Valuation of closely held stock.

In Manbelbaum, TC Memo 1995-255, three brothers owned all of the shares of a closely held company in the retail industry. The brothers were equal shareholders until they transferred shares o stock to their children. The stock was always completely owned within these three branches of the family.

All shareholders were actively involved in the business. Each shareholder's voting shares would become nonvoting if they were transferred to persons other than the board of directors. Board of directors and officers of the company were restricted to family members. Furthermore, the company had the right of first refusal if a shareholder wanted to transfer stock out of the family group.

Gift tax returns were filed by the three brothers on the transfer of shares of stock to their children and grantor trusts. In order to determine the gift tax on the transfer, the donors' accountant reduced the appraised value of the stock by marketability discounts ranging from 70% to 75%. The IRS's expert found the appropriate marketability discount to be 30% and the Service assessed penalties under former Sec. 6660 and Sec. 6662(a) and (g) for substantial valuation understatements.

The Tax Court agreed with the IRS'S expert, and found 30% to be an appropriate marketability discount factor. Several factors influenced the court's decision. The company's strong financial status (based on such factors as its financial statements, management, dividend policy, history, position in the industry and future potential) favored a below-average marketability discount.

The control factor was given an average marketability discount, since none of the blocks of stock represented substantial control. The court found that the shareholder agreements preserving control by the family did not severely restrict marketability, and that an above-average to average marketability discount was related to the expense involved with a public offering.

With respect to the penalties imposed by the Service for substantial valuation understatement, the court found that the donors used prudence and care by depending on a professional to determine the valuation of the gifts for tax purposes and therefore were not liable for penalties.

Much of the authority on marketability discounts for valuation purposes is found in case law. When determining the marketability discounts for closely held companies, professionals should compare their clients' situations to similar facts from case law. Proper documentation and professional appraisals are strongly recommended to derive the proper values of the gift and of the applicable discounts. This may protect a client from valuation penalties even when there are wide discrepancies.