Want to save your clients significant money on estate and gift taxes? Valuation discounts can be a game-changer for estate attorneys and tax advisors. Let’s dive into how these strategies work and how you can use them to benefit your clients.
How do Valuation Discounts Work?
A valuation discount is a reduction in the pro-rata fair market value of an equity interest in a closely-held business for gift and estate tax purposes to reflect certain economic realities. Applying these discounts can significantly reduce the amount of tax owed when transferring ownership of equity interests through exit or estate planning.
The two most common types of valuation discounts are:
- Discount for Lack of Marketability (DLOM): Reflects the reduced value of an interest due to the difficulty of selling it in the open market.
- Discount for Lack of Control (DLOC): