Valuation of closely held businesses: estate and gift tax issues.

The valuation of a closely held business for estate and gift tax purposes requires a thorough analysis to substantiate the value that is ultimately determined. Since closely held businesses do not have publicly traded price quotes listed on one of the major exchanges or over the counter, their valuation is that much more complex. The difficulty in valuing a closely held company can be compounded by the fact that many closely held companies are much smaller than their publicly traded counterparts. However, if the valuation practitioner is cognizant of the areas in which a smaller closely held company may differ, appropriate adjustments can be made during the valuation process.

It has been stated that valuation is more an art than a science. This may have been true historically; however, over the past 10 years increasingly more sophisticated financial models have been employed in the valuation of closely held companics. The large wave of mergers and acquisitions during the 1980s precipitated this increase in sophistication.

Historical Perspective

In today's estate and gift tax arena, a rigorous application of standard valuation approaches is appropriate. The days of absolute adherence to the valuation concepts and applications embodied in the landmark Central Trust Co.(1) case are over. Central Trust Co. was a gift tax case in which the taxpayer retained three independent expert witnesses and the Government retained two. The methodologies used by these witnesses were capitalization of earnings, capitalization of dividends, book value and prior sales.

The courts, as well as each of the experts, put the most weight on capitalization of earnings. The weighting of the other approaches differed depending on which expert was testifying. The deviation in the values (based on various approaches) among each of the experts varied from a low of $5.83 to a high of $33.83 before any discounts were applied. Final values varied from a low of $7.88 from one of the taxpayer's experts to a high of $21.85 from one of the Government's experts. The court opined somewhere in between at $16.67 per share.

In recent years, the courts have accepted more sophisticated techniques such as discounted cash flow.(2) However, although the approaches accepted in Central Trust are still applicable in current valuation cases, their application is typically more scientific, and the techniques more rigorously applied. The basis for selecting discounts has also changed considerably. In Central Trust, the experts and the courts used the cost of flotation to support a discount for lack of marketability. More recent cases have relied on subsequent detailed valuation studies that are considered better indicators for these types of discounts.

The courts continue to recognize that a discount for a minority interest and a discount for lack of marketability are appropriate, depending on the facts and circumstances of each case. In more recent years, the courts have recognized that the two discounts are distinct from each other. Other discounts that have been allowed in recent cases are key man or thin management discounts, investment company discounts, market absorption discounts and discounts for liquidation costs. The courts have also accepted implied discounts or adjustments in such areas as information access and reliability and lack of comparability.

Closely Held Company vs. Public Company

Many closely held companies are considered small to middle market companies; they exhibit specific attributes that distinguish them from their larger publicly traded counterparts.

Some common differences between public and private companies are:

* Public companies adhere to strict Security and Exchange Commission reporting requirements, including issuing audited annual reports and significant annual and quarterly disclosures in their 10-Ks and 10-Qs. At best, a private company would have audited financial statements. However, many have only reviewed or compiled statements.

* Many public companies, particularly the larger ones, are followed by investment analysts.

* Many publicly traded companies have a historical and well-documented track record. Even newer publicly traded companies typically present data going back three to five years.

In addition to potential problems with information availability and reliability, there are other differences between closely held companies and their publicly traded counterparts. Some of the more notable ones are:

* Many closely held companies are run by a very thin management layer.

* Many closely held companies are conservatively managed and may be underleveraged.

* The owner compensation structure may be different.

* Many closely held companies have nonoperating assets, such as marketable securities, insurance policies or real estate.

* Many closely held companies have shareholder or buy-sell agreements.

* Many smaller closely held companies lack diversification either geographically, demographically or by product line.

Approaches to Value

* Income approaches

Income approaches to valuation are used to estimate the fair market value (FMV) of a company based on the earnings and cash flow capacity of the company. These approaches evaluate the present worth of the future economic benefits expected to accrue to an investor in the business. These benefits or future cash flows are discounted to the present or capitalized at a rate of return that is commensurate with the company's inherent risk and expected growth. This present worth determines the FMV of a business. Two common income approaches are discounted cash flow and capitalization of earnings.

Discounted cash flow approach: This approach estimates the FMV of a company based on the earnings and cash flow capacity of the company. It begins with estimating the pro forma annual cash flows a prudent investor would expect the subject operations to generate over a period of time. In performing such a valuation, a set of projections is usually relied on that includes anticipated net income, future depreciation, future capital expenditures and future incremental working capital needs. These cash flows are then discounted at a rate of return commensurate with the risk inherent in the operations. Capitalization of earnings: This approach consists of capitalizing a single year or an average of several years' earnings or cash flow into perpetuity at a capitalization rate that reflects the risk and growth potential in the company. This can be based on a one year budgeted amount, a single year historical amount or an average of several prior years.

* Market approach

The market approach is a valuation technique in which the FMV of a business is estimated by comparing the subject company to guideline companies in similar lines of business. The market approach can use either publicly traded information or transaction information. Publicly traded company multiples: An often used technique for valuing closely held companies is the application of publicly traded company valuation multiples or ratios, i.e., P/E ratios, to the closely held company. Typical multiples employed are:

* Price to earnings (P/E).

* Price to book value (P/BV).

* Invested capital to earnings before interest and taxes (IC/EBIT).

* Invested capital to earnings before depreciation, interest and taxes (IC/EBDIT).

* Invested capital to revenue (IC/R).

* Price to dividend (P/D).

These multiples can be based on a projected figure, a most recent single year historical figure or an average of several historical periods.

Transaction valuation multiples: Under this method of valuing a company, the multiples are based on actual prices paid for companies relative to certain earnings or revenue parameters. However, these multiples are sometimes difficult to apply given the fact that, in many instances, it is difficult to assess how the transaction was structured and/or the historical earnings of the company.

It is important to note that the publicly traded multiples approach results in a liquid minority value, while the use of transaction multiples would indicate a control value.

* Cost approach

The third approach to valuing an enterprise is the cost approach or underlying asset approach. This approach requires the determination of the aggregate FMV of the assets and liabilities of the subject company. Under this approach, stockholders' equity is adjusted from book value to FMV.

The most difficult part of valuing an operating company when using the underlying asset approach is the calculation of goodwill, which is typically not a balance sheet item. This is particularly true in the valuation of service companies whose primary assets may be goodwill or other intangible type assets (see the section, "Rev. Rule 59-60," infra, for a more detailed discussion).

* Formulas and rules of thumb The most commonly used rules of thumb are revenue multipliers, however, their application may lead to inaccurate results. The example above illustrates the danger of using these formulas.

Rules of thumb can have their place in a valuation. They may be used by valuation professionals as a check for reasonableness or as a "first look" calculation but usually not as a primary valuation approach.

Rev. Rul. 59-60

* Purpose

Rev. Rul. 59-60(3) outlined the approaches and methods typically considered when valuing a closely held company for estate and gift tax purposes. It acknowledged the fact that closely held companies do not have readily available market quotations and that alternative valuation approaches must be used.

* Definitions

Valuations of closely held companies for estate and gift tax purposes must be made in accordance with Secs. 2031, 2032 and 2512.

Regs. Sec. 20.203 1-1 (b) (estate tax) and Regs. Sec. 25.2512-1 (gift tax) define FMV as the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under compulsion to buy and the latter is not under any compulsion to sell, and both parties have "reasonable knowledge of relevant facts."

The courts have also embraced the willing buyer/seller concept from the perspective of "a hypothetical sale from a hypothetical willing seller to a similarly hypothetical willing buyer."(4)

* Approaches to value

There is no single approach that is applicable to all companies in every case. The facts and circumstances of each individual situation must be evaluated in determining both the approaches to be used as well as the specific application.

* Factors to be considered

Rev. Rul. 59-60 discussed eight specific factors that must be considered in any valuation of a closely held company.

* History and nature of the business.

* Industry and general economic outlook.

* Book value and financial condition.

* Earning capacity.

* Dividend-paying capacity.

* Existence of goodwill or other intangible value.

* Prior sales and the size of the block of stock.

* Comparisons to similar publicly traded guideline companies.

History and nature of the business: The history and nature of a company must be evaluated in light of its historical and current anticipated performance. A thorough analysis should be performed to determine its growth prospects, inherent risks and diversity. An analysis should also be undertaken on the performance of management, product lines, geographical diversity, capital structure, adequacy of property, plant and equipment, and any other areas deemed relevant.

Industry and general economic outlook: The general economic environment should be considered in any valuation, tempered with specific information pertaining to the economic outlook for the industry in which the company operates as well as any regional or local effects. Competition must also be assessed in light of the company's historical and anticipated performance. Valuation practitioners are sometimes misled through historical, current and anticipated growth trends in a company. For example, research may indicate that a company's income has been growing at 5% per year for the past five years and is anticipated to continue that growth trend over the foreseeable future. Although this may appear, at face value, to be positive, further analysis may lead to a different conclusion. Suppose that while the company has been growing at 5% per year, the rest of the industry has been growing at 7% or 8% per year, indicating that the company is a below-average performer.

