Valuation of closely held businesses: estate and gift tax issues.

• Author: Hitchner, James R.

The valuation of a closely held business for estate and gift tax purposes requires a thorough analysis to substantiate the value that is ultimately determined. Since closely held businesses do not have publicly traded price quotes listed on one of the major exchanges or over the counter, their valuation is that much more complex. The difficulty in valuing a closely held company can be compounded by the fact that many closely held companies are much smaller than their publicly traded counterparts. However, if the valuation practitioner is cognizant of the areas in which a smaller closely held company may differ, appropriate adjustments can be made during the valuation process.

It has been stated that valuation is more an art than a science. This may have been true historically; however, over the past 10 years increasingly more sophisticated financial models have been employed in the valuation of closely held companics. The large wave of mergers and acquisitions during the 1980s precipitated this increase in sophistication.

Historical Perspective

In today's estate and gift tax arena, a rigorous application of standard valuation approaches is appropriate. The days of absolute adherence to the valuation concepts and applications embodied in the landmark Central Trust Co.(1) case are over. Central Trust Co. was a gift tax case in which the taxpayer retained three independent expert witnesses and the Government retained two. The methodologies used by these witnesses were capitalization of earnings, capitalization of dividends, book value and prior sales.

The courts, as well as each of the experts, put the most weight on capitalization of earnings. The weighting of the other approaches differed depending on which expert was testifying. The deviation in the values (based on various approaches) among each of the experts varied from a low of $5.83 to a high of $33.83 before any discounts were applied. Final values varied from a low of $7.88 from one of the taxpayer's experts to a high of $21.85 from one of the Government's experts. The court opined somewhere in between at $16.67 per share.

In recent years, the courts have accepted more sophisticated techniques such as discounted cash flow.(2) However, although the approaches accepted in Central Trust are still applicable in current valuation cases, their application is typically more scientific, and the techniques more rigorously applied. The basis for selecting discounts has also changed considerably. In Central Trust, the experts and the courts used the cost of flotation to support a discount for lack of marketability. More recent cases have relied on subsequent detailed valuation studies that are considered better indicators for these types of discounts.

The courts continue to recognize that a discount for a minority interest and a discount for lack of marketability are appropriate, depending on the facts and circumstances of each case. In more recent years, the courts have recognized that the two discounts are distinct from each other. Other discounts that have been allowed in recent cases are key man or thin management discounts, investment company discounts, market absorption discounts and discounts for liquidation costs. The courts have also accepted implied discounts or adjustments in such areas as information access and reliability and lack of comparability.

Closely Held Company vs. Public Company

Many closely held companies are considered small to middle market companies; they exhibit specific attributes that distinguish them from their larger publicly traded counterparts.

Some common differences between public and private companies are:

* Public companies adhere to strict Security and Exchange Commission reporting requirements, including issuing audited annual reports and significant annual and quarterly disclosures in their 10-Ks and 10-Qs. At best, a private company would have audited financial statements. However, many have only reviewed or compiled statements.

* Many public companies, particularly the larger ones, are followed by investment analysts.

* Many publicly traded companies have a historical and well-documented track record. Even newer publicly traded companies typically present data going back three to five years.

In addition to potential problems with information availability and reliability, there are other differences between closely held companies and their publicly traded counterparts. Some of the more notable ones are:

* Many closely held companies are run by a very thin management layer.

* Many closely held companies are conservatively managed and may be underleveraged.

* The owner compensation structure may be different.

* Many closely held companies have nonoperating assets, such as marketable securities, insurance policies or real estate.

* Many closely held companies have shareholder or buy-sell agreements.

* Many smaller closely held companies lack diversification either geographically, demographically or by product line.

Approaches to Value

* Income approaches

Income approaches to valuation are used to estimate the fair market value (FMV) of a company based on the earnings and cash flow capacity of the company. These approaches evaluate the present worth of the future economic benefits expected to accrue to an investor in the business. These benefits or future cash flows are discounted to the present or capitalized at a rate of return that is commensurate with the company's inherent risk and expected growth. This present worth determines the FMV of a business. Two common income approaches are discounted cash flow and capitalization of earnings.

Discounted cash flow approach: This approach estimates the FMV of a company based on the earnings and cash flow capacity of the company. It begins with estimating the pro forma annual cash flows a prudent investor would expect the subject operations to generate over a period of time. In performing such a valuation, a set of projections is usually relied on that includes anticipated net income, future depreciation, future capital expenditures and future incremental working capital needs. These cash flows are then discounted at a rate of return commensurate with the risk inherent in the operations. Capitalization of earnings: This approach consists of capitalizing a single year or an average of several years' earnings or cash flow into perpetuity at a capitalization rate that reflects the risk and growth potential in the company. This can be based on a one year budgeted amount, a single year historical amount or an average of several prior years.

* Market approach

The market approach is a valuation technique in which the FMV of a business is estimated by comparing the subject company to guideline companies in similar lines of business. The market approach can use either publicly traded information or transaction information. Publicly traded company multiples: An often used technique for valuing closely held companies is the application of...