When businesses are valued, the owner desires the highest value possible for the business. After all, it is human nature to desire the most wealth possible. Many times, valuations are prepared to determine what price potential exists if the business is sold. Even when a divorcee is trying to obtain an amount for a spouse’s business during a divorce proceeding, a valuation will be completed with a goal toward the highest value possible. Other situations exist where the client aims for a low value; such situations include estate planning, divorce when the client will be paying out a sum, and when a potential buyer desires to purchase a business.
Legitimate devices exist to reduce the value of a business when appropriate. Discounts determined for lack of control and lack of marketability are legitimate and even common in valuations. In addition, discounts taken for a built-in gains tax potential are becoming increasingly common as more case law develops.
The Three Key Discounts
1. People generally prefer to have controlling power as opposed to being controlled. The lack of control discount or minority ownership discount in closely held and small companies is given to reflect the detrimental effect of not having control of a business. While a minority interest in a publically traded company is not subject to a lack of control discount, in small companies, lack of control means the minority owner is subject to the whim of majority shareholders. Such detrimental decisions to minority shareholders can include: determination of management compensation, declaration of dividends and disbursements, setting the course of the business, and decisions to liquidate or sell business interests. Lack of control discounts can range from 35 to 50 percent, and even higher in some cases when compared to publically traded stocks. Readers should be aware that the state of Florida has recently passed a law making the minority discount illegal whenever a company that has ten or fewer owners is valued.
2. The lack of marketability discount applies to many small businesses as well. Owners prefer to have assets that are more liquid as opposed to less liquid. It is with this preference that those businesses that can be bought and sold quickly are worth more. Businesses that are hard to liquidate or are generally unmarketable are worth less than publicly traded companies. Because of this lack of marketability, certain businesses are given a discount to reflect the detriment of the ability to sell the company. Lack of marketability discounts can range in the area of 20 to 50 percent when compared to their publically traded counterparts.
3. As of late, discounts for built-in gains tax are gaining more and more support. When C corporations are converted from taxable entities into flow through entities such as S corporations, LLC’s and the like, the potential for a tax liability known as “built-in gains” appears. Because of this potential, the company must plan and maneuver carefully around built-in gains issues. Nonetheless, from time to time, decisions are made on business bases that demand that built-in gains be recognized and taxes become due to the government. Many businesses, including businesses with deceased owners, run the risk of paying built-in gains tax.
As such, taxpayers have successfully argued that such potential liability can be deducted from the value of a business under the theory that an investor, similarly situated, could purchase similar securities in a business without the built-in gains tax potential. This is because investors can invest elsewhere in order to avoid tax losses, theoretically, that the company with the built-in gain tax event potential is worth less than a company that does not have potential for a huge tax loss.
Some confusion results between the two types of discounts noted above when analysts arrive at discounts for control and marketability. Minority ownership interest discounts relate to the control the subject has in relation to the business. Marketability, on the other hand, deals with the potential to liquidate the company and how quickly and easily the company can be reduced to cash.
Discounts based on control and marketability have been around since the beginning of valuations. The built-in gains tax liability discount is new, and it has major estate tax implications as well as gift tax consequences then other discounts. Knowledge and use of the built-in gain discount is critical for valuations.
By: Roman Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors