Thoughts on the IRS’s Proposed End of Valuation Discounts

In early August, the IRS proposed final regulations that could severely curtail estate planning options – and potential tax savings – for owners of closely-held businesses. What are the implications of these regulations for business appraisers?

Normal adjustments to value

Valuation adjustments (or “discounts” as they are commonly known) proceed from the concept of “levels of value” in business valuation parlance. The following table illustrates this concept:

Levels of Value Based on Characteristics of Ownership

VALUE

PRICE/SHARE

PREMIUM / DISCOUNT / COMMENT

SYNERGISTIC CONTROL, MARKETABLE

$12.00

20% premium over Control, Marketable value

CONTROL, MARKETABLE

$10.00

25% control premium over Minority, Marketable value; 20% discount from Synergistic Value

MINORITY, MARKETABLE

$8.00

Minority shares if freely traded

MINORITY, RESTRICTED

$6.00

25% discount from Minority, Marketable value for lack of marketability

MINORITY, NON-MARKETABLE

$4.40

20% discount from Minority, Restricted value for private company stock

  • The highest level of value for a subject security is “synergistic control, marketable.” This level of value occurs in the securities markets when a strategic buyer pays a significant acquisition premium above the publicly traded share price for a synergistic acquisition of a publicly traded (and so instantly liquid, or marketable) company.
  • The next highest level of value is “control, marketable,” as represented by acquisition premiums paid by financial (versus strategic) buyers for public companies. Financial buyers generally lack the ability to extract synergies from acquisitions, so are unwilling to pay the acquisition premiums that strategic buyers might pay.
  • The “minority, marketable” level of value is the next highest level of value. This value is represented by the trading prices of single shares of stock of publicly traded companies. Because the owner of a single share lacks the voting interest power to influence the direction of a company, this level of value may be considered to represent the value of a minority interest.
  • A lower level of value, “minority, restricted” is evidenced in the market by prices paid for small blocks of restricted stock of publicly traded companies. Small blocks of restricted stock have limited liquidity. This is because it is possible, under current trading rules for restricted stock, to dispose of the interest over a period (depending on the size of the block relative to the trading volume of the underlying feely traded security) ranging from a few months to several years. Due to this restricted marketability, blocks of a company’s restricted stock often trade at lower prices than the company’s otherwise identical publicly traded securities.
  • The lowest level of value is “minority, non-marketable” and is estimated in the marketplace by observing the prices paid for large, illiquid blocks of restricted stock. These blocks may take years to dispose of, again due to restricted stock trading rules that limit trading volumes over time.
  • Finally, a level of value that is not observable in the public securities markets is “control, non-marketable.” This level of value is represented by prices paid for controlling interests in private companies.

Valuation discounts (I prefer “adjustments,” because to say that something is discounted implies that it’s somehow priced below its actual value) are real in an economic sense for two fundamental reasons:

  • Buyers will pay more for a business interest they can exert control over (for example, to make distributions to pay taxes) than one they cannot control. Thus, less control equals more risk equals lower value.
  • Buyers will pay more for a business interest they can readily sell (this is called being marketable) versus an interest that can’t be readily sold. All else equal, a business interest (such as a share of stock) that is traded daily on a public stock exchange is worth more than that same interest would be if privately held. There is risk in the unwanted holding period. So, less marketable equals more risk equals lower value.

A business interest lacking both attributes (minority non-marketable) can be much less valuable than that same business interest with these attributes.

Proposed IRS regulations

In a nutshell, the proposed IRS regulations  ignore the economic reality of higher risk and lower value associated with the lack of control and lack of marketability of minority interests in closely held businesses. They do this by (a) disregarding restrictions on control and transferability in governing documents, thereby attributing controlling interest ownership to minority interests through broad family attribution; and (b) assuming a “put” right for the seller of an interest which does not exist in the real world.

Disregarding the restrictions in effect determines the value of an interest in a business or family limited partnership to be not less than “minimum value” as defined by the proposed regulations. Minimum value is defined, effectively, as the fair market value of the entity’s assets less its liabilities, so that net asset value (on a market value basis) and minimum value are essentially the same.

The proposed regulations describe the put right as follows:
The term “put right” means a right, enforceable under applicable local law, to receive from the entity or from one or more other holders, on liquidation or redemption of the holder's interest, within six months after the date the holder gives notice of the holder's intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption ... [T]he term “other property” does not include a note or other obligation issued directly or indirectly by the entity, by one or more holders of interests in the entity, or by one or more persons related either to the entity or any holder of an interest in the entity ...

Under the proposed regulations, gift and estate tax returns will reflect higher values, resulting in higher tax collections. Entities covered by the proposed regulations include corporations, partnerships, limited partnerships, and limited liability companies. Please consult your legal, tax, and investment advisors for the details, but this is the essence of the proposed regulations.