Book value and financial condition: A thorough analysis of a company's balance sheet should be performed (using various financial ratios reflecting liquidity, working capital and debt levels) to determine its current capital structure and financial condition. Nonoperating assets, which may be valued separately and added back to the value of the operating company, should also be evaluated.

Earning capacity: A thorough review of profit and loss statements and cash flow statements should also be performed. Five years of financial statements are preferable. These statements should be evaluated for earnings and profitability trends. According to the ruling, "Potential future income is a major factor in many valuations of closely-held stocks, and all information concerning past income which will be helpful in predicting the future should be secured .... If, for instance, a record of progressively increasing or decreasing net income is found, then greater weight may be accorded [to] the most recent years' profits in estimating earning power."

Dividend-paying capacity: It is not uncommon for closely held companies to pay small or no dividends. Because of this situation, the capacity of the company to pay dividends (as opposed to actual dividends paid) should be evaluated. However, the ruling states that "lilt follows, therefore, that dividends are less reliable criteria of fair market value than other applicable factors." Existence of goodwill or other intangible value:

The revenue ruling states that "[i]n the final analysis, goodwill is based upon earnings capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets." Subsequent to Rev. Rul. 59-60, the Service issued Rev. Rul. 68-609,(5) which presented a formula approach for valuing the aggregate intangible assets of a business.

A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five)immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of, say, 15 to 20 percent, is the value of the intangible assets of the business determined under the "formula" approach. Rev. Rul. 68-609 stipulated that this formula approach is to be used only when no other better method is available.

Prior sales and the size of the block of stock: Any prior sale of closely held stock should be evaluated to determine whether it represents a transaction at FMV and at arm's length. Any intrafamily transactions that are used to determine value would probably be scrutinized to determine whether they were indeed at arm's length.

Rev. Rul. 59-60 also dealt with the concepts of minority interests, control value and the marketability of closely held shares: "The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minority interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock."

Comparisons to similar publicly traded guideline companies: As previously discussed, the market approach to value, employing data from publicly traded companies that are similar to the company being valued, should be considered. These guideline publicly traded companies should be in a similar business, although other factors such as profit margins, growth trends and capital structure should be evaluated.

* Weighting of factors

The valuation approach selected to value a closely held company has a tremendous impact on the final determination of value. In this regard, certain approaches may be more applicable to certain types of companies than others. For example, the underlying asset approach is commonly used to value real estate holding type companies whose primary assets are the underlying real estate. However, earnings and cash flow may also be considered.

The earnings and/or cash flow capacity of a company is typically of primary importance in valuing operating companies--whether a service or manufacturing company. As such, the income approach and the market approach would typically be used. In valuing professional practices, the underlying asset approach is often used with goodwill calculated using some type of excess earnings method.

* Capitalization rates

The choice of a capitalization rate to be applied to either earnings or cash flow must embody both the risk inherent in the business as well as growth prospects. Capitalization rates are also heavily influenced by the current economic times as well as interest rates on available fixed income type securities. As such, a capitalization rate derived using current economic data would typically be appropriate only for that time period. A valuation done a year later may result in a different capitalization rate reflecting both the economic conditions at that time and the then current outlook for the company.

* Average of factors

As Rev. Rul. 59-60 explained, "Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result." It is interesting to note that in Central Trust, all five experts and the court used a weighting system to determine value.

* Restrictive agreements A review of any buy-sell and/or restrictive agreements within a closely held corporation will typically reveal stockholder rights, including income and dividend preferences, liquidation preferences, voting rights, as well as limitations on the sale of stock.

Family Attribution Rules 

From the courts' perspective, it appears that the family attribution rules presented in Rev. Rul. 819,53(6) should not be a factor in a closely held business. Traditionally, valuation of such entities is premised on the concept of "a hypothetical sale from a hypothetical willing seller to a similarly hypothetical willing buyer." (7) The Service dismisses this concept by specifically identifying the parties of a transaction to be only immediate family members.

Rev. Rul. 81-9,53 was intended to state the Service's position on family attribution.

It is the position of the Service that ordinarily no minority discount will be allowed with respect to transfers of shares of stock among family members where, at the time of the transfer, control (either majority voting control or de facto control) of the corporation exists in the family...where a controlling interest in stock is owned by family members, there is a unity of ownership and interest, and the shares owned by family members should be valued as part of that controlling interest.

The Service held that no minority discount was allowable.

Since this revenue ruling was issued, numerous court cases have dealt with this matter. Chart I, above, represents some of the more important Tax Court cases in this area.

