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Financial professionals involved with wealth management need to be aware of the effects of court cases relating to valuation of minority interests in small businesses and related securities.
Cases brought to the tax court in recent years have shed some light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests. This is an issue that is faced by professional advisors regarding gift and estate taxes, and for financial planning.
Prior to these cases, appraisers generally treated valuation of such discounts as a relatively minor adjunct to the valuation of the basic (majority) position. Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies (which can be sold, usually at a discount, from their unrestricted brethren), and by IPO studies of stock values before and after the Initial Public Offering. The courts have virtually all rejected such valuations in the case of closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation (and, if litigated, they should dramatically enhance the chances of winning).
All appraisals are a defensible opinion of value, prepared by an expert, for an ownership interest. Such an ownership interest is often referred to as a “bundle of rights.” Normally ownership in fee contains the most valuable bundle of rights, and lesser forms such as ownership of a security interest, lease, license, or other such instrument will reduce the bundle of rights – and hence the value. Further, restrictions on marketability or control of such minority interests results in a reduction of value.
If the asset to be valued is a minority interest, and/or if it is subject to restricted marketability, and/or lack of control, appropriate discounts to value must be applied. Over the years, many appraisers have adopted policies that separated the lack of control discount from the lack of liquidity or marketability discount. However, this appears to be a difference without a distinction. All discounts from value appear to be, in the end, evidence of impairments in marketability. The fact that such discounts, even if treated as separate discounts, are multiplicands which are multiplied by each other to derive a final discount figure illustrates this point.
Though the appropriateness of applying such discounts in these situations has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying the appropriate discounts. (IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but it is silent on “exempted securities,” which make up the vast majority of privately held securities. Both are defined and described in the Securities Act of 1933.) The cases indicate a complete analysis is required.
To quantify the “marketability discount,” because of a lack of available specific data, some appraisers have been relying on two sources of data from public company transactions; Initial Public Offering Studies, and Restricted Stock Studies to defend their discount opinion. The “standard” discount often derived from these studies is typically between 30% to 40%. Three cases against the Commissioner in 2003 found that such studies, based upon data from public companies, were not sufficient basis to value closely held private (exempt and unregistered) ownership. Upon a deeper look, the reasons are fairly obvious:
The case of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use of irrelevant data is unacceptable, and sets forth some basic factors which might comprise the discount, but specified that this list was not exclusive, and other factors may (and should) apply as the situation dictates. It basically states that a complete analysis must be done which is relevant to the subject. The factors listed to be evaluated included but were not limited to:
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.