

xv

Foreword: Legal Practitioner’s Perspective

xvii

Foreword: Law Professor’s Perspective

xix

Foreword: Business Appraiser’s Perspective

xxi

Preface to the New Edition

Origin of the Book
Authors Provide Own Perspectives
Topics Covered

xxiii
xxiii
xxiv
xxiv

Acknowledgments

xxvii

About the Authors

xxix

CHAPTER 1
Standards of Business Valuation

1

Summary
Introduction
Sources for Defining Value
Definitions of Value
Premise of Value
Conclusion

1

2
3
7
17
18

CHAPTER 2
Subsequent Events
Summary
Key Question
Valuation Date
Subsequent Events—Exceptions
Conclusion

19
19
19
20
21
27

vii


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CONTENTS

viii
CHAPTER 3
Business Valuation Experts
Summary
Introduction
Proving Business Value
The Expert Appraiser
Types of Experts
Various Roles of Experts
Business Valuation Litigation Witnesses
Admissibility of Evidence Underlying Expert
Opinions
Limitations to Admissibility
Reliability of the Expert
Minimum Thresholds for the Business Valuation
Expert
Sarbanes-Oxley Act of 2002
Attorney Assistance to the Expert
Qualified Appraiser
Concerns about Expert Testimony
Court-Appointed Expert
Conclusion
Appendix: Expert Credentials and Qualifications

CHAPTER 4
Sources of Law and Choice of Courts

Summary
Structure of the American Legal System
Tax Law
Tax Litigation
Conclusion

CHAPTER 5
Burden of Proof in Valuation Controversies
Summary
Burden of Proof
Who Bears the Burden of Proof?
Burden of Proof: Exceptions to the General Rule

CHAPTER 6
Penalties and Sanctions
Summary
Introduction
Valuation Penalties
Preparer and Appraiser Penalties
General Penalties
Discretionary Sanctions

28
28
29
29
30
31
32
32

33
35
36
38
40
40
43
44
46
48
49

58
58
59
60
62
66

67
67
69
71
71

76
76
77
78
81

82
84


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Contents

ix

CHAPTER 7
How the Form of Entity Affects Valuation

86

Summary
Introduction
Corporations
General Partnerships
Limited Partnerships
Limited Liability Companies
Sole Proprietorships
Tax Classifications
Valuation Considerations

Entity-Level Discounts
Choice of Jurisdiction
Conclusion

86
87
88
89
89
91
91
91
92
94
95
97

CHAPTER 8
Valuation of S Corporations and Other Pass-Through Tax Entities:
Minority and Controlling Interests
Introduction
Case Law Background
S Corporation Minority Interest Appraisals
Comparison of Minority Interest Theories—A Summary of the Issues
S Corporation Controlling Interest Appraisals
General S Corporation Appraisal Considerations
Conclusion

98
98

100
104
106
108
110
110

CHAPTER 9
Transfer Pricing

112

Summary
Introduction
Conclusion

112
113
123

CHAPTER 10
Customs Valuation
Summary
Introduction
Customs Valuation Methods and Concepts
Related-Party Transactions
Conclusion

CHAPTER 11
Adjustments to Financial Statements

Summary
Separating Nonoperating Items from Operating Items
Addressing Excess Assets and Asset Deficiencies
Handling Contingent Assets and Liabilities

124
124
125
125
130
132

133
133
134
135
135


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CONTENTS

x

Adjusting Cash-Basis Statements to Accrual-Basis Statements
Normalizing Adjustments
Controlling Adjustments
Conclusion

CHAPTER 12
Comparative Financial Statement Analysis
Summary
Comparable Ratio Analysis
Common Size Statements
Tying the Financial Statement Analysis to the
Value Conclusion
Conclusion

CHAPTER 13
Economic and Industry Analysis
Summary
Objective of Economic and Industry Analysis
International Economic Analysis
National Economic Analysis
Regional and Local Economic Analysis
Industry Analysis
Conclusion
Partial Bibliography of Sources for Economic and
Industry Analysis

