Wealth Planning News

Vol. II, No. 6

Why Valuation Discounts?

Discounts reflect economic reality. A fractional interest in a closely held company is usually worth only a fraction of the fractional interest’s total percentage of the company. Example: You would not pay $490,000 for a 49 percent interest in a closely held business with assets of $1 million. You may never be able to get your money out, and would have to look long and hard to try to find some buyer foolish enough to take your interest knowing he would be outvoted on every issue, and would have no control of the entity.

Closely held business interests are also normally subject to restrictions on transfer contained in agreements among the owners. Transfer restrictions assure that ownership stays in the hands of family members or other persons acceptable to family members. A closely held business is not an entity whose shares or ownership interests can be freely sold to the general public.

What Valuation Discounts Apply?

1. Lack of Marketability. There is no ready market for an interest in a closely held business entity. These interests are not traded on any exchange and are not even found in newspaper ads. Lack of marketability discounts are magnified by the types of transfer restrictions that normally apply to closely held business entities.

2. Lack of Control. Minority interests lack voting power to control the company. So minority ownership interests have less value to potential buyers. You can most easily understand this lack of control discount when you think of a limited partnership interest. Instead of merely being outvoted on each issue, limited partners have no vote and no control in the management and operation of the limited partnership.

Do Asset Types Affect Discounts?

Type of assets owned by the entity is only one factor to consider. Why? Because assets contributed to an entity are no longer owned by any person. Instead they are owned by the entity.

The type of assets owned by the entity do affect the value of the entity as a whole. So if the assets are all publicly traded securities the value of the entity is pretty easy to determine, and the total company value is not affected by any adjustments for lack of marketability. But this does not mean that fractional entity interests, especially limited partnership interests, have any ready market.

Assets that are themselves difficult to sell will reduce the value of the company owning such assets. So type of assets does have some effect on company value.

After value of the entity as a whole is determined, the next step is to value fractional interests in the entity itself. Example: What would you give to buy a 40% nonvoting interest in an entity owning $1,000 of cash, knowing you cannot control how the cash is used, cannot control distribution of income produced, and you cannot force a liquidation of the entity? Is that 40% interest worth $400? Would you give even $100 for that interest, knowing the entity may go on for the rest of your life without hiring you or paying you any dividend, or dissolving?

Bottom line: Taxes are based on market value of the entity interest one owns, which in turn is based on what a willing buyer would pay to a willing seller for the fractional interest where neither is under compulsion to buy or sell. The very nature of a closely held business entity results in a discount for lack of market and lack of control. With proper design and proper choice of the closely held business entity, the discounts can be maximized.

Call us for a free consultation on this topic.