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Valuation of minority discounts in closely-held companies.

Early in 1993, the Internal Revenue Service (IRS) announced a major change of policy with respect to the valuation of closely held corporate stock for both estate and gift taxation. After more than a decade of insisting that a minority discount for intrafamily transfers was not permitted in valuing stock for estate and gift tax purposes, the IRS has acquiesced to the Estate of Elizabeth M. Lee v. Commissioner (69 TC 860, Nonacquiesced 1980-1 CB 2) and thereby revoked Rev. Rul. 81-253.

The principal issue in Rev. Rul. 81-253 was whether a minority interest discount should be allowed when valuing the transfer, either by gift or bequest, of a minority interest in a closely held family corporation to the donor's children. In the ruling, the Treasury acknowledged that Regulation Section 25.2512-2(f) provides that the degree of control of the business represented by the block of stock to be valued is among the factors to be considered in valuing stock where there are not recent sale prices or bona fide bid and asked prices. Both the 2nd and 8th Circuit had denied a minority discount. The IRS in turn affirmed its position that unless there was evidence of family discord or other factors indicating the family would not act as a unit in controlling a corporation, no minority discount will be allowed with respect to transfers of shares of stock among family members where, at the time of transfer, control (either majority voting control or de factor control) of the corporation exists in the family (Rev. Rul. 81-253, 1981-1 C.B. 187).

In 1978, the Tax Court decided the case of the Estate of Elizabeth M. Lee v. Commissioner (69 TC 860, Nonacquiesced 1980-1 CB 2), wherein the government argued that the transfer by her estate to her husband of her interest in a closely held corporation should not have its value reduced because the amount transferred constituted a minority interest. The decedent and her husband were residents of a community property state and collectively owned 80% of the corporation's outstanding stock. Because her bequest transferred her undivided 40% minority interest, the executor reduced its value accordingly.

The IRS took the position that since the transfer was to the husband, the aggregate interest, and thus control, had not changed with this transfer, so no discount should be allowed for the value of the stock included in the decedent's estate.

In 1981, the IRS again lost on this argument in the Estate of Mary Frances Smith Bright, Deceased v. U.S. 619 F2d 410 (USCA 5), 46 AFTR 2d 81-6292 (1981) where, in a community property state (Texas) there was a transfer of a minority interest (decedent's undivided half of 55%) to members of the family. Her bequest was to a trust for the primary benefit of the deceased's children, with the surviving husband as trustee.

With these setbacks, IRS promulgated Rev. Rul. 81-253 and indicated it would follow cases which have not allowed such discounts (i.e., Blanchard v. United States, 291 F. Supp. 248) for the transfer of a minority interest and expressly would not follow cases such as Lee and Bright.

Rev. Rul. 81-253 is couched in terms of intervivos gifts of minority interests in a closely held corporation to the children of the majority shareholder. The issue as framed in the ruling is "Whether minority discounts should be allowed in valuing for Federal gift tax purposes three simultaneous transfers of all of the stock in a closely held family corporation to the donor's three children." The ruling analyzes the situation using the regulations under IRC section 2512 and specifically Reg. 25.2512-2(f) where "the degree of control of the business represented by the block of stock to be valued is among the factors to be considered in valuing the stock where there are not sales prices or bona fide bid and asked prices." Stating that "Judicial authority is inconsistent regarding the correct legal principle governing the availability of a minority discount... This ruling is intended to state the Service's position."

The Service's position was that no discount is allowed for these types of interfamily transfers of a minority interest. When there is evidence that there is "family discord or other factors indicating that the family would not act as a unit in controlling the corporation, a minority discount may be allowed." Similarly in cases of transfer to an unrelated party, a discount may be allowed.

The New Position in Rev. Rul. 93-12

The IRS has "...decided to acquiesce to the Tax Court's decision in Lee (above) and not assume that all voting power held by family members must be aggregated for purposes of determining whether the transferred interests should be valued as part of a controlling interest." In a situation nearly identical to those set forth in Rev. Rul. 81-253, the IRS stated in Rev. Rul. 93-12 (1993-7 IRB 1) that "a minority discount will not be disallowed simply because a transferred interest, when aggregated with the interests held by other family members, would be part of a controlling interest." Further, the IRS expressly revoked Rev. Rul. 81-253.

The Implications of This Change

Clearly, the valuation of closely held stock can now be discounted in cases of transfer of a minority interest within the family unit. The practitioner should review prior gift and estate tax returns for possible opportunities to file amended returns for refunds due to over evaluations. Moreover, this ruling holds planning opportunities for intervivos transfers, giving less than the annual gift tax exclusion of $10,000.00 per donee. Then a series of transfers made each year might be nontaxable and yet still deplete the donor's estate. The result is that the donor's estate ends up with only a minority interest entitled to a minority interest discount, thereby reducing estate taxes from both intervivos gifts and the minority interest discount.

In estate planning, a transfer to the spouse at a discounted value could have significant effect on the amount of property passing by a marital deduction provision based on value.

In the area of IRC 303 redemptions, however, it could be a double-edged sword. On one hand, it may reduce the taxable estate, but it may also reduce or eliminate altogether the benefits of the IRC 303 redemption by reducing the value and thus the percentage of the decedent's estate which is made up of this closely held corporate stock.

In corporate redemption situations, the amount needed to fund a buy-out could be reduced and costs of insurance saved. There may be other problems with this; however, in providing liquidity to an estate or cash to a retiring shareholder. Where the retiring minority shareholder obviously does not want to agree to a minority discount in valuing his or her stock and the corporation pays a proportionate value of the company's value for the stock, IRS could argue that the part of the payment equal to what should have been the discount is a constructive dividend and subject to ordinary income tax.