As can be seen by this chart, substantial discounts for minority interests and a lack of marketability have been accepted by the courts. It is also important to note the numerous times the courts have addressed and/or adopted the hypothetical buyer/seller concept as stipulated in Rev. Rul. 59-60. This concept is instrumental in defending minority discounts and ignoring family attribution. The chart also indicates that the concept is equally applicable for gift or estate taxes.

Application of Discounts and Other Adjustments

The most common discounts or adjustments that should be considered in valuing ownership interests in a closely held company are:

* Minority interests.

* Lack of marketability.

* Key man or thin management.

* Investment company.

* Information access and reliability.

* Comparability.

* Market absorption and blockage.

* Liquidation and/or capital gains.

Discount for minority interest: There is usually a lesser perceived risk in an investment when the investor has the right to control the company's course of action. As such, a controlling interest in a closely held company typically commands a higher price than a minority interest in that same company. To the extent that the company was initially valued on a control basis, a discount for minority interest may be appropriate to the extent that the minority stockholders have little in the way of control prerogatives. These rights include the election of directors, the selection of management, compensation, acquisition and liquidation of assets and/or companies, and the setting of dividend policies.

Discount for lack of marketability: A discount for lack of marketability is applied to the value of the capital stock of a closely held company to reflect the lack of a market for the stock and that such is not readily transferable. Investors typically prefer investments that have access to a liquid secondary market and that may be readily converted to cash. Shares without such marketability characteristics would normally sell at a discount from prices of comparable publicly traded shares. A better understanding of marketability discounts in recent years has led to increasing discounts. These discounts typically range between 9.0% to 60% for minority interests depending on the facts and circumstances.

Key man/thin management discount: A key man or thin management discount would be appropriate in the valuation of a closely held company to the extent that the operations of the company are embodied in one or a few individuals. This is not an unusual situation in many smaller closely held companies. Rev. Rul. 59-60 dealt with this issue by stating: "The loss of the manager of a so called 'one-man' business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise." The selection of a discount to reflect the loss of a key manager or a thin management structure must be tempered by the effects of any life insurance policies that are in existence as of the date of the valuation.

Chart II, above, summarizes some of the more relevant Tax Court cases that have recognized a discount associated with the loss of a key manager.

In all but one case, the court ruled in favor of a discount for the loss of a key manager, since each manager in question was an integral part of an operation with little or no succession of management. In Est. of Oman,(8) a key man discount was rejected since the decedent's sons were managing the company both before and after the father's death.

Investment company discount: It is not unusual for investment companies to sell on the basis of their assets rather than their earnings. An analysis of publicly traded investment real estate companies reveals that minority interests in investment companies typically sell at a discount from their respective pro rata share of the firm's net assets restated to FMV. The application of this discount would account for the shareholders' indirect ownership of these assets, and their inability to force the sale, liquidation or merger of these assets. Investment company discounts typically range anywhere from 10% to 60%, depending on the facts and circumstances of each case as well as the type of assets owned by the company.

At first glance, the investment company discount in its purest form may be considered a minority interest discount; however, an investment company adjustment has been recognized by the courts for application to majority interests. In Est. of Folks,(9) the court recognized that different investment company discounts may apply to different ownership percentages for the same company. The court opined that a 50% discount was allowable for a minority interest and a 40% discount was allowable for a majority interest. It is important to note that the court also allowed an additional marketability discount for the minority interest.

In Est. of Dougherty,(10) the court decided that a 35% discount was allowable for nonmarketability and operating and liquidation costs. 1t is important to note that the decedent held a 100% beneficial interest in a trust that owned a 100% interest in a company that owned primarily real estate and other nonliquid assets.

Adjustment for information access and reliability: In valuing a closely held company, an adjustment for information access and reliability may be in order. This adjustment will reflect the fact that the company being valued may not have audited financial statements or will have financial statements that will require modification. If a company being valued is being compared to publicly traded companies, adjustments to the financial statements or valuation multiples (e.g., depreciation, leverage, taxes, nonrecurring items and nonoperating assets) may be in order to put them on a more comparable basis. If there is additional risk associated with uncertainty in the underlying data, it may be appropriate to apply a discount. The magnitude of such a discount would depend entirely on the facts and circumstances of each individual situation. Furthermore, if the proper financial adjustments are made, a further discount may not be appropriate.

Adjustment for lack of comparability: The degree of comparability between the subject closely held company and its publicly traded counterparts must be evaluated. To the extent that a smaller closely held company is being compared to a larger publicly traded company, an adjustment for size may be appropriate. Merger, acquisition and financial data are available that indicate that the prices paid for smaller closely held companies can be less than the prices paid for their larger publicly traded counterparts.(11) Furthermore, there are studies indicating that rates of return required for investing in small companies can be higher than the rates of return required on much larger publicly traded diversified companies.(12) This is important in light of the fact that the higher the rate of return, the lower the final value. Market absorption and blockage discounts: In the valuation of a closely held real estate investment holding company, a discount for potential market absorption should be considered. When the company owns a large block of similar real estate holdings within a similar geographical area, it may be difficult to market these properties over a reasonable period of time.

