Valuation Discounts for Marketability and Control

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

Lack of Marketability discounts for a closely held business are triggered when valuing a minority interest for a myriad of reasons, but the most common are buying out a partner and gift and estate tax planning.  Applying a discount for lack of marketability for a minority interest can be a painstaking task for the appraiser. It is not an exact science but an educated estimate, and as often is the case, there is no identifiable market for the interest and the unexpected tax consequences to the client can be significantly costly. In both instances, partnership buyouts and estate planning, the measure is fair market value as:

"the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts" [1] 

Some of the rationale for applying a discount for lack of marketability to a closely held minority business interest is driven by dividends or distributions available for minority interest holders, size of the potential market for buyers, restrictions on transferability of the minority interest and relative size and financial strength of the aggregate entity.

With respect to a business interest, marketability is commonly defined as:

"The ability to quickly convert property to cash at minimal cost." [2]

Marketability, then relates to the (lack of) liquidity of an investment relative to a comparable and actively traded alternative. To accommodate such relative difference the "nonmarketable" price of a security is discounted relative to the price of its marketable counterpart. The discount for lack of marketability is typically stated as a percentage (or sometimes an amount) of a marketable value. Therefore, an appropriate Discount for Lack of Marketability is defined as:

"An amount or percentage deducted from value of an ownership interest to reflect the absence of marketability." [2] 

Illiquidity Factors Affecting Non-Controlling Ownership Interests

Unlike the owner of publicly traded securities, the owner of a non-controlling ownership interest in small business cannot call up a securities broker, sell that non-controlling ownership interest in seconds at a predetermined price and with a nominal transaction commission, and realize the cash proceeds of the sale in three business days. Rather, selling a non-controlling ownership interest in a small business is a lengthy, expensive, and uncertain undertaking. 

The only means of liquidating a controlling ownership interest in a small business is a public offering of the controlling block of stock; sell the overall business enterprise in a private transaction (and equitably allocate the sale proceeds to all of the business owners). Sell the controlling ownership interest only (to the other minority ownership stockholders or to an independent third-party buyer).

The non-controlling owner of a small business who wishes to liquidate a non-controlling ownership interest generally faces the following transactional considerations:

1. Uncertain time horizon to complete the offering or sale.

2. Cost to prepare for and execute the offering or sale.

3. Risk concerning eventual sale price.

4. Form of the transaction proceeds.

5. Risk concerning financing and inability to require additional property or goods as security without surrendering ownership.

Marketability Discount Trends

The valuation of closely held entities for gift and estate tax purposes has been a popularly contested issue-especially with the proliferation of family limited partnerships and limited liability companies that are implemented primarily for estate planning purposes. In many instances these closely held entities do not carry on an active trade or business. Valuation adjustments are intended to reflect the lack of control inherent in limited partnership interests and the lack of marketability inherent in any type of closely held partnership interest. These are two separate issues that usually result in two separate adjustments or discounts. The courts recognize the need for these discounts but often disagree about what their amounts should be. Due to the popularity of family limited partnerships (FLPs) and the significant tax savings they can provide, the IRS has sought to limit the benefits of their use. As part of its attack on an FLP, the IRS frequently will challenge the value of the FLP that is claimed on an estate or gift tax return

Court cases reveal that the valuation of closely held entities is a judgment call that relies upon the opinion of experts. Courts have long upheld a premise often reflected in expert opinions-that the value of closely held interests is usually less than the value of similar publicly traded interests. The factors underlying this premise include the inability to quickly convert the property to cash at minimal cost ("lack of marketability") and the inability, if the interest held is less than a majority interest, to control managerial decisions and other aspects of the entity ("lack of control").

Discount for Built-In Gains Taxes

While the courts and the IRS have agreed that built-in gains (BIG) tax on a corporation's appreciated assets should be taken into account in valuing its stock using the net asset valuation method, they have not agreed on the proper method for quantifying the discount. However, it is interesting to note, that in many of the cases, the court has set the discounts to match the tax liabilities and in some cases higher than the Estate's appraiser used.  Many average between 30% to 40% and some as high as 50%.

As the Government is always short on money, and more so now than I can remember, it seems the IRS would like all it can get, so the appraiser and the tax practitioner need a solid understanding of the various appraisal approaches and methods and should keep up to date on the latest developments in IRS and court decisions.

Divorce and Guns - Can They Backfire?

A recent decision by the Superior Court of Pennsylvania, Smith v. Yusavage (unpublished), got me thinking about the problems surrounding gun ownership for spouses facing marital separation or divorce.

In Smith, one of the unmarried partners filed a Petition for Protection from Abuse (PFA) seeking a restraining order and eviction from their shared residence. Most of the allegations of abuse sound like the kind of shouting matches that might occur from time to time in many relationships. One striking feature of the testimony, however, was that one of the partners applied for a concealed weapons permit, and the other partner would not support the application because of safety concerns. This evidence, in my mind, seemed to convince the judge to issue the restraining order. The Superior Court affirmed.

(In an interesting side note, the Superior Court refused to consider the arguments made in pages 71-122 of the defendant's brief because they exceeded the 70 page limit imposed by appellate procedural rules.)   Read more...

 IRS Debunks Frivolous Tax Arguments

WASHINGTON - The Internal Revenue Service today released the 2011 version of its discussion and rebuttal of many of the more common frivolous arguments made by individuals and groups that oppose compliance with federal tax laws.

Anyone who contemplates arguing on legal grounds against paying their fair share of taxes should first read the 84-page document,  The Truth About Frivolous Tax Arguments.

The document explains many of the common frivolous arguments made in recent years and it describes the legal responses that refute these claims. It will help taxpayers avoid wasting their time and money with frivolous arguments and incurring penalties.

Congress, in 2006, increased the amount of the penalty for frivolous tax returns from $500 to $5,000. The increased penalty amount applies when a person submits a tax return or other specified submission, and any portion of the submission is based on a position the IRS identifies as frivolous.

The 2011 version of the IRS document includes numerous recently decided cases that continue to demonstrate that frivolous positions have no legitimacy.

Frivolous arguments include contentions that taxpayers can refuse to pay income taxes on religious or moral grounds by invoking the First Amendment; that the only "employees" subject to federal income tax are employees of the federal government; and that only foreign-source income is taxable.

In addition, the document highlights cases involving injunctions against preparers and promoters of Form 1099-Original Issue Discount schemes, and the imposition of criminal and civil penalties on taxpayers who claimed they were not citizens of the United States for federal income tax purposes.