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Gift and Estate Tax Valuation Essentials

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If an individual holds an interest in a closely held entity, careful consideration should be given to the valuation of this entity for gift and estate tax reporting purposes, and how this valuation will affect their tax burden.

Apr 26th 2021
Director Opportune LLP
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While personal and corporate income tax tends to receive most of the media attention, it’s important to remember that gift and estate taxes can also have a profound impact on an individual’s long-range financial planning.

Upon performing a valuation of shares of a closely held entity for gift and estate tax purposes, accountants should keep the following factors in mind:

1. IRS Guidance

Valuations for gift and estate tax purposes must follow the tenets outlined in IRS Revenue Ruling 59-60. First set forth in 1959, Revenue Ruling 59-60 outlines the approaches, methods, and factors to consider when valuing shares of a closely held entity where market quotations are either unavailable or based on scarce trades. The factors to consider under Revenue Ruling 59-60 are as follows:

  1. The nature of the business and the history of the enterprise from its inception.
  2. The economic outlook in general and the condition and outlook of the specific industry.
  3. The book value of the stock and the financial condition of the business.
  4. The earning capacity of the company.
  5. The dividend-paying capacity.
  6. Whether or not the enterprise has goodwill or other intangible value.
  7. Sales of the stock and the size of the block of stock to be valued.

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

2. Narrative Report

With tax valuations, a great deal of emphasis is placed on the quality of the narrative report. This report should be detailed as to the approaches and assumptions utilized and should discuss how each of the Revenue Ruling 59-60 factors outlined above were considered. The report should also discuss in detail the considerations mentioned in #2 and #3 below.

3. Different Approaches to Value

Valuations of closely held stock should consider various approaches to value, which could include an income approach analysis via discounted cash flows, and the market approach via guideline public company and/or guideline transaction multiples. The results of these two approaches should be compared with the company’s underlying book value to assess for reasonableness.

Also, within both approaches, great care should be taken to ensure that the financial projections being utilized are appropriately vetted and reviewed and that they account for current company, market and industry conditions. When selecting guideline market transactions and/or guideline public companies for use in the market approach, the guideline selection process, the selection of which multiple to use (e.g., lower quartile, median, or upper quartile of the comps, etc.) and any weightings that are applied between the various approaches should be appropriately documented.

4. Valuation Discounts

In many instances, additional discounts may need to be applied to the value being estimated. These discounts, which have been enumerated over the years in a variety of court cases, account for two possible factors. The first discount, a discount for lack of control, accounts for the view that a shareholder of a single share of stock, or a small block of stock doesn’t have the ability to impact company operations and make important decisions like a controlling shareholder would.

The second discount, a discount for lack of marketability, accounts for the view that a shareholder of a closely held enterprise cannot sell his or her interest as easily as a shareholder of a publicly traded enterprise. Both discounts require a great deal of research and both qualitative and quantitative analysis and should be based on the facts and circumstances of the entity being valued, as well as the size of the block of shares being valued.

For example, a discount for lack of control may not be appropriate in instances where a controlling interest in an entity is being valued. Likewise, a discount for lack of marketability may not be appropriate in instances where liquidation of the entity is imminent, and the estimated holding period represents a very short period. Such discounts should have a basis in market-derived data.

5. Not One-Size-Fits-All

The process of valuing closely held businesses for gift and estate tax reporting purposes is not a cookie cutter, one-size-fits-all exercise. Great care and consideration should be given to the analysis, both quantitatively and qualitatively. Discussions should be held with the management team of the subject business regarding its history, current operations, and outlook.

Every business is different, and even with each business, different classes and blocks of shares have varying characteristics. Revenue Ruling 59-60 specifically points out that “no formula can be devised that will be generally applicable to the multitude of different valuation issued arising in estate and gift tax cases,” and that “a sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process.”

Conclusion

As the potential for changes in gift and estate tax law receives more attention, so too will the valuations of closely held businesses for gift and estate tax reporting. Sometimes, disputes can and do arise between the IRS and taxpayers because of incomplete, poorly defended, or documented valuations. Individuals needing valuations for this purpose should be prepared with defensible, supportable analyses that can stand up to IRS review.

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