The Internal Revenue Code requires that business appraisers
use the “fair market value” standard when valuing a business for
gift and estate tax purposes. This article will explain the concept of fair
market value and how the provisions of certain corporate documents impact marketability
“Fair market value” is defined as the price at
which property 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. The determination of fair market value of some
assets, such as publicly-held stock, can be as simple as looking at the market
price in a recognized exchange, such as the New York Stock Exchange (NYSE).
With other assets, such as minority non-controlling interests in privately-held
businesses, determining the fair market value may not be so easy.
The Internal Revenue Service and the courts recognize that
the fair market value of a minority, non-controlling interest in a privately-held
business usually does not equal the shareholder’s proportionate share
of the underlying value of 100 percent of the business. Also, the fair market
value standard often requires that the proportionate share be reduced by, among
other things, some factor to account for the share’s lack of marketability.
What is Marketability?
Marketability, sometimes called liquidity, is defined as the ability to quickly
convert property to cash at minimal cost. Minority, non-controlling interests
in privately-held companies are generally difficult to sell and therefore
often suffer from a lack of marketability. The benchmark for determining
the marketability of an ownership interest in a business is three days, or
the time required to liquidate public stock that is traded on a national
stock exchange, such as the NYSE. Empirical evidence suggests that investors
are willing to pay a price premium for this level of liquidity, and conversely,
extract a price discount relative to stocks or other investment interests
that lack this high degree of liquidity. Studies track stock prices for certain
restricted stocks, for which Securities and Exchange Commission (SEC) rules
govern transfers, and initial public offerings in publicly-held companies.
The restricted stock studies compare the restricted stock prices to prices
of freely-traded shares in the same companies. The initial public offering
(IPO) studies compare the relationships between the prices of companies whose
shares were initially offered to the public and the prices at which their
shares traded privately before the public offering.
While other methods of determining the discount for lack
of marketability exist, business valuation analysts often use the restricted
stock and IPO studies to justify discounts and to calculate the amount of the
discount. The 1995 tax court decision of Mandelbaum v. Commissioner has
been widely cited by the business valuation community for its in-depth analysis
of factors impacting the discount, which valuators base on the use of averages
derived from the restricted stock studies. In Mandelbaum, Judge Laro
noted that ascertaining the appropriate discount for limited marketability
is a factual determination.
Calculation of the Discount
When business valuation analysts determine discounts for lack of marketability,
they usually calculate a starting point for the discount using the data in
the empirical studies and then adjust the discount upwards or downwards,
depending on financial and legal factors. Most importantly, the analysts
review the business’ corporate documents and compare shareholders’ rights
to those rights of shareholders in the empirical studies. When analysts find
impediments to transfer more onerous than those for the companies in the
empirical studies, they often increase the discount for lack of marketability
from the starting point.
As an example, by-laws or operating agreements for family-held
businesses often contain provisions that prohibit shareholders from transferring
their interests to non-family members. In contrast, shareholders of the publicly-held
companies in the empirical studies may transfer their shares freely. Accordingly,
business valuation analysts would increase the discount for lack of marketability
from the starting discount.
Other provisions in corporate documents which may affect
the level of the discount include:
on transfer. Other than outright prohibition of transfer to non-family
members, some corporate documents require consent for transfer of shares,
which might also affect marketability. Analysts also look for rights of first
refusal found in by-laws and buy-sell agreements. (Note that under common
law and the Internal Revenue Code, the price paid for a decedent’s
stock under a buy-sell agreement may or may not determine the value of the
stock for estate tax purposes).
access and reliability. The SEC requires the publicly-held companies
in the empirical studies to file audited financial statements and other corporate
information on a regular basis. Business valuation analysts look at corporate
documents that give shareholders the right to access the business’
books and records at certain times or require the preparation of financial
reports with a certain frequency. The quality and accessibility of these records
could have an affect on marketability of an ownership interest.
In conclusion, business valuation analysts calculate discounts
for lack of marketability on a case-by-case basis, comparing, among other things,
the business’ shareholders’ rights to those of publicly-held companies.
Attorneys drafting corporate documents should also be aware of their impact
on future gift and estate tax matters.
Karen R. Wilkowsky, Esq., AVA, is an attorney and accredited valuation analyst
with the accounting and business consulting firm of Hertzbach & Co., P.A.,
in Owings Mills, Maryland. She concentrates her practice in the areas of business
valuation, litigation support and forensic services.