Act Now Before It’s Too Late

Valuation Discounts Considered in Gift and Estate Planning

With a look forward to December 31, 2025, when the current lifetime exclusion levels for estate taxes are slated to sunset, wealth planners and their clients have much to discuss. Valuation and estate planning professionals have a key opportunity to strategize and develop the best plans for family businesses and high-net-worth individuals.

With a look forward to December 31, 2025, when the current lifetime exclusion levels for estate taxes are slated to sunset, wealth planners and their clients have much to discuss. They have a key opportunity to strategize and develop the best plans for family businesses and high-net-worth individuals.

Under the 2017 Trump-era tax reform bill, the Tax Cuts and Jobs Act (TCJA), the lifetime estate and gift tax exemption jumped from $5 million (as indexed for inflation) to $10 million per person (as indexed for inflation). For 2024, the IRS threshold for estate tax is $13.61 million. (For the purposes of this article, we assume the level will remain at $13.61 million until December 31, 2025.)

The valuation of a business, whether a fractional interest or in its entirety, is an important component of gift and estate planning. While a valuation is only a piece of a lengthy and laborious process, a valuation requires time and extensive discussions with the client and other advisers to ensure the gift and estate planning is synchronized. And, with less than 14 months before the TCJA sunset, the time to act is now!

As a follow up to our recent whitepaper, “Now is a Good Time to Review Strategies for Estate Taxes and Gifting”, this paper discusses the use of minority discounts (also known as the discount for lack of control or DLOC) and the discount for lack of marketability (DLOM) when determining values of privately held businesses and fractional interests for gift and estate planning. Given the current high annual exclusion, the allowable discounts for lack of control and lack of marketability are tools that could save a significant amount of tax dollars for business owners and high net worth individuals.

In any valuation, we conduct an in-depth review of the organizational structure of the business before we perform our valuation analysis. We are engaged in a variety of valuation assignments ranging from family-owned or private partnerships and limited liability companies that have diverse business operations to passive asset holding companies, such as real estate holding entities and private funds and portfolios holding various asset classes.

A more complex organization may have several affiliates and/or fractional interests in other related entities or may be a multi-tiered entity. Certain businesses may be structured with several intervening layers of ownership that emerged as the business grew over several family generations, ownership changed, and assets diversified. There may be hundreds of interrelated entities with several layers of complex ownership in place. In general, the upper-tier entity provides a mechanism to centralize and roll-up holdings of partial interests in various entities. Thus, there may be an additional layer of ownership between a minority interest investor in an upper-tier company and a minority interest in the lower-tier entity that either holds certain assets or is involved in various segments of the business operation. Therefore, additional layers of valuation discounts may be warranted.

DLOC or Minority Discount

When considering the three traditional approaches to valuation, namely, the income, market, and asset-based approaches, if the resulting value reflects a controlling interest in the subject company, the owner of such interest must be able to execute an order to liquidate and receive the fair market value of the company. For fractional interests that are not actually imbued with this level of control, adjustment must be made to account for the fact that a prudent buyer would not be able to manage the assets or control investment decisions. This adjustment is typically made in the form of a minority discount or DLOC, which is calculated based upon a predetermined control premium.

To be able to apply a minority discount, a critical first step is to assess the provisions of an operating agreement or partnership agreement to ensure that provisions are in place that restrict owners of minority interests. These restrictions exist to centralize the management of the entity and preserve the operation of the business for the long-term. The following are a few of the prerogatives that are often not exercised by a minority interest investor which is common in all types of private investment partnerships and is prevalent in the real estate industry:

1. Control the day-to-day operations of the company;
2. Change the company’s by-laws or amend the operating agreement;
3. Set the general direction and investment policy of the company;
4. Sell any or all underlying assets of the company;
5. Liquidate the company;
6. Borrow funds on behalf of the company;
7. Determine the timing and amount of distributions;
8. Appoint, replace, or remove management; and
9. Hire and fire employees.

We may also defer to empirical data involving the sale of non-controlling interests. While the minority discount estimate is based on objective evidence, such as the empirical data, there are also subjective elements that deserve consideration. These subjective elements are generally evaluated based on our judgment and interpretation of specific prerogatives of control vested in the owner of the partial interest as outlined in the operating agreement mentioned above. For instance, based on the specific prerogatives of control of the interest as outlined in the operating agreement, an additional lack of control discount may be applied to the empirical data initially determined.

