Corporate Finance
Business Valuations
Mergers & Acqusitions

United States • Europe • Asia

Private Securities Gift Tax Valuations

Windeye Partners performs business valuations for gifts of securities in privately held companies, such as gifts of shares by large shareholders to children, relatives or employees. Gifts by U.S. citzens or residents above a certain value must be reported on IRS Form 709. In the absence of a price for a publicly traded stock, the Fair Market Value of the shares in the privately held company must be determined through a business valuation and reported to the Internal Revenue Service. Currently a value of up to $15,000 (per recipient) can be gifted annually tax free, while larger values will reduce the lifetime extate tax exclusion amount. Typically gifts of securities are minority shareholdings and therefore discounts for lack of control and lack of marketability need to be considered.

Private Securities Donation Valuations

Windeye Partners performs business valuations for gifts of securities in privately held companies to charitable organizations, including Donor Advised Funds. Donations of securities by U.S. citzens or residents must be reported on IRS Form 8283 and signed by a valuation professional. The Fair Market Value for this purpose is defined by 26 CFR 1.170A-1 (c)(2) as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Similar to with gifts of securities, discounts for lack of control and lack of marketability with respect to the securities need to be considered.

Estate Tax Valuations

Windeye Partners performs business valuations for estate tax purposes with respect to privately held companies or interests in them. Normally estate tax valuations will be based on the Fair Market Value Standard. In the case of minority sharegoldings, potential adjustments for lack of control and lack of marketability must be considered.

Professional Standards

For any business valuation that pertains to a tax matter it is essential to use a valuator or appraiser that is both qualified and indendent. The courts generally take note of professional credentials from certain organizations including the American Institute of Certified Public Accountants (AICPA), the National Association of Certified Valuators and Analysts (NACVA), the American Society of Appraisers (ASA) and the Institute of Business Appraisers (IBA). Under IRS Code section 6662, penalties of 20% can be imposed for substantial valuation misstatements (property value is 65% or less of the correct amount) and penalties of 40% for gross misstatements (property value is 45% or less of the correct amount). However, there is an exception to these penalties under IRS Code section 6664 if the taxpayer can show reasonable cause for the underpayment and acted in good faith. Courts have generally held that relying on a professional valuator will establish good faith if acting reasonably.

Standard of Value - Fair Market Value

In order to determine the value of a business or a business interest we must first have a definition of the meaning of value.

Business valuations in the United States for gift and estate tax purposes must generally use as a Standard of Value the Fair Market Value as defined by the U.S. Internal Revenue Service in IRS Revenue Ruling 59-60: “the price at which the subject equity ownership would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is under no compulsion to sell, both parties having reasonable knowledge of relevant facts.” In addition, the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property under the Fair Market Value standard.

Control Adjustments (DLOC)

It is commonly recognized and that an ownership interest in a private business enterprise lacking control will sell at a lower price than an equivalent controlling ownership interest. When control is not conveyed with the sale of an ownership interest, a downward adjustment to the preliminary indication of value may apply. This is commonly referred to as a Discount for Lack of Control (“DLOC”) but also known as minority discount. In some instances a premium (as opposed to a discount) for control may be applied when valuing a controlling ownership interest.

A controlling position in a private business enterprise is typically worth more on a pro-rata basis than a non-controlling minority position for many reasons, including the rights of controlling owners to do any or all of the following:

• Elect management/directors
• Select and/or remove management
• Set dividend/distribution policies
• Establish compensation and benefits
• Set business strategies and goals
• Acquire and liquidate assets
• Self-dissolve, or recapitalize the entity
• Revise organizational documents
• Establish or change buy-sell agreements or clauses
• Cause the entity to become publicly traded

A non-controlling interest holder cannot cause these actions to occur.

To quantify a Discount for Lack of Control a common approach is to consult studies of premiums paid in acquisitions of public companies, which many believe indicates the implied discount for lack of control. However, other academics and valuation professionals believe that there is little or no control premium present in public companies and that acquisition premiums instead represent synergy values or discounts imposed on poorly run companies.

Marketability Adjustments (DLOM)

Marketability is defined as the ability to convert an ownership interest into cash within a short period of time. This lack of marketability may cause the ownership interest to be less valuable than an equivalent ownership interest that is marketable. When an ownership interest lacks certain elements of marketability an adjustment from the preliminary indication of value may be applicable. This is commonly referred to as a Discount for Lack of Marketability (“DLOM”).

The standard for marketability is publicly traded stocks that enjoy significant trading volume on a major stock exchange. Owners of these stocks can know the value of their interests on a minute-by-minute basis, and can buy or sell these stocks at a moment's notice with the proceeds (net of fees) delivered in a matter of days.

A privately held business enterprise does not enjoy such marketability. Liquidating a position in a privately held entity is more costly and time consuming. Fees may need to be paid to a business broker and other marketing costs may be incurred. Time is required to find a buyer, negotiate a price and draw up the necessary legal documents. In some cases the purchase price is paid over a period of years.

In some cases, more onerous restrictions are placed on the ownership of privately held enterprises through by-laws or shareholder agreements. These can include rights of first refusal, giving existing owners the right to purchase an ownership interest before it is sold to an outside party, and in some cases, an outright ban on the transferability. For these reasons, the marketability of a minority interest is important to estimating its value.

The estimation of a Discount for Lack of Marketability is difficult and subject to ongoing debate among valuation professionals and the courts. Methods used include empirical market studies (Restricted Stock, Pre-IPO Stock, IPO Flotation Costs) and quantitative methods (discounted cash flow, put option analysis) and a valuation analyst will often consider several of these before arriving at a conclusion.

Factors that can impact the marketability of an equity ownership interest in a business enterprise were identified in the Mandelbaum Tax Court decision in 1995. The Estate of Mandelbaum court considered various studies on the lack of marketability as benchmarks and adjusted the benchmark discounts using nice factors affecting marketability. However these adjustments are by definition subjective.