Internal Revenue Service (IRS) regulations require an owner to report the value of a business interest when it is transferred for gift or estate purposes. The reported value of such an interest is used in tax liability calculations. Unlike the value of an interest in a publicly-held company, the value of an interest in a closely-held company is generally not readily ascertainable because interests in closely-held companies do not trade on established markets. Consequently, a business appraiser may be need to help determine value. 

IRS regulations generally require the use of the Fair Market Value (FMV) standard when valuing closely-held business interests for gift and estate tax purposes. The determination of FMV for a closely-held business interest is an educated estimate based on the use of generally accepted appraisal standards such as the Uniform Standards of Professional Appraisal Practice (USPAP). It is important that an appraiser is qualified according to IRS regulations and understands and can appropriately apply the principles of FMV and USPAP.

The need to use a qualified appraiser has become increasingly clear in recent years as the valuation of closely-held business interests for gift and estate tax purposes has been a hotly contested issue between taxpayers and the IRS – on occasion requiring the opinion of the Court to settle the issue. This is especially true with the increase in the use of family limited partnerships and limited liability companies that are implemented primarily for estate planning purposes. In many instances, these closely-held entities do not carry on an active trade or business but instead, are holding companies for family held investments that, in effect, may reduce tax liabilities.

Transfers of business interests for gift and estate purposes regularly involve partial or non-controlling closely-held interests. Courts have long upheld, and the IRS has recognized, positions taxpayers have taken on two issues: 1) the value of a partial interest in a business is often worth less than its pro-rata share of the business, and 2) the value of a closely-held interest is often less than the value of otherwise similar publicly-traded interests. We will look separately at the factors underlying these premises commonly quantified through a Discount for Lack of Control (DLOC) and a Discount for Lack of Marketability (DLOM).

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When an owner holds a partial interest in a business, often the rights associated with such an interest are limited compared to ownership of 100% of the business. An owner of a partial interest generally does not have the ability to unilaterally act or otherwise manage the business. Consequently, when valuing a partial interest in a business one must consider the potential diminution in value resulting from the limitation in rights conveyed. 

The DLOC, or minority interest discount, is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds to the net asset value per share of the same funds. For entities holding real estate, the DLOC can be determined by comparing the trading price of shares of a selected sample of registered real estate limited partnerships (RELPs) or real estate investment trusts (REITs) to the net asset value of the respective shares.

Courts have ruled many times that citing overall averages or using non-representative samples of data is not sufficient in substantiating value. Accordingly, the appraiser’s skill in selecting an appropriately representative sample of closed-end funds is essential.

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The DLOM is the inability to quickly convert property to cash at minimal cost. The International Glossary of Business Valuation Terms defines DLOM as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. 

Two types of empirical studies are commonly used to benchmark discounts for lack of marketability. They are: 1) restricted stock studies, and 2) pre-initial public offering (pre-IPO) studies.

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Public companies often issue restricted stock, or unregistered shares. SEC rules restrict the transferability of such shares by mandating a minimum holding period and by limiting the pool of eligible buyers for such shares. 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. The difference is attributed to the lack of marketability of the restricted shares.

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Pre-IPO studies compare the price at which a stock was sold while its issuer was still closely-held with the price of the same company’s common stock at the time of an initial public offering. 

Just as in DLOC study comparisons, recent courts have ruled that it is exceedingly important that the appraiser ties the selected studies to the facts of the subject interest. Approximately 18 restricted stock and Pre-IPO studies exist and overall, the average marketability discount reflected in these studies is between 30% and 40%. Ultimately, factors specific to the subject interest must be understood and considered when attempting to determine an applicable discount.

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Business appraisals for gift or estate tax reporting purposes must be prepared by a qualified appraiser and adhere to IRS regulations. Additionally, subjective areas of analysis must be supported by appropriately representative empirical data. Finally, an appraiser must consider precedent court rulings when determining the value of an interest under such circumstances.