The Minority Discount

As a general rule, buyers of minority interest in corporations are not willing to pay a proportionate share of the value of the company because power is vested in the controlling shareholders. These powers usually include the right to elect directors, set corporate policy, pay dividends and hire corporate managers. The lack of this power and its effect on marketability is the justification for the minority discount.

The minority interest discount is related but not the same as the lack of marketability discount. However, unlike the minority interest discount, the lack of marketability discount can apply to a controlling interest. The courts have acknowledged that unlisted stocks are not as marketable as listed stocks. In Central Trust Co. (305 F.2d 393,405), the Court stated "an unlisted closely held stock of a corporation such as Heekin, in which trading is infrequent and which therefore lacks marketability, is less attractive than a similar stock which is listed on an exchange and has ready access to the investing public."

It is also important to note that the blockage concept must be distinguished from the lack of marketability concept, even though it is related. Blockage applies to large blocks of shares of a listed company. There is an established market for the shares, but if sold on that market (plus what was normally traded in that company's stock) the quantity of shares being offered would depress the market price. Obviously, where a corporate stock is infrequently traded, even though it is listed, the distinction between blockage and lack of marketability is difficult.

Although the courts generally combine the minority interest and the lack of marketability principles into one discount, we need to examine them separately. In valuing a minority interest, the value of the company as a whole must take into consideration the lack of marketability if the company is unlisted. Although there is no judicial support, the IRS could argue that implicit in this concept is that if the company as a whole has one value and the minority interest is worth less than its proportionate share of the corporate value, then the controlling interest is worth a premium in excess of its proportionate share of the corporation's value.

A word of caution before we take an in-depth look at the minority discount. The discount for both the minority and lack of marketability is applied only when you are using intrinsic factors such as earnings, dividend capacity and assets value to determine the value of the shares--not when using normative values based upon a prior sale of a minority interest.

The issue becomes "how much of a discount?" As previously mentioned, often the courts combine the minority and lack of marketability discount into one, but there are cases that discuss the two separately. Before reviewing several cases and the discount allowed, it is important to understand that the discount was determined by the amount for which experts testified the minority shares could be sold, not arbitrary percentage amounts applied to the minority interest value, and the percentages were calculated after the facts. In Whittemare v. Fitzpatrick (127 F. Supp. 710), the court allowed a 50% discount for lack of marketability, then allowed an additional discount on the lack of marketability value--32%--resulting in a total discount of 66%. In Drigbrough v. U.S. (208 F. Supp. 279), the corporation was a real estate holding company in which the court combining the minority interest discount and the lack of marketability, allowed a 35% discount from the net asset value. In the Estate of Jessie Ring Garrett (12 T.C.M. 1142), a 30% discount was allowed for a minority ownership in a family-owned corporation. In Bartrom v. Graham 157 F. Supp. 757, the court emphasized the minority discount but combined it with the lack of marketability factor and limited the discount to 20%.

When trying to determine the minority interest discount, we must determine the value of the company as a whole. The beginning of the valuation process begins by gathering data. In addition to gathering data, the following factors, although not all-inclusive, are fundamental and require careful analyses for each case:

* The nature of the business and the history of the enterprise from its inception.

* The economic outlook in general and the condition and outlook of the specific industry in particular (that is, the value of a business in a growing industry will be worth more than a business with the same net assets in a declining industry).

* The book value of the stock and the financial condition of the company.

* The company's earning capacity.

* The company's dividend paying capacity.

* Whether or not the company has goodwill or other intangible assets.

* Prior sales of the stock and size of the block to be valued.

* The market price of stocks of corporations engaged in the same or a similar line of business and having their stock actively traded in a free and open market, either on an exchange or over-the-counter.

The data that needs to be reviewed includes the following:

* Five years of historical financial statements and tax returns. The financial statements need to be adjusted for current values as opposed to historical values.

* Business plans and budgets.

* Other company operating data such as organizational charts, customers list, promotional material, price list, product information, etc.

* Legal documents.

* Miscellaneous documents such as key employee resumes and younger managers and engineers slated for the replacement of near-retirement employees.

* Economic data and market conditions of the nation and industry or industries in which the company does business.

Rev. Rul. 59-60 provides in detail the above approach, methods and factors to be considered when valuing shares of a closely held corporation. Once the corporation's value has been determined, the next issue is the amount a minority interest is discounted. Often this can only be determined by market research.


There is no standard discount percent for minority ownership or lack of marketability. The issue is the price at which a willing buyer and a willing seller agree, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. Simply stated, this is what is the fair market value of a minority interest.

To determine that value, the valuator must consider the lack of control issue and how it affects the value of the minority interest. This lack of control includes the minority interest's inability to direct, manage or otherwise control the day-to-day operations of the business; to appoint managers and determine salaries; to elect directors; to declare and pay dividends; or to liquidate the business, if desirable.

Minority interest discounts vary from 15-60% and lack of marketability discounts have ranged from 10-50%. When the minority interest and lack of marketability discounts have been combined, the discount has ranged from 25-75%. The actual discount amount depends on the market for the particular industry and company, taking into consideration the disadvantages of owning a minority interest in an unlisted corporation.

James F. Hopson, JD, CPA, is professor and dean, and William J. Sheehy, JD, LLM, is associate professor and associate dean of the College of Management at Lawrence Technological University in Southfield, MI.
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Author:Hopson, James F.; Sheehy, William J.
Publication:The National Public Accountant
Date:Dec 1, 1993
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