Business owners often receive generous discounts when valuing company stock for gift tax purposes. Here’s how one couple transferred shares of their business to family members at a 40 percent discount.

When valuing gifts of stock in a closely held business, it’s not unusual for steep discounts to be allowed.

For gift tax purposes, the discounts are available for two reasons: The lack of marketability of shares in a closely held company and the lack of control that a minority shareholder has in the business.

Experts come up with the exact valuations using various complex methods, as one Tax Court case illustrated, but the bottom line for your clients is this: A professional valuation can help business owners pass a company on to their children at a greatly-reduced tax cost.

In the case, Donald and Dorothy Janda transferred shares of their company to their children. The company owned 94.6 percent of the Bank of St. Edward, located in a small agricultural community in Nebraska.

During the year in question, the Jandas gave each of their four children 6,850 shares of stock. At the time of the gifts, there were 130,000 shares outstanding so each gift represented a 5.27 percent interest in the company.

The couple filed gift tax returns reporting the transfers and valuing each block of stock at $145,357 ($21.22 per share), a figure calculated by a professional appraiser.

The IRS assessed gift tax deficiencies based on the valuation, which the Jandas challenged in Tax Court. They hired a valuation expert who was not the same person as the professional appraiser who valued their stock shares for the gift tax return.

At trial, experts for the Jandas and the IRS testified about how the stock transfer should be valued. Both experts agreed on the amount of the minority control discount (10 percent) but disagreed widely on the amount of the marketability discount. Take a look at their opinions:

The Janda’s expert stated that a 65.77 percent discount was appropriate, which made each block of stock worth $108,436 ($15.83 per share).
The IRS expert recommended that a 20 percent discount should be applied, which made each block of stock worth $269,821 ($39.39 per share).

The Tax Court judge rejected both experts’ opinions and came up with its own conclusion. It applied a discount of 40 percent for lack of control and marketability to the pre-discount fair market value of the company stock. So the value of each transferred block of stock was $211,186 or $30.83 per share.

Different Valuation Approaches

The Jandas’ expert used a mathematical approach called the “Quantitative Marketability Discount Model” (QMDM). However, the Tax Court said it had “grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65 percent.”

The court also rejected the IRS expert’s “benchmark analysis” approach stating, “We believe that he merely made a subjective judgment as to the marketability discount without considering appropriate comparisons.” He looked at only “generalized studies which did not differentiate marketability discounts for particular industries.”

In applying its 40 percent discount, the court noted that a hypothetical seller and buyer of the common stock would take into account that unloading the shares would involve “a private sale by the owner, a public offering by the company or a complete acquisition” of the business – options that could take an extended period of time and involve significant transaction costs. (Janda, TC Memo 2001-24)

When you need a business valuation for estate planning purposes, it’s critical to hire a qualified appraiser to solidify your position with the IRS and the courts.

Fair Market Value

“Because prices for shares of stock in a closely-held corporation are generally not available in the marketplace,” the Tax Court noted, it decides fair market value by looking at:

• A company’s net worth.
• A company’s prospective earning power.
• Dividend paying capacity.
• Goodwill and management.
• Position in the industry.
• The economic outlook in the industry.
• Degree of control in the company represented by the shares subject to valuation.
• Available values of securities in companies engaged in a similar business.
(Janda, TC Memo 2001-24)

To learn more contact Kent Pummel at [email protected].
copyright BizActions 2011