CHAPTER 14
Site Visits and Interviews
Summary
Site Visits

Management Interviews
Interviews with Persons Outside the Company
Conclusion

CHAPTER 15
The Income Approach
Summary of Approaches, Methods, and Procedures
Introduction to the Income Approach
Net Cash Flow: The Preferred Measure of Economic
Benefit in the Income Approach
Discounting versus Capitalizing
Relationship between Discount Rate and Capitalization Rate
Projected Amounts of Expected Returns
Developing Discount and Capitalization Rates for Equity Returns
Weighted Average Cost of Capital (WACC)
The Midyear Convention

136
136
137
139

140
140
142
147
147
148

149

149
150
150
150
151
151
153
153

159
159
159
160
160
161

162
162
163
164
166
166
172
172
176
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Contents

The Income Approach in the Courts
Conclusion
Appendix: An Illustration of the Income Approach to Valuation

CHAPTER 16
The Market Approach
Summary
The Market Approach
Revenue Ruling 59-60 Emphasizes Market Approach
The Guideline Public Company and the Guideline Transaction
(Merger and Acquisition) Method
How Many Guideline Companies?
Selection of Guideline Companies
Documenting the Search for Guideline Companies
Choosing Multiples Based on Objective Empirical Evidence
What Prices to Use in the Numerators of the Market Valuation
Multiples
Choosing the Level of the Valuation Multiple
Selecting Which Valuation Multiples to Use
Assigning Weights to Various Market Multiples
Sample Market Valuation Approach Tables
Other Methods Classified Under the Market Approach

Conclusion
Appendix: An Illustration of the Market Approach to Valuation

CHAPTER 17
The Asset-Based Approach
Summary
Adjusted Net Asset Value Method
Excess Earnings Method (The Formula Approach)
Conclusion

CHAPTER 18
Entity-Level Discounts
Summary
Trapped-In Capital Gains Discount
Key Person Discount
Portfolio (Nonhomogeneous Assets) Discount
Discount for Contingent Liabilities
Conclusion

CHAPTER 19
Minority Discounts/Control Premiums
Summary
Minority Discounts/Control Premiums
Conclusion

xi
179
185
186


195
196
196
196
197
202
204
206
206
206
207
209
211
211
211
216
217

243
243
243
244
248

249
249
250
256
263
267

269

271
271
271
278


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CONTENTS

xii
CHAPTER 20
Discounts for Lack of Marketability

Summary: General Introduction to Shareholder-Level Discounts
and Premiums
Definition of Marketability
Benchmark for Marketability Is Cash in Three Days
Investors Cherish Liquidity, Abhor Illiquidity
Degrees of Marketability or Lack Thereof
Empirical Evidence to Quantify Discounts for Lack of Marketability:
Restricted Stock Studies

Empirical Evidence to Quantify Discounts for Lack of Marketability:
Pre-IPO Studies
Criticisms of the Pre-IPO Studies
Factors Affecting the Magnitude of Discounts for Lack of
Marketability
Use of the Databases for Quantifying Discounts for Lack of
Marketability
Discounts for Lack of Marketability for Controlling Interests
Option Pricing as Indicator of DLOM
Discounts for Lack of Marketability in the Courts
Conclusion
Partial Bibliography of Sources for Discounts for Lack of Marketability

CHAPTER 21
Other Shareholder-Level Discounts
Summary
Voting versus Nonvoting Shares
Blockage
Discounts for Undivided Fractional Interests in Property
Conclusion

CHAPTER 22
Personal versus Enterprise Goodwill
Summary
Definitions of Goodwill
Tax Implications
Indications of Personal versus Enterprise Goodwill
Landmark Cases
Excerpt from Personal Goodwill Appraisal Report
Conclusion


CHAPTER 23
Weighting of Approaches
Summary
Theory and Practice
Mathematical versus Subjective Weighting

279
280
281
281
282
283
283
290
292
294
297
300
305
309
319
320

321
321
321
324
330
332


333
333
334
334
334
335
339
342

343
343
343
344


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Contents

Examples of Weighting of Approaches
Conclusion

CHAPTER 24

IRS Positions
Summary
Introduction
Rev. Rul. 59-60
Rev. Rul. 65-192
Rev. Rul. 65-193
Rev. Proc. 66-49
Rev. Rul. 68-609
Rev. Proc. 77-12
Rev. Rul. 77-287
Rev. Rul. 83-120
Rev. Rul. 85-75
Rev. Rul. 93-12
Tax Advice Memorandum 9436005
Rev. Proc. 2003-51
Rev. Proc. 2007-41
Rev. Rul. 2008-35

CHAPTER 25
Business Appraisal Reports
Summary
Business Valuation Report-Writing Standards
Elements of the Business Valuation Report
Organization of the Report
Qualities of a Good Appraisal Report
Conclusion

CHAPTER 26
Valuation of Options


xiii
345
347

348
348
349
350
358
362
363
366
368
370
376
379
381
383
386
390
393

399
400
400
412
418
418
419


420

Summary
Introduction and Background
General Principles of Option Valuation
Specific Rules for Valuing Options
Conclusion

420
421
422
427
433

CHAPTER 27
Questions to Ask Business Valuation Experts

434

Summary
Qualifications
Financial Statement Adjustments and Analysis
Economic and Industry Data
Site Visits and Interviews

434
434
435
436
436



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CONTENTS

xiv
General Questions about Methodology
Discount and Capitalization Rates in the Income Approach
Projections Used in the Income Approach
The Market Approach
Asset-Based Approach
Entity-Level Discounts
Minority Interest Discounts/Control Premiums
Discounts for Lack of Marketability
Voting/Nonvoting Stock
Questions about Contradictory Prior Testimony

436
436
438
438
438
438

439
439
439
439

APPENDIX A
International Glossary of Business Valuation Terms

441

APPENDIX B
Bibliography

447

Books
Articles and Papers
Periodicals
Mergers and Acquisitions Databases
Discount for Lack of Marketability Databases

447
448
450
451
452

Table of Cases

453


Index

461


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Foreword to Second Edition

T

he Honorable David Laro and Dr. Shannon Pratt present a comprehensive primer
on federal tax valuation controversies that will benefit both tax practitioners (attorneys and CPAs) and valuation practitioners.
I use the term ‘‘primer’’ because the book introduces the attorney/CPA to an
area—the mechanics of valuation—with which many tax practitioners are unfamiliar, and introduces the valuation professional to an area—the mechanics of
federal tax disputes—with which many valuation practitioners are similarly unfamiliar. The book will assist both the tax practitioner representing the client in a
federal tax dispute and the valuation professional engaged to render an expert opinion to better understand the area of expertise in which each operates. It will serve to
‘‘bridge the gap’’ of understanding between tax and valuation practitioners which,
in my experience, is key to effectively presenting a client’s position and the independent expert’s opinion of value to a court.
The Second Edition introductory material on standards of value and subsequent
events will prove to be useful to both the tax and valuation practitioner in understanding the underlying basis for a valuation performed for a federal tax matter.
The discussion of business valuation experts will assist the tax practitioner in assessing the qualifications of potential valuation experts. While the choice of an expert
when a dispute arises is important, in my experience the potential of future tax disputes can be greatly reduced through the choice of the best valuation expertise for

the valuation needed in the initial transaction.
The chapter explaining the structure of federal tax law and the courts for resolving tax disputes effectively introduces the reader to what often appears to be an
exceedingly complex system. The authors then clearly explain the rules of the courts
as to which party—taxpayer or government—bears the burden of proof, depending
upon the circumstances. They then explain the penalties and sanctions to which the
valuation professional may be subject if the expert fails to provide a supportable,
independent opinion of value.
The authors then explain how the form of the entity affects its valuation; in
particular, they discuss the continuing controversies surrounding the valuation of
subchapter S corporations and other pass-through entities.
The authors present clear explanations of the mechanics of preparing a valuation report in a federal tax matter, including illustrations of applying the income
and market approaches to valuing a business.
The authors provide detailed discussions of the issues surrounding the often
contentious topic of discounts. They clearly review the myriad possible adjustments
related to control and marketability that may affect the value of the entire subject
business or the value of a minority interest in that business compared to the indicated ‘‘as if freely traded’’ value of an entire business. The Second Edition adds