In Est. of Folks, the court accepted a 20% discount for market absorption, stating: "In simplistic terms, blockage refers to an immediate oversupply of goods which demand (the market) will not absorb at optimum prices. It is not unreasonable that placing 5 lumberyards on the market simultaneously in a limited geographical area would depress prices 20 percent."(13)

The Tax Court also accepted market absorption discounts in Carr(14) (30% discount)and Est. of Grootemaat(15) (15% discount). Discount for liquidation and/or capital gains: An ongoing disagreement between the IRS and some tax practitioners revolves around the cost of liquidating the assets in the estate. Certain costs such as brokers' fees, holding period interest and, most importantly, capital gains tax would be incurred to realize the property's FMV. It has, therefore, been argued that these costs should be used to reduce the value of the property in the estate. The IRS recently outlined its position in Letter Ruling (TAM) 9150001.(16) In general, the ruling stated that if the immediate liquidation of the subject assets is not contemplated, the capital gains tax cannot be used to reduce the value of the estate. Obviously, many tax practitioners disagree with this assumption.

Summary of the Salient Factors in Estate and Gift Tax Valuations

* Fair market value is usually defined in terms of a hypothetical sale from a hypothetical seller to a hypothetical buyer. As such, reflecting specific attributes of any one buyer or seller can violate this hypothetical premise.

* Minority discounts and discounts for lack of marketability, although related, are quite distinct from each other.

* The starting point for any valuation dictates which discounts and premiums are appropriate and how they are to be applied, i.e., values derived from the application of publicly traded P/E ratios result in a minority, marketable value. In this case, a discount for lack of marketability would be appropriate to value a minority interest. When using an underlying asset approach to valuation, the result is usually the full value of the corporation and thus would reflect control. A minority discount and marketability discount may be appropriate in valuing a minority interest.

* Blind applications of publicly traded valuation ratios can result in distorted results. Adjustments may have to be made for comparability, size, diversification, thin management and risk, among others.

* Family attribution is typically not an issue in the valuation of a minority interest of a 100% family owned corporation.

* An ownership interest, whether majority or minority, in a real estate holding company, can be worth significantly less than the FMV of the underlying assets. Investment company discounts may be appropriate.(17)

* Discounted cash flow techniques, although common in economic valuations, are slowly gaining acceptance in the tax courts.(18)

* A key man or thin management discount can be quantified through the use of financial models. Experience in valuations for asset allocation purposes can also be used.

* Care should be exercised in the use of weighting of approaches.

* It can sometimes be argued that discrepancies in valuation resulting from the use of different approaches can mean one of two things, either the approach was inappropriate or it was applied incorrectly.

* Rules of thumb are typically based on averages. To the extent that the company being valued is average, the application of the rule of thumb may be indicative of value.

* Facts and circumstances dictate the selection of the approach, its application, as well as the magnitude of any discounts taken.

References

1 The Central Trust Co., 305 F2d 393 (Ct. CI. 19621(10 AFTR2d 6203, 62-2 USTC[paragraph]I2,092).

2 See, e.g., The Northern Trust Co., 87 TC 349 119861.

3 Rev. Rul. 59-60, 1959-1 CB 237.

4 Est. of Woodbury G. Andrews, 79 TC 938 (1982J, at 955.

5 Rev. Rul. 68-609, 68-2 CB 327.

6 Rev. Rul. 81-253, 81-2 CB 187.

7 See note 4.

9 Est. of T. John Folks, Jr., TC Memo 1982-43.

10 Est.. of Albert L. Dougherty, TC Memo 1990-274.

11 Mergerstat Review, 7990 (Schaumburg, Ill: Merrill Lynch Business Brokerage and Valuations, Inc., 1990).

12 Stocks, Bonds, Bills, and Inflation, 1991 Yearbook (IbBotson Associates, Inc.).

13 Est. of Folks, note 9, at 82-188.

14 Jack D. Carr, TC Memo 1985-19.

15 Est. of Clarence 1. Grooteraaat, TC Memo 1979-49.

16 IRS Letter Ruling (TAM) 9150001 (8/20/91).

17 See Est. of Folks, note 9, and Est. of Dougherty, note 10.

18 See Northern Trust Co., note 2.