Implications for Business Valuation

The IRS’s proposed regulation has at least two significant implications for business valuation:

  • Hypothetical conditions the regulation assumes may not be compatible with the definition of fair market value.
  • The “put right” assumed in the proposed regulations has unintended consequences that could undercut the value of the enterprise being appraised.

Problems with the hypothetical conditions and fair market value

The venerable IRS Revenue Ruling 59-60 defines the fair market value standard as the standard to be used for gift and estate tax appraisals. Fair market value is defined there as “the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

As noted above, the proposed regulations create hypothetical conditions by disregarding legal and economic circumstances that exist for business owners in the real world. This triggers a requirement for appraisers following business valuation standards. Business appraisers following professional standards such as SSVS No. 1, the AICPA’s Statement on Standards for Valuation Services , or the Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP)   must disclose hypothetical conditions in business appraisals. Appendix B of SSVS 1 (the International Glossary of Business Valuation Terms) defines a hypothetical condition, sensibly, as “that which is or may be contrary to what exists, but is supposed for the purpose of analysis.”

Meanwhile, the USPAP defines a hypothetical condition as:

a condition, directly related to a specific assignment, which is contrary to what is known by the appraiser to exist on the effective date of the assignment results, but is used for the purpose of analysis.

Comment: Hypothetical conditions are contrary to known facts about physical, legal, or economic characteristics of the subject property; or about conditions external to the property, such as market conditions or trends; or about the integrity of data used in an analysis.

Business valuation standards require that hypothetical conditions be clearly and prominently disclosed in valuation reports. Here is the language from SSVS No. 1:

Hypothetical conditions affecting the subject interest may be required in some circumstances. When a valuation analyst uses hypothetical conditions during a valuation or calculation engagement, he or she should indicate the purpose for including the hypothetical conditions and disclose these conditions in the valuation or calculation report (paragraphs 52(n), 71(o), and 74).

USPAP (Standard 9) also requires the business appraiser to “identify any hypothetical conditions necessary in the assignment.” Here’s the comment to that definition:

  • A hypothetical condition may be used in an assignment only if:
  • use of the hypothetical condition is clearly required for legal purposes, for purposes of reasonable analysis, or for purposes of comparison;
  • use of the hypothetical condition results in a credible analysis; and
  • the appraiser complies with the disclosure requirements set forth in USPAP for hypothetical conditions.

USPAP Standards Rule 10-2 requires that the valuation report must “clearly and conspicuously state all extraordinary assumptions and hypothetical conditions and state that their use might have affected the assignment results.”

Under the proposed regulations, the disregarded restrictions that otherwise would indicate a lack of control and lack of marketability in the subject interest, and the assumed put option result in a hypothetical negotiation between buyer and seller that would likely never occur. This nullifies the transaction between willing buyer and willing seller that is assumed under the fair market value standard. The seller would be there, happy to sell his or her interest for the “minimum value” (undiscounted price), but the buyer would not show up for the hypothetical negotiation. No willing buyer would be willing to pay what is essentially the pro rata value of the enterprise (representing the control, marketable level of value in the above illustration), even with an assumed put right in place.

Problems with the put right

Apart from problem of meeting the fair market value requirement under the hypothetical conditions assumed by the proposed regulations, the put right creates issues related to the value of the entity itself (or any portion of it). The fictitious put right assumes that all holders of interests in the subject entity have the right to exercise a put option at any time, and to receive sale proceeds within six months of its being exercised. The assumption that every owner has a put right puts the business purpose and very existence of an enterprise at risk. Why? Because if an owner can demand and receive within 60 days “minimum value” for his or her interest, how could a business reasonably operate or plan for the future?

Clearly, the buyer of an interest in an enterprise subject to such a put right by any of the owners would consider the added risk of the other put rights on the continued existence (versus liquidation) of the entire enterprise. Generally, a company’s value is lowest in a forced liquidation scenario. The unknown extent and timing of put rights that can be exercised thus serves to increase risk and lower the value of the entire enterprise. The only logical conclusion is that the value would be below the “minimum value” promulgated by the proposed regulations.

So what?

Every business appraisal rendered under the proposed regulations will be considered hypothetical in nature – yet under the hypothetical conditions assumed, a transaction between a willing buyer and seller would likely never occur. For the reasons outlined above, the fair market value of a transferred interest under the proposed regulations will likely be less than “minimum value” and will require analysis by the business appraiser of the effects on the enterprise of the put right of each interest, not just the subject interest. This analysis assumes that a transaction could even occur, given the assumptions of the proposed regulations. It will be interesting to observe how the business valuation community grapples with these issues if these IRS regulations become final as proposed.