Because transfer taxes depend on FMV, effective planning for business owners includes valuing the business. For those who partially own privately held entities, valuation discounts, that reduce an owner’s share of business value, may apply. Valuation discounts:
- offer significant tax minimization opportunities because they reflect that partial ownership a business entity is worth less than the owner’s proportionate share of the whole, and
- are commonly used for business appraisals for private businesses held in corporations, partnerships (including family limited partnerships, or “FLPs”) and limited liability companies (LLCs).
Applying discounts can reduce valuations for estate tax purposes while simultaneously allowing lifetime gifting of a percentage of the corporation, LLC, trust, or FLP at a reduced tax rate.
What Are Valuation Discounts?
In determining the FMV of an owner’s business interest, appraisers typically start with the owner’s proportionate share of the FMV of the entire business. Then, appraisers may adjust this amount for factors including form of ownership, restrictions on ownership transferability, and prevailing market conditions. Adjustments that decrease value are valuation discounts, and adjustments that increase value are valuation premiums.
Valuation discounts reflect economic reality. For example, a 25% interest in a private company isn't simply worth 25% of the company's net asset value. Instead, its FMV is diminished by the minority owner's inability to control company affairs. Also, in contrast to publicly traded corporation shareholders, the private owner cannot readily convert the interest to cash by selling. For wealth transfer planning, this gap between proportional and actual market value creates legitimate tax advantages when properly structured.
Common Valuation Discounts
The most common valuation discounts are those for lack of marketability, lack of control, and minority share discounts. These discounts can range from 10% to 45%, depending on several factors.
Lack of marketability: Refers to the discount applied when valuing a company that is not publicly traded. The idea is that a discount exists between a stock that is publicly traded (and therefore has a market) and a privately held stock, which often has little if any marketplace. In other words, because a privately held stock does not have clear market, it deserves a discount.
Lack of control: Refers to a reduction in a company’s share value due to a shareholder’s lack of ability to exercise control over the company. Here, a business interest is considered to be worth less than a controlling interest in a company because business decisions (e.g., determining compensation, setting policies, deciding to sell or liquidate, and declaring dividends) are not in the shareholder’s control. Thus, when noncontrolling or nonvoting shares are valued for a private company, a discount for lack of control is often applied.
Minority share: Refers to the disadvantage of holding a minority interest in a business. The minority share discount, also called a minority interest discount, is closely related to the lack of control discount. It reflects the idea that a partial ownership interest is worth less than its pro rata (proportionate) share of the total business due to the minority owner’s lack of control in business decision making.
FLP and LLC owners often use valuation discounts because the entity structures lend themselves to discounts. While the Internal Revenue Service closely scrutinizes family-controlled entities, decades of litigation have produced a substantial body of case law that offers clear guidance for properly applying discounts. These precedents establish a well-defined pathway for legitimately and legally transferring wealth to heirs while significantly reducing gift and estate taxes.
Valuation discounts are undoubtedly important in determining FMV for transfer tax purposes. However, to properly value an ownership interest in a privately held business, it is important to consider the level of control and marketability of the equity interest being transferred. Proper discount application requires careful navigation of complex regulations and adherence to the principles established through numerous court decisions. Consulting with a valuation analyst or an estate planner can help you to determine the applicability and level of discounting to apply to your business or your circumstances.