Once we have adjusted for lack of control of the partial ownership interest, a second adjustment is considered to account for the lack of liquidity and lack of marketability

DLOM

After the application of a minority discount or DLOC to a fractional interest, the next incremental adjustment in the valuation of partial, non-controlling interests is called DLOM.

The diagram below graphically illustrates the basic levels of value as we apply discounts: the starting point is the control level which emanates from the 100% controlling value of the company. The marketable minority (or “as-if freely traded”) level results from the application of a minority discount and, conversely, the application of a control premium from the freely traded value brings back to the control level of value. The lowest level is called the nonmarketable minority level which results from the application of a DLOM and represents the conceptual value of nonmarketable (i.e., illiquid) minority interests of privately held entities that lack active markets for their shares or units.

A DLOM is used to compensate for the difficulty of selling shares of stock that are not traded on a public stock exchange. For instance, shares of IBM, Google, or Apple trade on the New York Stock Exchange or another public stock exchange and can be converted to cash within three days. But investments in any privately held business can take months or even years to sell. The degree of impaired marketability is even more significant for an owner of a non-controlling (i.e., minority) interest in a privately held entity that owns assets that have a long gestation period for liquidation such as real estate. Because of the inherent riskiness of real estate as an asset class versus other alternative assets and the inability to sell a real estate asset quickly, the DLOM for a real estate holding entity may be higher than an entity that holds marketable securities.

In determining the DLOM, we review and dissect data obtained from various sources; the most widely used of which are restricted stock studies and pre-IPO studies. There are a multitude of empirical studies and methods to determine the DLOM. Some business appraisers turn to regression analyses and other mathematical formulas to better support their DLOM calculations. Aside from benchmark restricted stock studies and pre-IPO studies, option pricing models such as the Black-Scholes, Finnerty, and Chaffee models quantify the cost of an option based on the price of comparable publicly traded stock options and inputs related to the subject fractional interest.

Other quantitative models include the quantitative marketability discount model (QMDM) and long-term anticipation equity securities (LEAP). The quantitative models have been criticized due to the number of subjective inputs required to conclude on a DLOM.

In Mandelbaum v. Commissioner, Judge David Laro proposed a list of nine factors for valuators to consider when quantifying a DLOM:

1. Financial statement analysis;
2. Company dividend policy;
3. Nature of the company (history, position in industry, economic outlook);
4. Company management;
5. Amount of control in subject business interest;
6. Restrictions on transferability of stock;
7. Holding period for stock;
8. Company redemption policy; and
9. Costs associated with making a public offering.

There are many other methods used to develop DLOM, such as flotation cost or bid-ask spread methodologies; however, there is no consensus on what methods are definitive or acceptable. And none are likely to gain universal acceptance in the foreseeable future.

In order for DLOM to withstand IRS scrutiny, we synthesize the available empirical data with our intimate understanding of the specific facts, circumstances, and marketability features of the business, including: the transfer restrictions specific to the minority interest in the entity, the dividend policy, potential buyers of the interest, remaining term of the entity, riskiness and type of business operations performed or assets held by the entity, and size and value of the interest.

Thus, in the end, the determination of DLOM is intertwined with the determination of DLOC and ultimately, in the determination of the fair market value of the fractional interest.

The valuation process for privately held entities involves complexity and multiple considerations. Hiring a qualified and experienced business appraiser to prepare a comprehensive and defensible valuation report provides not only tax savings but can also potentially lower the risks of an audit and potential costly litigation.

Conclusion

We do not know what tax policies will be enacted. Despite this uncertainty, we think that it is certainly the best time now to consider taking advantage of the current higher exclusion of gifting, as the laws are most favorable. This assumes that individuals (including business founders) can afford to and want to give away their assets and business shares. The crystal ball is cloudy, so the time to act is now!

This article was previously published on CBIZ Insights, 2024, and is republished here by permission.

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Angela Sadang, MBA, CFA, ASA, ABV, is Managing Director, Valuation and Transfer Pricing Services, CBIZ Advisors, LLC.

Ms. Sadang can be contacted at (212) 207-3012 or by e-mail to angela.sadang@cbiz.com.