Valuation discounts and their limits

In short

A friend of mine who owns a family business once told me his accountant said the shares were worth far less than the company itself. He laughed, and then he asked if that could possibly be true. If you hold a share in a family company or partnership, you are likely wondering the same thing. A valuation discount is a lower price placed on a minority piece of a business because that piece is hard to control and hard to sell. Gift and estate tax law counts a gift at its fair market value, so a defensible discount can shrink the taxable number. The Internal Revenue Service pushes back when the discount looks like a trick rather than a fact. Get a written appraisal from a qualified, independent appraiser. Report the gift on a gift tax return so the clock starts running on the period for audit.

The whole of it

What it is

I once watched an old farmer try to sell one fifth of a field he shared with his brothers. Nobody wanted it. A buyer would get no say over what was planted and no way to force a sale. So the farmer took a low offer, and he was right to. That small story is the heart of a valuation discount. When a person gives away a minority stake in a closely held business, the stake is worth less than a simple slice of the whole. The law asks what a willing buyer would pay a willing seller, with neither one forced to act. That standard comes from the Treasury regulations under the gift and estate tax rules, and the courts have used it for decades.

Two discounts come up again and again. The first is a lack of control discount. A minority owner cannot hire the manager, set the pay, or decide when to sell the assets. The second is a lack of marketability discount. There is no stock exchange for shares in a private family company, so a seller may wait a long time and take a lower price. Appraisers often apply both. Which one fits depends on the facts of the business, and there is no fixed rate set by statute.

You might feel a bit uneasy about all this, and that is a sensible instinct. The discount is not a loophole someone invented last week. It reflects a real fact about how hard it is to own a sliver of a private company. Still, it is a fact that must be shown, not assumed.

How it works

If you are planning to pass part of a family company to your children, the order of events matters. A donor gives a minority interest to a child, or to a trust for the child. The donor then reports that gift on a gift tax return, which is IRS Form 709. The return states the value of the gift. That value comes from a written appraisal, and the appraisal explains each discount and why it applies.

The discounted value counts against the donor's lifetime gift and estate tax exemption, which is a total amount a person may transfer free of federal tax. Congress sets that amount, and it changes by year. At the time of writing, the figure is the current figure, which the official source publishes each year. A lower reported value uses up less of that exemption. That is the whole reason people care.

Here is the part that trips people up. The donor does not just get to name a number. The appraisal has to hold up if the IRS examines it. The agency can challenge the value, and if it wins, the donor owes more tax, and sometimes a penalty. Filing the return also matters for timing. When a gift is adequately disclosed on the return, the period during which the IRS may question it begins to run. Without that disclosure, the period may stay open.

A family business often sits inside an entity, such as a limited partnership or a limited liability company. The operating agreement sets the rules for who may sell, who may vote, and what happens when someone wants out. Those terms are a big part of the discount story, because they decide how weak the minority stake truly is.

The numbers, and where to find yours

Three kinds of numbers drive this topic. The first is the value of the whole business or the pool of assets. The second is the percentage a donor gives away. The third is the discount rate the appraiser applies. Only the first two come from your own records. The third comes from the appraiser's work, and the appraiser must support it with evidence.

To find the value of the whole, look to your balance sheet, your tax returns, and any recent outside offers. For a company, an appraiser will study earnings, assets, debts, and comparable sales. For a pool of securities held in an entity, the appraiser starts with the market value of what the entity owns. You can find the percentage you hold in the operating agreement or the partnership agreement.

The annual exclusion is another number to know. Each donor may give a set amount to each person every year without using any exemption or filing for that purpose, and the figure is the current figure, which the official source publishes each year. The estate and gift exemption was named above. Both are published each year by the Internal Revenue Service, so check its official pages for the current amounts rather than trusting an old article, including this one.

The tax rate on transfers above the exemption is also set by law, and it is the current figure, which the official source publishes each year. Look for these on the IRS website under gift and estate taxes.

A worked example

Let me tell you about a woman I will call Margaret. She owns 100 percent of a family holding company that owns rental property. An independent appraiser finds the property, after debt, is worth $40,000,000. Margaret wants to give 20 percent to a trust for her daughter.

Without any discount, 20 percent of $40,000,000 is $8,000,000. That is the plain slice.

Now the appraiser studies the agreement. The 20 percent stake has no vote and no right to force a sale. The appraiser supports a combined discount of 25 percent, and writes down the reasons. A 25 percent discount on $8,000,000 is $2,000,000. The reported value of the gift is then $8,000,000 minus $2,000,000, which is $6,000,000.

So the gift uses $6,000,000 of Margaret's exemption instead of $8,000,000. The difference is $2,000,000 of exemption saved. If that $2,000,000 had been taxed at a rate of 40 percent, the tax at stake would be $2,000,000 times 0.40, or $800,000. The rate here is only an illustration for the arithmetic. The actual rate is the current figure, which the official source publishes each year.

Notice what Margaret did not do. She did not pick 25 percent out of the air. She hired someone independent, kept the reasons on paper, and filed Form 709 with the appraisal attached.

Where it goes wrong

I have seen good people get into trouble by treating the discount like a coupon. It is not one. The first way it goes wrong is a weak appraisal. If the appraiser works for the family, or uses a number with no support, the IRS has an easy target. Courts have turned down discounts that rested on thin evidence.

The second problem is an entity with no real purpose. Suppose a person puts a pile of marketable stocks into a partnership only to claim a discount, then keeps full use of the money. The IRS may argue that the assets should be pulled back into the estate. Section 2036 of the Internal Revenue Code is one rule it uses when a person keeps the benefit of transferred property. The partnership needs a real reason to exist beyond saving tax, and the donor must respect it.

Third, timing and sloppiness hurt. A donor who forms an entity and gives away shares on the same day invites questions. A donor who pays personal bills from the entity's account invites more. Fourth, the rules can change. Congress and the Treasury have looked at limiting these discounts before. Any plan should be read against the law as it stands on the day of the gift.

Last, a discount cuts both ways. A lower value at the time of a gift can mean a lower tax basis for the person who receives it, which may raise income tax later when the asset is sold. Saving one tax can cost another.

Questions to answer before you leave this page

Have you read the operating agreement closely enough to know what a minority owner can and cannot do? Do you have an independent, qualified appraiser who will explain each discount in writing and stand behind it? Does the entity have a real business or investment purpose that you can state in plain words? Will you keep the entity's money and your own money apart, every month, without fail? Have you checked the current exemption and annual exclusion on the Internal Revenue Service website, rather than relying on a figure you heard years ago? Will the gift be reported on Form 709 with the appraisal attached? And have you sat down with a tax lawyer and a tax adviser who can look at your actual papers, since no article can see them?