How Discounts can Lower the Taxable Value of Your Business for Estate Planning
Business appraisers as part of valuation standards and accepted practices will often use applicable discounts in valuing privately held businesses. The identified value for equity interests as part of the overall estate are what the IRS use to determine the proper taxation. Meaning all else equal, if discounts are correctly applied to the said equity interests, this lowers their value, and hence lowers the taxable amount for estate planning / gifting of equity interests. As a result, discounts, can have a significant impact on the future tax liabilities for owners and their families. In this Business Valuation article, we will explain which discounts can be applicable to your business and how these are determined.
First, it’s important to understand the standard of value on which your privately held business is valued. Under the standard of valuation for gift and estate tax purposes most used by the IRS is ‘fair market value’, where the business valuation expert will find the value at which a business would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts, as defined by the IRS. The standard of value is an important part of the valuation framework because it impacts what discounts are applicable.
Business Valuation Discounts
The most common valuation discounts applicable to privately-held businesses are for lack of marketability (“DLOM”), lack of control (“DLOC”), key man risk, and discount for lack of liquidity (‘DLOL”). These discounts can add up to 70% of a business’ equity value, depending on several factors. The reasoning behind each discount is as follows:
- Discount for Lack of marketability – refers to a discount applicable to assets that don’t have a readily available market to be sold on. For example, a 10% minority interest in a privately-held business has a very limited amount of marketplaces where it can be sold, for this reason, investors will apply a discount as all else equal, as the buyer is compensated for the cost of lack of marketability.
- Discount for Lack of control – A non-controlling interest is considered to be less valuable than a controlling interest in a company, since control prerogatives, like compensation determinations, policy setting, deciding to sell or liquidate, and declaring dividends, can impact a business value. Thus, when non-controlling or minority interests are valued for a privately-held company, a discount for lack of control is often applied.
- Discount for Key Man Risk – For some privately-held businesses, a discount for key man risk might be applicable when the cash flows generated by the company are closely tied to a key person. For example, the ability to generate revenue, or operational know-how being tied to one key person. Thus, if the key man was to become incapacitated, pass away, or simple quit, the same cash flows would be at a higher risk of not being generated, and hence a discount is applied.
- Discount for Lack of Liquidity – Liquidity refers to the ability of converting an asset into ready cash without affecting its market price. Liquidity has a close relationship to marketability; generally, a non-marketable asset will be illiquid, but not the other way around. An example is a 10% non-controlling interest in a private business which can be non-marketable vs a 100% controlling interest in a private business which is marketable through different avenues such as sale by an investment bank, or business broker, but it will still take on average of 6 – 9 months to be sold vs the 3 days that a stock of a public company takes to be sold.
- Discount for Built-in Gain Taxes – Some privately-held businesses have assets that would be subject to capital gains tax if sold, which can be taken into account when valuing the business for estate tax purposes. For example, John owns a privately-held business that specializes in the manufacturing of widgets. The business has been profitable for many years and has accumulated a significant amount of inventory. The inventory is valued at $500,000, but if it were sold, it would generate a capital gain of $200,000. Thus, in order to avoid double taxation, built-in gain taxes reduce the value of the business.
How to Determine / calculate a Privately Held Business Discount
Business owners will need a qualified business appraiser to determine appropriate discount(s) based on an analysis of the company being valued and specific case factors such as, the size of the interest, or restrictions outlined in the articles of incorporation / shareholder agreement, among others. This is a very sensitive process as erroneously determining a discount might lead challenges from the IRS, including audits, fees, hefty penalties, and litigation fees, in addition to the appropriate estate tax liability determined by the courts.
Adequate disclosure of gifts for gift tax purposes and non-gift completed transfers to family members often require a qualified appraisals, as defined by Treas. Reg. § 301.6501(c)-1(f)(3). These include that the valuation expert is qualified to appraise the gifted asset under relevant qualifications such as education, experience, and/or membership to professional appraisal associations. Courts usually take note of accreditations, professional affiliations, and credentials, such as the CFA, ABV, ASA, CVA, and CBA. Click here to see an article on how to select the right accredited appraiser.
Valuation appraisers will use different tools to determine the discounts applicable to privately-held business interests such as:
- Discount for Lack of Marketability: Two types of empirical studies are commonly used to determine discounts for lack of marketability which are restricted stock studies and pre-initial public offering (pre-IPO) studies. Approximately 15 restricted stock studies exist which analyzed the differences in value of restricted stock to their respective publicly traded stock, restrictions that were imposed by the SEC. Pre-IPO studies compare the price at which a stock was sold while it was still privately-held with the price of the same company’s common stock after its IPO (now a public company).
- Discount for Lack of Control: The discount for lack of control is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds to the net asset value per share of the same funds. For companies holding real estate, the discount is determined by comparing the trading price of shares of a selected sample of registered real estate limited partnerships (RELPs) or real estate investment trusts (REITs) to the net asset value of the respective shares.
- Discount for Lack of Liquidity (“DLOL”): In order to estimate a DLOL, the analyst should focus on the results of studies that quantify the appropriate discount for 100% of a closely held company compared to the value of a publicly traded equivalent company. There are three studies that are consistent across time in their findings. The Koeplin, Sarin, and Shapiro Study, the Block Study, and the De Franco et al Study.
- Key Man Discount: Although there is no empirical methodology for establishing key man discounts, the discount should consider services rendered by the key person and degree of dependence on that person, likelihood of loss of the key person (if still active), health and age of the key person, risk of person to compete (without a noncompete agreement), depth and quality of other company management, amongst others, and the impact on cash flows if any of these impacts were to happen.
- Discount for Built-in Gain Taxes: The discount for built-in gain taxes is determined based on the applicable capital gain taxes that would be generated from selling different assets held by a company.
Current Tax Law and Valuation Discounts
Under the current tax law, people can give $12.92 million in 2023 per person in gifts over the course of their life without incurring gift taxes. There are set amounts per year whilst living, and then the remainder after death. However, this provision is set to expire at the end of 2025.
The Build Back Better Act (H.R. 5376) was introduced in the House of Representatives on September 27, 2021. If this bill is signed into law, non-operational assets will not be applicable for discounts. For more context, currently, when valuing a business, discounts are applicable to the 100% equity held by a business, even real estate, related party loans, and/or investments in assets not related to the operation of a business. If the bill passes, these assets will not be applicable for discounts.
Valuation discounts have a significant impact on estate tax liabilities as the privately-held businesses value can be discounted by up to 70%, depending on several factors. Nevertheless, the application of discounts should be determined by an expert business appraiser to avoid potential IRS challenges, audits, penalties, and worse, litigation.