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Valuing Assets: Art or Science?
ppraising assets has been compared to nailing jello to a tree. Some would say that it is merely a matter of using all the available technology to reduce the jello to a form that can be manipulated to accomplish the desired objective. To others, valuation concepts are so illusive as to be meaningless, except when they are directly impacted. One factor complicating appraisals for business interests is that the standards for valuation are dependent on the purpose for which the valuation is sought. For instance, the client may be attempting to realize the maximum investment value of the property, as opposed to either "fair value" or fair market value often assumes that some synergy will increase the profitability and/or value of the enterprise. The concept of fair value originates from state cases primarily in dissenting shareholder actions.
In 1958, the Treasury Department defined "fair market value" as "the price at which the 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." Reg. 20.2031-1(b)For actively traded stocks and bonds, the rules for valuations are narrowly circumscribed. Reg.20.2031-2(b). However, when an active market does not exist, the issue surrounding the valuation process becomes substantially more complex. Accordingly, an objective of the prudent estate planner is to establish the market value of an interest in a closely held business by using a formula or other valuation method in a buy-sell or other ownership agreement.
Restrictive Agreements
Different standards apply to establish the value of a business interest in buy-sell agreements with related parties and unrelated parties. In either case, certain conditions must be met before a restrictive agreement will be effective in fixing the value for estate tax purposes.
Unrelated Parties
Three requirements must be addressed to effectively fix a stock purchase price for estate tax purposes between unrelated person: 1) the agreement must restrict the shareholder from disposing of the shares during his lifetime without first offering them to the corporation or other shareholders at the price fixed in the agreement; 2) decedent's estate must sell the shares at the agreed upon price; and 3) the agreement must set forth the price or method for valuation of the shares. Regs. 20.2031-2. The theory of this regulation is that an agreement between unrelated persons is presumed to be a bona fide business arrangement and not a device to pass the decedent's property to his natural beneficiaries at less than fair consideration in money or money's worth.
Related Parties
Three additional tests must be addressed to have the value respected for estate tax purposes when the agreement is with the related parties: 1) the agreement must be bona fide business arrangement supported by adequate consideration and not a substitute for testamentary disposition; 2) it cannot be advice to transfer property for less than adequate consideration to the transferor's beneficiaries; and 3) the agreement must be comparable to similar arrangement entered into in an arm's length transaction. Reg. 25.2703-1(b)(i). The obvious intent of these proposals is to require that stock prices for transfers between related persons are comparable to the fair market value of the shares. Where a portion of the shares is owned by related persons and a portion by unrelated persons, the related party rules will not apply unless more than 50% of the value of the interests that are subject to the restrictive agreement are with related parties. If a restrictive agreement does not preclude a shareholder from disposing of the underlying securities at any price that he chooses during his lifetime, it will not be effective for valuing the shares at death.
Example: An agreement obligating another shareholder to purchase whatever shares the decedent owned at death would not be given effect for purposes of valuing the shares. However, if the shareholder were required to first offer the shares at a given price to other unrelated shareholders, before selling on the open market, the price fixed in the agreement may be respected for death tax purposes even if the remaining shareholders were not obligated to acquire the shares.
A right of first refusal or option that is effective both during lifetime and upon death is sufficient. This presumes that the estate or deceased shareholder did not have the right to acquire all of the other shares prior to the option becoming effective, thus defeating the option. The restrictions on buy-sell agreements set forth in §2703 do not apply to agreements entered into before October 9, 1990, unless they are substantially modified after October 8, 1990. A substantial modification means any discretionary modification of a right or restriction under an agreement that results in other than de minimus change to the quality, value, or timing of the rights of any party with respect to property that is subject to the right or restrictions. Reg.25.2703-1(c)(1).
Valuing the Business Entity
Where there is no active market for securities being valued or an agreement effectively fixing value, the Treasury has set forth in Reg.20.2031-2(f) some of the relevant valuation factors. These factors that must be considered in determining the fair market value are as follows: the company's net worth; prospective earning power; dividend paying capacity; goodwill of the business; economic outlook of a particular industry; the company's position in the industry; the company's management; the degree of control represented by the block of stock to be valued; the value of actively traded securities of corporations engaged in similar lines of business; proceeds of life insurance policies payable to or for the benefit of the company; restrictions or options on the sale of such securities; and "other relevant factors."
