Calculating Fair Market Value in Legal Valuations: Do Adjustments in Value for Non-Systematic Risk Violate the Fair Market Value Standard?

Generally-accepted appraisal practice assumes the Hypothetical Buyer is not well-diversified because the typical real-world buyer does not possess sufficient wealth to own a well-diversified portfolio with assets each in similar value to the subject closely-held interest under appraisal (e.g., see Estate of Hendrickson v. Commissioner, T.C. Memo 1999-278, 78 T.C.M. (CCH) 322). This reflects a failure to appreciate the distinction, in all its implications, between the purely fictional Hypothetical Buyer and the typical real-world buyer. “The world of fair market value is not the real world”; it is not “populated by real people” (Mercer and Brown 1999, p.16). “The particular characteristics of these hypothetical persons are not necessarily the same as those of any specific individual or entity” (Estate of Noble v. Commissioner (T.C. Memo. 2005-2), p.12), such as the typical real-world investor. Fair Market Value is determined under hypothetical market “conditions other than those that actually exist” in real-world markets (Bonbright 1937, p.27). “[‘]The effort is to find out not what a real buyer and a real seller, under conditions actually surrounding them, do, but what a purely imaginary buyer will pay a make-believe seller, under conditions which do not exist[’]” (Bonbright 1937, p.61, citing McGill v. Commercial Credit Co. (243 Fed. 637, 647 (D. Md. 1917))). Being simultaneously financially able, well-informed, and rational, all Hypothetical Buyers are defined to possess the following concurrent characteristics: All (a) command the financial resources needed to purchase the subject closely-held interest, (b) know the benefits of diversification, and (c) behave rationally by investing in a well-diversified portfolio of assets—each in a similar dollar amount to the subject interest—prudently aimed at maximizing portfolio return. Always rational and well-diversified, no Hypothetical Buyer requires any form of discount in value for non-systematic risk.