Valuing gifts of closely held stocks.

As with any other gifts, when corporate stock is given as a gift, the stock must be valued (and any applicable gift taxes paid). Therefore, the issue of the stock's value is a critical one. And when the gift involves stock in a closely held corporation--which doesn't have a readily available, easily ascertained market value--the determination of the gift's value is even more important.

VALUATION PRINCIPLES

The Internal Revenue Service guidelines for valuing stock in closely held corporations are very general. Basically, the business's value is determined first, and then the value of the stock interest in that business. In general, determining the value of the business is based on a determination of the fair market value of the business's assets, capitalization of its earnings or an analysis of its dividend-paying capacity.

Valuing a business. The first step in the process of valuing a stock interest in a closely held corporation is valuing the entire business. Once this is done, a specific value for the particular interest in the corporation can be examined.

The factors used in this determination include the company's net worth (the fair market value of its assets), its prospective earning power, its dividend-paying capacity, the economic outlook of the company's industry, the company's position in the industry and company management.

Valuing a stock. Once an overall value for a closely held company is determined, the value of the actual stock interest must be determined. (Usually, because of the nature of the corporate structure and the lack of a ready market for the closely held company's stock, this value is lower than the proportionate share of the company's assets. Factors that are considered in this determination include the degree of control represented by the amount of stock to be valued and the value of stock of companies engaged in the same (or similar) lines of business that do have a readily ascertainable value (those that are listed on a stock exchange).

DISCOUNTS

Once a dollar value for closely held stock is ascertained, the determination is not necessarily complete. Because there is no ready market for such stock, its value for gift purposes may be adjusted, sometimes significantly, depending on the circumstances.

Minority interests. Minority shareholders in a closely held corporation often are at a distinct disadvantage. Because control of the company lies with those holding a majority of its stock, minority shareholders do not have the power to determine corporate policies. As such, the value of these shareholders' stock may in reality be worth less than its dollar value.

Inherent capital gains liability. Since the Tax Reform Act of 1986, it has been virtually impossible for most taxable corporations to sell or distribute appreciated assets without incurring some taxable gain. Based on this capital gains tax, many taxpayers have discounted the value of their stock, arguing that the value of the appreciated assets would be adjusted to reflect the payment of this tax. Except when a liquidation actually was contemplated at the time of the stock's transfer, this argument has been largely unsuccessful. However, some courts have allowed such a discount when it was supported by a valuation expert's testimony.

Swing vote. A recent situation in which an adjustment to the value of a block of stock offset a minority discount involved a taxpayer whose stock interest was the swing vote. Because there was no one controlling interest in the corporation, the taxpayer's minority interest, when coupled with the interests of any of the other shareholders, was enough to control the corporation. Thus, even though the taxpayer's interest was a minority one, its "swing vote" potential could increase its value and needed to be considered.

For a discussion of some of these factors, see the Tax Clinic, edited by Michael Koppel, and Tax Trends, edited by Nicholas Fiore, in the December 1994 issue of The Tax Adviser. Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.