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If a decedent owned stock of a closely held business at his or her death, the value of the stock generally must be determined before an estate-tax return can be filed. The value for estate-tax purposes is the fair market value (FMV) on the date of death or, if an election is made under Internal Revenue Code (IRC) � 2032, the FMV on the “alternative valuation date,” six months later. In the case of gifts of closely held stock, the FMV on the date of the gift must be determined for gift-tax purposes. The determination of fair market value is simple when the stock to be valued is publicly held because the appraiser can readily obtain the date-of-death (or date-of-gift) FMV from the Wall Street Journal (or various Internet-based pricing services). Unfortunately, stock in a closely held business, by nature, does not have a readily ascertainable FMV. In most closely held businesses, the shares are not widely traded, and may be held by a small number of investors. As a result, the business appraiser must take the long way in determining FMV, independently calculating the individual components of value that are already factored into the trading price of a publicly held stock. The process will generally include the estimation of the total enterprise value of the closely held company followed by the application of discounts or premiums to account for the specific facts and circumstances surrounding the interest in the company being valued. Valuation discounts are continually in the spotlight because they lead to a direct reduction in the estate tax liability. Therefore, when both the courts and the Internal Revenue Service (IRS) have agreed that certain reductions in closely held stock value are permissible, tax advisers and appraisers should sit up and take notice. The remainder of this article will provide a brief background on the nature of the most common valuation discounts, as well as a review of certain relevant cases providing guidance on the court’s current view on the subject. Guidelines for the valuation of closely held businesses are set forth in the IRC, the treasury regulations to the code and various revenue rulings. The IRC addresses the valuation of closely held securities in � 2031(b). Revenue Ruling 59-60 provides additional guidance for valuing closely held stock for estate- and gift-tax purposes. Revenue Ruling 59-60 discusses the proper approach to valuation, the factors to consider, the weight to be afforded the various factors, the determination of capitalization rates and the effect of restrictive covenants. Revenue Ruling 68-609 explicitly extended these factors to the valuation of noncorporation closely held securities, such as partnerships. Revenue Ruling 77-287 amplifies Revenue Ruling 59-60 by specifically recognizing criteria for determining an appropriate discount for lack of marketability. It also provides guidance for discounts to be applied to publicly traded securities restricted under federal securities laws. Revenue Ruling 83-120 contains guidelines for valuing preferred stock. Despite what appears to be detailed guidance in the code and the various revenue rulings, the ultimate determination of FMV depends on the facts and circumstances of each case (see Revenue Ruling 59-60 � 3). Predictably, taxpayers often view the facts and circumstances affecting value in drastically different ways than the IRS. After all, the definition of fair market value-namely, the price at which the property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller-dictates the use of myriad financial and economic assumptions and professional judgment. Valuation discounts follow from the realization that the value of the stock to the decedent or donor is often different than the pro rata valuation of the entire company. The difference, if any, may be attributed to a number of possible factors including, but not limited to, the dimunition in value that results from the difficulty in marketing less than full ownership in the company; the diminution in value that results from the lack of control the owner of a noncontrolling interest may exercise in the day-to-day affairs of the company; and the diminution in value to the holder due to trapped-in capital gains, and so forth. The starting point from which each discount (or premium) adjustment is made is an important conceptual issue to understand in order to avoid incorporating the same risk factors twice (or not at all) in the analysis of fair market value. For example, valuations that start with the prices of publicly traded securities are usually understood as beginning from a marketable, minority interest standpoint. Thus, it would not usually be appropriate to make a further discount adjustment for relative lack of control. The remainder of the article will provide a brief description of a few of the potential valuation discounts as well as a recap of recent cases concerning each. Lack of marketability Perhaps the most common valuation discount is the discount for lack of marketability (DLOM). The DLOM can be the valuation adjustment with the largest monetary impact on the final determination of value. Marketability is defined as the ability to convert an investment into cash quickly at a known price and with minimal transaction costs. All else being equal, the more marketable an asset, the higher the price an investor will be willing to pay for the asset. The lack of marketability of an asset can be costly to an investor because it potentially causes the investor to miss opportunities to allocate capital to alternative, higher-yielding uses. The DLOM is a downward adjustment to the value of an investment to reflect its reduced level of marketability. Two general types of empirical studies provide evidence for the existence and magnitude of the DLOM. The first type, restricted stock studies, compares the trading prices of a company’s publicly held stock sold on the open market with those of unregistered or restricted shares of the same company sold privately. The second type, preinitial public offering (IPO) studies, examines the prices of transactions while the company was still private, compared to the eventual IPO price. The restricted stock studies have found average DLOMs in the range of 25% to 35%, while the pre-IPO studies have reported average DLOMs generally around 45%. The studies also have found a very wide range of discounts, depending upon the transactions, from 90% to minus-10% (i.e., a premium). A valuation professional cannot simply apply the average or median discounts found in the studies to the subject company, but must analyze the characteristics of the subject company to determine a rational and supportable DLOM. Factors to consider In Bernard Mandelbaum v. Commissioner, T.C. Memo 1995-255 (June 12, 1995), Tax Court Judge David Laro addressed the issue of marketability discounts. In doing so, Laro set forth 10 factors to be considered in determining an appropriate discount for lack of marketability: the value of a similar corporation’s public and private stock; an analysis of the company’s financial statements; the company’s dividend-paying capacity and payment history; the nature of the corporation, its history, industry position and economic outlook; the company’s management; the degree of control transferred; restrictions on transferability; the investor’s holding period; the company’s redemption policy; and the costs associated with a public offering of the stock. The court considered each of the above 10 factors and determined subjectively that a 30% marketability discount was appropriate. More recently, in Estate of Webster E. Kelley v. Commissioner, T. C. Memo 2005-235 (Oct. 11, 2005), the decedent died owning 33 1/3% of the limited liability company (LLC) that owned a 1% general partnership interest in the limited partnership and 94.8% of the limited partnership (L.P.) interests. The assets were exclusively invested in cash and money-market funds as of the date of death. Tax Court Judge Juan Vasquez decided that a 12% discount for relative lack of control and a 23% discount for relative lack of marketability were appropriate in this case. He considered the evidence presented by the appraisers for each side, along with the restrictions on the interests arising from the LLC and L.P. agreements. In Estate of Jelke v. Commissioner, T.C. Memo 2005-131 (May 31, 2005), the taxpayer, namely the decedent’s estate, challenged the valuation by the IRS of the taxpayer’s interest in a closely held corporation. The parties disagreed over the applicable reduction in value for the applicable discounts for lack of marketability and control, and the built-in long-term capital gains tax liability. (See discussion below). The estate presented expert testimony asserting that the value should be reduced by discounts for lack of control and marketability. The tax court determined that a 15% discount for lack of marketability and a 10% discount for lack of control should be applied to the taxpayer’s interest in the corporation. See also Estate of Thompson v. Commissioner, T.C. Memo 2004-174 (July 26, 2004); Estate of Lea K. Hillgren, T.C. Memo 2004-46 (March 3, 2004). Once the FMV for 100% of a closely held company is calculated, the appraiser must decide whether the subset of shares being valued would share equally in that value. In other words, are the shares of controlling stockholders worth more per share than the shares of the noncontrolling stockholders? In many, if not most cases, the answer is yes. Value comes from, among other places, the ability of the controlling shareholder to select the company’s management; borrow money; buy, sell and pledge assets; enter into contracts; issue and repurchase stock; register stock for public offering; and liquidate, sell or merge the company. The controlling party can also set management compensation, declare dividends, make capital distributions and control contracts and payments to third parties. Noncontrolling, or minority, shareholders usually have minimal influence on these important activities. The magnitude of the control premium depends upon whether the potential buyer believes he or she can enhance the value of the company. Obviously, the size of the premium will depend upon how much incremental value buyers believe can be created. A discount for lack of control is only relevant when valuing shares in a closely held company. Publicly traded shares are already priced as noncontrolling interests, requiring no discount from the quoted value of the stock. This is not so for a noncontrolling interest in a private company. The tax court has allowed discounts for lack of control, but it has frequently been difficult or impossible to determine whether the discount was being allowed because the shares rep- resented a noncontrolling interest, lacked marketability or both. As a result, one can look to the same cases discussed above for discussion of the discount for lack of control, including: Estate of Kelley; Estate of Jelke; Estate of Thompson; and Estate of Hillgren. Trapped-in capital gains tax Before 1986, a corporation could liquidate, distribute all proceeds to stockholders within a year and avoid paying capital gains tax at the corporate level under the so-called general utilities doctrine. The Tax Reform Act of 1986 repealed that doctrine, leaving no practical means for a C corporation to avoid paying capital gains tax on the sale of appreciated assets. If the entity is liquidated or the assets sold, a cash cost will be incurred for the capital gains tax paid. In effect, the true value is the net cash received rather than the gross asset value. Disputes have arisen between taxpayers and the IRS as to whether this built-in or trapped-in tax should be recognized as a valuation discount or adjustment. Further inquiry is often made as to whether a sale was planned or contemplated at the valuation date. In Estate of Artemus D. Davis v. Commissioner, 110 T.C. No. 35 (1998), the issue was whether a discount should be allowed in arriving at the fair market value of C corporation stock when the underlying assets had trapped-in, or built-in, capital gains. The taxpayer applied a 15% discount due to built-in gains tax as part of the discount for lack of marketability. Despite the testimony of its own expert at trial for a similar discount, the IRS rejected it. The tax court ultimately rejected the IRS position, stating that a hypothetical willing seller and a hypothetical willing buyer would not have agreed on a price for the blocks of stock in question without consideration of the built-in capital gains tax. In Eisenberg v. Commissioner, T.C. Memo 1997-483 (Oct. 27, 1997), the key issue again was whether the potential capital gains tax inherent in low-basis assets trapped inside a C corporation allowed for a discount if no liquidation was contemplated. Tax Court Judge Lapsley W. Hamblen Jr. granted summary judgment for the IRS, reasoning that no discount for such trapped-in capital gains was allowable in the absence of a plan to liquidate. Following the decision in Davis, which was rendered in the interim, the 2d U.S. Circuit Court of Appeals overturned the summary judgment and remanded the case to the tax court for a determination of the discount. The IRS acquiesced to the 2d Circuit’s decision in January 1999. See also Estate of Jameson v. Commissioner, T.C. Memo 1999-43 (Feb. 9, 1999), vac’d and rem’d, 267 F.3d 366 (5th Cir. 2001); Estate of Simplot v. Commissioner, 112 T.C. No. 13 (1999), rev’d and rem’d, 249 F.3d 1191 (9th Cir. 2001); Estate of Jelke. When valuing a closely held business for estate- and gift-tax purposes, the appraiser must not only have a thorough understanding of valuation principles, but must also keep a close eye on relevant court decisions. The FMV of a closely held business is a question of fact and, as dictated by Revenue Ruling 59-60, a product of facts and circumstances. Although valuation methodology has developed and been refined over the years, IRS regulations and positions taken in revenue rulings can be overturned by a single or series of adverse judicial rulings. Curtis R. Kimball is the director of the Atlanta regional office, as well as the national director of estate- and gift-tax valuation services, at Willamette Management Associates, a business asset valuation company. James J. O’Sullivan is a senior manager in the company’s litigation services group based in the New York office. He is a lawyer and a certified public accountant.

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