Revenue Ruling 59-60, 1959-1CB 237, has become the seminal ruling in determining the factors to consider and weigh in valuing an entity. Rev. Rul. 59-60 uses eight intrinsic factors that should be addressed in valuing a business:
Nature of Business
Special attention should be paid to the stability of the entity's earnings and both internal and external influences on those earnings. For instance, interest rates affect real estate markets or may influence the success of subcontractors.
Economic Outlook
Economic conditions at the effective date of the appraisal must be addressed. This would include an evaluation of the company's competitive status.
Book Value
The financial statements of the company for the preceding several years may reveal trends that offer clues to the future prospects of the company. Book value is especially important with a holding company or other entity where a controlling interest is being valued, since it may reflect liquidation value. Book value may not be so relevant when valuing operating companies, labor-intensive businesses, or companies with substantial goodwill. In any event, capital assets not essential to the operation of he business (investment assets) should be revalued at market and should have a lower rate of return than operating assets.
Earning Capacity
The capitalized earnings approach attempts to determine the fair market value of the company by projecting its future earnings by applying a multiplier factor to its past earnings. The proper capitalization rate is dependent on the nature of the business, the risk involved, and the stability of earnings, often by reference to comparable companies in the public sector. The most difficult challenge of this method is finding true comparable in terms of business type and accounting methods. A business that is not truly comparable with the subject entity results in a flawed analysis.
Dividend Capacity
The dividend policy of most closely held corporations is determined by the key shareholders. Obviously, dividends actually paid may not be representative of dividends that would have been paid with comparable publicly traded companies. This, dividend capacity is what is important, not dividends actually paid. The difficulty of using the dividend paying capacity approach is that dividend capacity is based not only on overall profitability, but also on the corporation's current capital needs and future expectations. Identifying comparable entities becomes problematic since seldom are two businesses exactly situated.
Goodwill
The presence of goodwill and other intangible assets may be a major factor in determining the value of an entity. The ruling maintains that goodwill is based upon excess earning capacity. Therefore, the existence of goodwill will be dependent on earnings in excess of what could have been obtained from a fair return on the net book value of the tangible assets of the business. Thus, it is possible that there would be no goodwill if the earnings of the business ere less than a "fair" return on the entity's investment in capital assets.
Sales of Stock
Sales of stock may not be an important factor with closely held businesses, since the sales are seldom at arm's length. Isolated sales of minority interests may not control for valuation purposes. However, the presence of control or the lack thereof, as related to the size of a block of stock, will be an important factor to be addressed by the appraiser in determining the value of the interest subject to appraisal, with a premium applied to the control shares.
Market Price
The sale of shares in comparable, publicly traded corporations is the eighth factor enunciated in Rev. Rul. 59-60. The key issue is whether or not the entities comparable. The appraiser must identify a company listed on an active exchange or market which is most like the company being valued with respect to as many as possible of the other factors listed in the ruling. Once comparable companies are identified, then the appraiser must apply a discount for marketability. This discount is often determined by reference to the discounts applicable to restricted securities of publicly traded companies.
Once all of the factors are addressed, each must be weighed to determine its relative importance. The nature of the business may determine the relative weight of each factor. For example, if the entity sells to the public, earnings will be the most important factor, while book value may be the most important for a holding company. While this ruling provides a general approach to valuing closely held securities, appraisers have developed a multitude of other methods of valuing securities, which will no doubt be tested in the future.
Valuing interests in an entity
Once the value of the enterprise is determined, the estate planner then must consider the value of separate interests. Publicly traded shares are minority interests. Regulations 20.2031-2(b) and (c) and 25.2512-2(b) and (c) provide that shares of publicly traded securities be determined by actual sales prices or the mean of the bid and asking price. However, even with publicly traded securities Reg. 20.2031-2(e) acknowledges an exception if the transferor can show that the block of stock to be valued is so large in relation to sales in the existing market that it cannot be disposed of within a reasonable time without sales depressing the market. With closely held businesses, ownership interests may be valued differently depending on the control represented by the interest being valued and the marketability of the interest.
Minority Interests
The owner of a minority interest in a closely held business is at a serious disadvantage to the owner of a controlling interest. For instance a minority owner cannot force liquidation or control corporate policy. Since the controlling shares can elect a majority of the directors, the minority owner has very limited rights over dividend policy, executive salaries and other policy matters. The minority owner generally cannot force the controlling shareholders to sell the business, regardless of the merits of the proposed sale, rendering the investment value of the company moot. This also impacts the marketability of the shares, since the market for a minority interest is usually limited to the controlling shareholders.
