Estate Gift Taxation Planning

Estate and Gift Tax: Making Sense of Valuation Discounts

Valuing an ownership interest in a closely held business is often required to determine gift and estate tax exposure. Appraisers handling this work know it calls for careful effort. Since such an interest usually has no ready market, the outcome is an informed estimate rather than an exact number. That uncertainty can lead to surprising gift or estate tax results when interests pass between related parties, whether during the transferor's lifetime or at death. If the value the transferor places on a business interest is lower than the fair market value the IRS later determines, a larger gift tax bill may result. Likewise, an IRS redetermination of the fair market value of interests held in an estate can uncover an estate tax underpayment. Fortunately, valuation analysts can use methods that taxing authorities and the courts accept as a sound basis for these estimates. In applying those methods, qualified appraisers also review recent court decisions for guidance. This discussion summarizes valuation principles for gift and estate tax purposes, examines current trends in establishing fair market value, and offers suggestions for finding a qualified appraiser.

The Willing-Buyer / Willing-Seller Standard

For gift and estate tax purposes, fair market value is measured as of the transfer date. The standard is the price at which the property would change hands between a hypothetical willing buyer and a willing seller, with neither party under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. This is known as the willing-buyer, willing-seller test (Treas. Reg. § 20.2031-1(b)). Assets that trade on an established market, or that carry a readily ascertainable value, are valued at their fair market value on the date of transfer or death. For other assets, value must be established through an informed estimate.

Approaches to Valuing Closely Held Entities

Three valuation approaches are generally used to calculate the fair market value of an interest in a closely held entity.

• Market method (comparable sales method): compares the closely held company, whose stock value is unknown, with similar companies whose stock values are known.
• Income method (discounted cash flow): discounts the company's anticipated future income to present value.
• Net asset value method (balance sheet method): relies generally on the value of the company's assets net of its liabilities.

The market or income method is most often used when the closely held company operates an active trade or business. Net asset value is most often used when the company primarily holds real estate or investment assets and does not carry on an active trade or business.

Current Trends in Valuation Discounts

Valuing closely held entities for gift and estate tax purposes has been a hotly contested issue, particularly as family limited partnerships and limited liability companies have proliferated, often implemented mainly for estate planning purposes. In many instances these closely held entities do not carry on an active trade or business. Court cases show that valuing a closely held entity is a judgment call resting on expert opinion. Courts have long upheld a premise often reflected in expert opinions: the value of closely held interests is usually less than the value of similar publicly traded interests. The factors behind this premise include the inability to convert the property quickly to cash at minimal cost (lack of marketability) and, where the interest is less than a majority stake, the inability to control managerial decisions and other aspects of the entity (lack of control).

Discount for Lack of Marketability

Two kinds of empirical studies are commonly used to benchmark discounts for lack of marketability (DLOM): restricted stock studies and pre-initial public offering (pre-IPO) studies. Public companies often issue restricted stock (unregistered shares). SEC rules limit how such shares may be transferred by imposing a minimum holding period and by narrowing the pool of eligible buyers. Restricted stock studies compare the price of publicly traded, unrestricted shares of companies with the private market price of restricted shares of the same companies, attributing the difference to the restricted shares' lack of marketability. Roughly 15 such studies exist, showing discounts ranging from 13% to 45%. SEC restrictions have become less stringent, so average discounts in newer studies are lower than in earlier ones. Pre-IPO studies compare the price at which a stock sold while its issuer was still closely held (and the shares were unregistered) with the price of the same company's common stock at the time of an initial public offering. Sources of pre-IPO studies include Willamette Management Associates' Valuation Advisors' Lack of Marketability Discount Study and those developed by John D. Emory of Emory & Co. These studies generally show a discount for lack of marketability ranging from 18% to 59%, higher than in restricted stock studies. Recent court decisions make clear that what matters more than the type of study used to quantify a discount is the analysis the appraiser performs to tie the study to the facts of the specific case. Failing to tailor the analysis to specific facts can have drastic consequences.

So why not account for the portion of the discount related to holding period restrictions? The IRS expert argued that he could not think of an economic reason why the partners in this situation would not agree to let another partner be bought out. Because the partnership agreement allowed dissolution by unanimous consent and the partnership's sole asset was highly liquid Dell stock, the partners could dissolve the partnership by unanimous agreement, transfer the Dell stock pro rata to the exiting partner, and then reconstitute the partnership with the remaining partners at little economic risk. Both parts of the decision are troubling: the Tax Court's acceptance of the argument that the DLOM inherent in restricted stock studies is only 12%, and the court's acceptance, without much reasoning or computation of the likelihood of liquidation, that the partnership would be dissolved at a limited partner's request simply because dissolution would pose little economic risk to the remaining partners. The argument that discounts shown by restricted stock studies contain components other than lack of marketability is not new. Another critic of restricted stock studies (and pre-IPO studies), Mukesh Bajaj, attempted to isolate the DLOM. In 2001, with David Denis, Stephen Ferris and Atulya Sarin, he studied registered and unregistered private placements and concluded, albeit controversially, that the average discount attributed exclusively to marketability is only 7.23% ("Firm Value and Marketability Discount," Journal of Corporation Law, Vol. 27, No. 1). Adding pressure to the argument for lowering discounts is the claim that the older restricted stock studies are outdated, since the restrictions the SEC places on securities have been relaxed over time. This argument is flawed because, during that period, the inherent limitations faced by private companies have not changed.

Discount for Lack of Control

The discount for lack of control (DLOC, also called a minority discount) is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds with the net asset value per share of the same funds.