What are some reasons that would cause you not to pay full price for something? Where do you find yourself looking for a discount from the purchase price? Probably just about anywhere you can if you are a prudent consumer. After all, why pay full price when you can get it at a discount?
But how would one know when a discount is appropriate when purchasing a specific asset? Ultimately, you can’t simply demand a discount on your regular goods and services such as auto maintenance, groceries, and gasoline. Discounts are found where the market commands them, and one type of asset on which the market has commanded discounts for decades is ownership in closely held companies, especially minority ownership. In this article, I will discuss in plain terms the various valuation discounts, the rationale for them, the benefits of them, and how they are determined.
There are many types of discounts applicable to minority interests, but the two most common, and the ones we will focus on in this article, are the discount for lack of control, and a discount for lack of marketability; often colloquially referred to as “minority discounts.”
A discount for lack of control is based on the fact that buyers in the market are not willing to pay full pro rata value for an interest in a company that will not grant them control or any management and participation rights. Effectively, this would mean the purchaser would be at the mercy of the manager(s) of the company and their decisions, which is considerably less desirable than having influence or control over the company.
A discount for lack of marketability is based on the fact that even if one wanted to sell their interest in a company, there is not an active market for it, and it could take a considerable amount of time and expense to sell, assuming it ever sells.
In general, these two discounts are considered independently of each other from an evidence standpoint, but the discount for lack of marketability is often increased due to the existence of a lack of control. Practically speaking, this makes sense, as a 100% controlling interest could be considered non-marketable, but a minority interest should virtually always be considered less marketable than a controlling interest.
The sheer existence of valuation discounts is possible through a combination of theory, empirical evidence, and a little bit of practicality. What I mean by that is when we combine the definition of fair market value with observable evidence for discounts on closely held entities, and an observation of the psychology of potential buyers, we can conclude that discounting the value of these interests makes sense. At a very high level, prudent investors are generally not willing to pay pro rata value for a minority ownership in a closely held company, but we need to be able to display evidence of that in our work so that we move beyond simply “feeling” that a discount makes sense and move into proof that they exist in reality.
All this is to say, when it comes to proving your discounts to the IRS, you need to have someone with the proper credentials and experience to display this evidence in a formal report, or it will be rejected, potentially even during an audit. Due to the utilization of valuation discounts as tools for lowering estate taxes (more on that below), the IRS gives great scrutiny to formal valuation reports, especially ones that list discounts on the value.
To illustrate some scenarios that could trigger discounts, let’s consider the reasons for owning your own business. Owning your own business is desirable, naturally, for the tremendous economic upside you could realize, but with that also comes control of the company. You get to be your own boss, and you call the shots in every aspect of the company. This doesn’t just include being the figurehead of the company, you also get to dictate the company’s image, management strategy, market participation, as well as behind the scenes decisions that are very appealing, such as when distributions are paid and how much. Potential buyers place a tremendous amount of value in the idea of buying a controlling interest in a company, especially a unilateral, 100% ownership where they don’t have to report to anyone but themselves.
Consequently, by the same token, potential buyers are considerably less interested in buying minority ownership, even with the most profitable of companies.
In a previous article, Paper It Up: The Importance of Ownership Agreements and Buy/Sell Documents, we alluded to the effect that operating agreements have on the discounts assessed to an ownership interest in a closely held company. The reason for this is that operating agreements are designed to govern how a company is legally allowed to run with the goal of avoiding disputes, but they also govern and restrict who can even become an owner of the company. Good operating agreements are airtight and are specifically designed to discourage transfer of ownership outside a small group of trusted people, often family members. Therefore, when considering that fair market value is the price between hypothetical, willing buyers and sellers, we have to consider what that buyer is getting when they purchase an interest in a closely held company, or what rights they are receiving in exchange. The operating agreement is a crucial document at this juncture, as it answers the question, “I have purchased an interest in the company, so now what am I allowed to do?” The answers to this question have been identified in valuation as some of the most important items affecting the fair market value of an interest; even as much as the company’s financials may affect it.
The following are vastly important non-financial items considered in the determination of discounts:
- Restrictions on who can sell their interest and to whom they can sell
- Whether the purchaser is admitted as a member or as an assignee (this is a big one)
- Who decides when distributions are made and the amount
There are other factors, of course, but these are three of the biggest we see and wanted to highlight for this article.
On the financial side of things, we will always consider the balance sheet and income statement of the company, as well as the asset mix when quantifying discounts. We will look at distribution capacity and actual distributions in particular. An entity that pays regular distributions will receive a lower discount than one that has not paid distributions in years. Additionally, a company that is very illiquid will appear less desirable, as even if management wanted to pay distributions, the idea that they may have to dispose of assets and pay taxes on the disposal in order to pay distributions is less than ideal and could potentially not be in the best interest of the company. That being said, even companies that only hold cash and marketable securities can still have large discounts if the company agreements are up to par.
As mentioned before, the rights attributable to the potential ownership interest should be considered in the hands of the buyer. A buyer would consider who their co-owners and partners would be. They would also consider that even if they bought into the company, unless the other owners vote (usually unanimously) to admit the buyer as a member, they would only have the rights of an assignee, which is, in effect, minority ownership. Assignees typically cannot vote or control the company at all, even if they own a significant percentage of the company. Assignees are often given the right to receive distributions in-line with their sharing ratio, but again, the decision to even make distributions would lie with the manager(s) or other owners who control the company. These factors, among others, impact the marketability of an interest. Another item affecting a lack of marketability discount is floatation costs, or, in other words, the costs of listing and marketing an interest for sale. These are usually the costs that give rise to a marketability discount on a unilateral, 100% controlling interest. Valuators often differ in opinion on whether a 100% interest should carry a marketability discount.
Valuators quantify discounts by leveraging studies of closely held entities and similar investments and how they trade on secondary markets, often by analysis of purchase price as a percentage of total net asset value. While case law and tax court rulings have supported and upheld the use of discounts in determination of fair market value, courts have not prescribed a specific method for arriving at a discount, and the discounts calculated depend entirely on the facts and circumstances of each company.
Finally, valuation discounts can be one of the most useful estate planning tools, as it allows an owner to transfer large amounts out of their estate at a discounted value. As estate and gift tax valuations call for the use of fair market value of a transferred asset by the IRS, the owner can typically gift minority ownership in an entity at a significant discount. Given that valuation discounts can be so substantial, this is an extremely popular method used by individuals with larger estates for reducing future estate tax and fulfilling gifts to heirs in one fell swoop. On top of that, when it comes to operating companies, an owner can also find out the value of their company from a professional valuator at the same time that they gift.
At the time of writing this article, the estate tax threshold is still rather elevated at $12.92 million for individuals ($25.84 million for married couples) as a result of the Tax Cuts and Jobs Act. That figure is set to reduce drastically when that act sunsets on December 31, 2025. If you have substantial assets that could potentially be subject to estate tax down the road, you should speak with an estate planning attorney as soon as possible to make sure those assets are placed within a legal entity (for liability purposes and to take advantage of valuation discounts in the event of a gift or estate tax event), and to discuss strategy for reducing estate tax liability for your heirs. Our valuators are credentialed and experienced in discussing valuations for estate and gift tax planning and our reports are designed to meet adequate disclosure requirements by the IRS. Contact our office to discuss how we can assist you with this process.