A minority interest discount may not be justified if the basis for valuing the shares is the trading price of other minority interests. However, when the value of the shares is being interpolated from the value of the enterprise as a whole, a discount for a minority interest is appropriate. Moreover, a minority interest discount is appropriate even when an intrafamily transfer is involved. Regs. 20.2031 and 25.2512. Most courts have found that more than 50% of the voting interests represents control. Less than 50% is a minority interest. In California, 50% of the shareholders can force liquidation of a corporation. Corporations Code §1900. Even with this power to force dissolution, a 50% shareholder cannot control corporate policy other than to terminate its existence. Therefore a 50% shareholder should be entitled to some minority interest discount, but perhaps not as large as a 49% shareholder, since the 49% shareholder has no ability to liquidate the enterprise.
Proactive transfers
The courts are mixed in their decisions on whether an owner of controlling interest can reduce his or her ownership to a minority interest and claim that the transfers should be valued by taking into account a minority interest discount. In Heppenstall Est. v. Comr., 8 T.C.M. 136 (1949) and Whittemore v. Fitzpatrick, 127 F. Supp. 710 (D. Conn. 1954), the court found no authority to aggregate gifts between family members for valuation purposes. This is consistent with the IRS position in blockage cases where it commonly asserts that each gift must be valued separately to minimize the discount. Some courts have valued intrafamily transfers as if they were an integrated transfer of control requiring a valuation premium since the shares remain owned by a single family unit, especially when subsequent events cause the transfers to lack bona fides except for tax avoidance (death bed transfers, and sale of controlling interests shortly after the gifts). Murphy Est. v. Comr., 60 T.C.M. 645 (1990); and, Blanchard v. U.S., 291 F. Supp. 348 (S.D. Iowa 1968).
As might be expected, the IRS has ruled that transfers of minority interests to family members should be aggregated for valuation purposes, at least when a minority interest discount is at issue. PLR 8010017 claims that the unified transfer tax system would be frustrated by permitting minority interest discounts with transfers to family members whose ownership when aggregated represents control.
However, in Rev. Rul. 93-12, 1993-1 C.B. 202, the IRS acknowledge the propriety of using a minority interest discount in valuing shares, even where the donor controlled the corporation before the gift, using a "willing buyer-willing seller" premise, consistent with the Tax Court decision in Andrews Est. v. Comr., 79 T.C. 938 (1982). The IRS has indicated in TAM 9504004 it would not apply Rev. Rul. 93-12 in abusive situations, applying a form-over-substance theory. In TAM 0436005, the IRS further confused the issue by according a control premium to a minority interest where it was a "swing vote" that may control the entity when acting in concert with other related shareholders.
Community Property
Taxpayers in community property states have the advantage of claiming minority interest discounts even when the controlling interest is held as community property. The Tax Court in Bright v. U.S., 658 f. 2d 999 (5th Cir. 1981) refused to aggregate the ownership of the shares even when the surviving spouse held 27.5% individual and 27.5% as trustee for their children. This reasoning was followed in Lee Est. v. Comr., 69 T.C. 860 (1978); Acq. Rev. Rul. 93-12, 1993-1 C.B. 202.
Control Premium
The converse of a minority interest discount is the control premium that may be justified on the basis of the owner's right to dictate the affairs of the corporation. The Regulations specifically acknowledge this factor. Regs. 20.2031-2(f) and 25.2512-2(f). The control premium is applied to the entire block being valued, not just the shares representing the control factor.
Marketability Discount
A discount for lack of marketability is an additional discount that is available in valuing shares of closely held entities. This discount should be available for control stock as well as for minority interests. Obviously, a minority interest is substantially less marketable than a controlling interest and would be accorded a greater discount.
Conclusions
Similar to a person duplicating a masterpiece by using a paint-by-the-numbers kit, appraising the value of any asset is a mixture of art and science. The problem relates to the hypothetical nature of the transaction. There is no sale. There is no willing buyer and seller, reasonably apprised of all the facts.
When there is no active market, the appraiser is often on uncharted waters, attempting to balance the relative importance of each factor. In such cases, valuation is no more science than the egg yolks and other methods artists have historically used to create paints and colors for their palettes.
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