xv


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FOREWORD TO SECOND EDITION

expanded material on measuring minority discounts and control premiums and new
material on differentiating between personal and enterprise goodwill. The topics are
clearly explained and will serve both tax practitioners and valuation practitioners as
effective introductions to these technical areas.
They close with a handy compilation of IRS positions on valuation matters and
a compilation of components of a properly prepared, thorough expert report for a
business valuation.
The Second Edition is assembled with great care by two of the most renowned
experts in their respective fields. The authors provide practical and clearly explained
insights to this complicated area. The Second Edition will serve as a valued reference
source for both tax and valuation practitioners and an introductory text for legal
and valuation training.
Roger J. Grabowski
Duff & Phelps, LLC


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Foreword:
Legal Practitioner’s Perspective

J


udge 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 usefulness 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 profession 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, thoroughness, and an
effort to be helpful to the reading public as well as fair to the litigants in the
particular 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
discussions of ‘‘the General Utilities doctrine’’ in Chapter 18 and discounts for lack
of marketability in Chapter 20 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 discussions 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 valuation law. That chapter is at once the most eclectic
and the most meticulous discussion of these challenges I have seen to date.


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FOREWORD: LEGAL PRACTITIONER’S PERSPECTIVE

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


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Law Professor’s Perspective

T

o 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 provides 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 treatises leave out. And it analyzes several important
evolving issues, such as valuing S corporation 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 insight, 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 professional 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 treasure 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

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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 believe 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 seeing 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 phenomenal 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 believe 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 opportunity to be a little part of it all.
Then there is Dr. Pratt. He needs little if any discussion in the valuation profession. I have often 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
unbridled salesmanship.) He has formalized many of the processes and theories that
we currently apply 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 (i.e., court, audit, appeal, etc.) of a valuation matter from the

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FOREWORD: BUSINESS APPRAISER’S PERSPECTIVE

perspective of both the court and the expert. Many valuators get involved in a project from the perspective of completing 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 valuation 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 environment. 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


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Preface to the New Edition

V

aluation issues permeate the Internal Revenue Code. Some people have estimated
that there are several hundred sections in the Internal Revenue Code, as well as
thousands of references in the Federal Tax Regulations, that deal with fair market
valuation. Each year, taxpayers report on their tax returns millions of transactions
that require estimates of value. Billions of tax dollars are at stake in valuations and,
naturally, the Internal Revenue Service is interested in collecting the amount properly due the Government. Given the multitude of transactions and the significant
amount of tax revenue at stake, there are frequent controversies over the issues related to correct valuation.

A book on the relationship between federal taxes and business valuation is
therefore not only appropriate, but also timely. This book focuses on the law, procedure, and perspective of business valuation, exploring not just the rules, but also the
policy or administrative reasons for implementing them. This is not a book on how
to litigate before any particular court. There are many fine litigation treatises available, and one interested in learning more about federal litigation should consult them
as the need occurs. In this book, the authors have drawn upon almost 75 years of
combined practical experience in the areas of taxes and business valuation, to provide the reader with a comprehensive resource for education and practice.
The reader who is looking for a discussion of some of the very latest tax cases
may have to look elsewhere. For ethical considerations, Judge Laro must decline to
comment on any tax case that is not beyond the appeal period or is in appeals. However, there is also another reason why such a discussion is not included here. This
book endeavors to help the reader understand the law, procedure and perspective of
business valuations, and as such is not dependent on any one case. As the reader will
observe, case law on this subject is highly fact-specific; therefore, while a particular
case may be interesting, it often is not precedential for the next case. The authors,
therefore, have chosen to concentrate on providing the reader with the tools to analyze a proper business valuation, with the hope that grasping the essentials will be
infinitely more helpful than studying a past case with limited application.

ORIGIN OF THE BOOK
The idea for writing this book came about when both authors appeared together a
few years ago on a business valuation continuing education program. In addition to
being a sitting judge on the U.S. Tax Court, David Laro also teaches business valuation to law students. Shannon Pratt, a well-known educator of long standing, has
previously authored several books on valuation. Over an enjoyable lunch, we discussed the need for clear and helpful educational materials on valuation, and

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