Review and Analysis of Discounts for Estate and Gift Tax Purposes
Valuing closely held corporations for estate and gift tax purposes is frequently a very contentious issue. IRC section 2031(a) notes that the value of the estate shall be detennined at the time of decedent's death, and section 25 12(a) states that a gift of property should be valued on the date of the gift. By its very nature, however, stock of closely held corporations can be difficult to value due to the relatively small number of stockholders and limited trading of shares. Furthermore, the IRS does not provide a specific formula to assess the appropriate value of the company's stock. Revenue Ruling 59-60 (1959-1 CB 237) stipulates: 'In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes." Because there are several million closely held corporations in the United States (E. P. Smith, P. J. Harmelink, and J. R. Hasselback, 2011 CCH Federal Taxation: Comprehensive Topics, CCH, 2010), the topic is an important one.
This article examines the pertinent factors to consider and the methods used in valuing closely held stock. Once the base amount is determined, various discounts, such as lack of marketability or lack of control, may be applied to ascertain the final share value. The main focus of this discussion is the key person discount This markdown is suitable in instances where an individual who is the dominant force behind the success of the company is lost due to death, retirement, or other reasons. An in-depth analysis of the key person discount is presented. Numerous factors must be considered when detennining if the discount is appropriate, along with the proper reduction in stock value. Two of the various methods of applying this discount are presented below, along with judicial decisions in which the methods are utilized.
Valuation of Closely Held Corporate Stock
When a U.S. citizen dies, an estate tax is assessed by the federal government on the transfer of that person's taxable estate (IRC section 2001). Similarly, a federal gift tax is imposed on the transfer of property during a person's lifetime (TRC section 2501) for "less than an adequate and full consideration" (IRC section 2512[b]). Because the value of the property determines the amount of tax, it is important to ascertain the true worth of the transferred items. IRC section 2031(a) states: "The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated." In addition, IRC section 2031(b) addresses the valuation of unlisted stock and securities. It states that because the value of unlisted stock cannot be determined by examining bid and ask prices, stock prices of similar companies that are listed on an exchange should be analyzed along with all other factors that could affect the valuation. In addition, Treasury Regulations IRC section 20.20311(b) notes that the fair market value of an item cannot be determined from a forced sale or from the selling price in a market different from that in which the item is generally sold. Because the stock of closely held corporations is not sold on an exchange, one cannot simply value such shares by examining the stock price of other corporations with actively traded stock engaged in a similar line of business. Other pertinent issues that affect the stock price have to be examined.
Section 4.01 of Revenue Ruling 59-60 provides the following, nonexclusive, list of fundamental factors to consider in valuing closely held stock:
* Nature and history of the business
* General economic forecast and outlook for the specific industry
* Financial condition and book value
* Earning potential
* Dividend-paying ability
* Goodwill or other intangible assets
* Stock sales and number of shares to be valued
* Market price of actively traded stock for corporations in the same or similar line of business. …