How closely held business interests are valued

Start with the interest being valued, the financial evidence and any agreement affecting its price. The sections below explain the valuation factors, supporting records and limits on using an agreement price.

Stock without reliable market prices

When actual sales and bona fide bid and asked prices are lacking, making the regulation's market pricing provisions inapplicable, estate and gift stock valuations consider the following factors:

• Net worth, prospective earning power and dividend capacity.
• Goodwill and the economic outlook in the particular industry.
• The company's position in its industry and its management.
• The degree of control represented by the block of stock.
• Values of listed securities of corporations in the same or similar lines of business.

The weight of each factor depends on the case. Estate valuation also considers nonoperating assets, including insurance proceeds payable to or for the company, to the extent they have not already been counted.

Partnerships, proprietorships and goodwill

Partnership and proprietorship valuations consider tangible and intangible assets, including goodwill, demonstrated earning capacity and applicable stock valuation factors. Estate appraisals use the applicable valuation date, while gift appraisals use the gift date.

Supporting financial and expert data accompany the valuation. The estate regulation calls for special attention to goodwill where no agreement for adequate and full consideration passes the interest at death, while the gift regulation expressly emphasizes goodwill.

Approaches and financial adjustments

IRS examiner guidance calls for considering asset, market and income approaches. Professional judgment selects the approaches and methods that best indicate the interest's value, rather than requiring every appraisal to use all three.

The guidance calls for analyzing historical financial statements and adjusting them if necessary. Adjustments reflect appropriate asset values, income, cash flows or benefit streams consistently with the methods selected.

Control and marketability

Actual or effective control can affect stock value. Prices paid for other lots of stock may have little relation to the value of a controlling block.

IRS guidance calls for separately considering marketability and control over operations, sale or liquidation when appropriate to the assignment and not already considered through other valuation procedures.

Marketability analysis considers the nature of the business and ownership interest, relevant contractual and legal restrictions, and market conditions. These factors do not establish a standard discount percentage.

Sequential discounts use the remaining value

Sequential discounts apply to the value remaining after the preceding discount. The Form 706 illustration follows this order:

1. Start with $100.00 before discounts.
2. Subtract 10% of $100.00, or $10.00, for lack of control, leaving $90.00.
3. Subtract 15% of $90.00, or $13.50, for lack of marketability, leaving $76.50.
4. Divide the $23.50 total reduction by $100.00 to calculate an effective discount of 23.50%.

These percentages are illustrative. Discounts depend on the particular interest.

A “Yes” answer to Form 706, Part IV, line 11b for a partnership, unincorporated business, LLC or closely held stock requires a statement identifying the Schedule F line, item and total effective discount.

For covered lifetime transfers reported on Schedule G, a “Yes” answer to that line requires the corresponding Schedule G statement identifying the line, item and total effective discount.

Financial records supporting the return

For inactive or closely held stock, Form 706 instructions require complete valuation data with Schedule B. Include balance sheets, especially the one nearest the valuation date, and earnings or operating results and dividends for each preceding five years.

For partnership or unincorporated business interests, attach assets and liabilities for the valuation date and preceding five years, net earnings for those five years and the entity EIN. Account for goodwill.

Partnership interests generally belong on Schedule F. Jointly owned partnership interests belong on Schedule E.

For gifted closely held or inactive stock, Form 709 instructions require balance sheets, particularly the one nearest the gift date, and earnings or operating results and dividends for each preceding five years.

An appraisal meeting the gift disclosure regulation's qualifying appraisal requirements may replace those Form 709 financial attachments. It satisfies the valuation information component of adequate disclosure, rather than the remaining disclosure requirements.

Buy and sell agreements

An estate tax option or contract price receives little weight if the decedent remained free during life to sell the securities at any price.

Even a binding lifetime price is disregarded unless the arrangement is bona fide and is not a device to pass shares to the natural objects of the decedent's bounty for less than adequate and full consideration.

Where applicable under the regulation's applicability provisions, the separate §2703 tests also apply. A binding price alone does not satisfy those tests.

Under §2703, an option or agreement to acquire property below fair market value, or a restriction on sale or use, is disregarded for transfer tax valuation unless all three tests are met:

1. It is a bona fide business arrangement.
2. It is not a device to transfer property to family for less than full and adequate consideration.
3. Its terms are comparable to similar arrangements between parties dealing at arm's length.

Company insurance and redemption obligations

In Connelly, company owned life insurance funded a redemption at fair market value. The proceeds increased the corporation's value, and the redemption obligation did not offset those proceeds.

The holding is specific to those facts. A corporation's obligation to redeem shares is not necessarily a liability reducing its estate tax value.