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A Question of Value

January 12, 2011

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When an estate contains stock in a closely held business interest, it is essential to have a professional valuation that uses recognized and accepted methods. The IRS often challenges these values – and the underlying methods must be able to withstand scrutiny from auditors and the courts. In one case, a decedent’s shares in a bank holding company were valued at $50 a share on the estate tax return, yet IRS auditors determined the value to be $320 per share.
“For unlisted stocks, the best indicators of fair market value are actual arm’s-length sales in the normal course of business within a reasonable time before or after the date of death … Where actual sale prices are unavailable, the stock value is determined by weighing the corporation’s net worth, prospective earning power, dividend-paying capacity, and other relevant factors.”

  – The U.S. Tax Court, in Estate

of Mildred Green, TC Memo 2003-348

 

Party determining
fair market value

Total Value

Price
Per
Share

IRS audit determination

$1,048,320

$ 320

Reported on estate tax return

 $  163,800

$  50

IRS determination at trial

$  860,000

$262.52

Tax Court

$  721,297

$220.18

Same Stock: Several Different Valuations

Careful valuation of closely held stock is critical in achieving estate planning goals. One case involving a Missouri bank holding company illustrates how an estate’s end result was far different from the decedent’s original plans.

Mildred Green owned 5.09 percent of Royal Bancshares Inc. (RBI) when she died. RBI had 62 shareholders at the time, with no one person holding a controlling interest. The corporation owned a subsidiary, Royal Banks of Missouri, which operated five branches in the St. Louis metropolitan area.

In her will, Green provided for the disposition of most of her assets, including the closely-held stock. Her will directed that one-half of the “rest, residue and remainder” of her estate’s property go to a charitable foundation and the other half to a trust for her three grandchildren.

The IRS audited the estate and determined that the value of the Royal Bancshares stock was more than six times what was reported on the estate tax return. A federal estate tax and generation skipping tax deficiency of $1,205,541 was assessed and the bequests to the charitable foundation and the grandchildren were reduced.

At trial, the Tax Court explained that “valuation of stock is a purely factual determination; there is no one universally applicable formula.” And as the right-hand chart shows, the different parties came up with diverse valuations. Part of the complicated calculations allocated two discounts to the value of the stock shares due to a lack of control and a lack of marketability.

These two discounts come from the fact that a buyer would be unwilling to pay full price for an interest in a closely-held company since the shares can’t be easily sold and don’t provide opportunities for controlling matters such as salary, dividends, contracts and mergers.

But despite the discrepancies in the total valuation of the Royal Bancshares in the Green estate, the court noted that the IRS’ expert witness and the estate’s expert witness agreed “to a considerable extent on the valuation of RBI stock … The greatest difference in the experts’ respective positions relates to the lack of marketability discount.”

Here is a rundown of the determinations:

Lack of control
discount

Lack of marketability
discount

IRS expert witness

15 percent

25 percent

Estate expert witness

17 percent

40 percent

In the end, the Tax Court ruled there was a 17 percent discount for lack of control and a 35 percent discount for lack of marketability.

Complex methods are used by business valuation professionals to arrive at a fair market value of closely-held stock shares. It is not unusual for IRS auditors to challenge the amount, as they did in the Green case. So it is critical to engage a professional who applies recognized and accepted valuation approaches that can withstand IRS scrutiny. Contact our firm if you need more information.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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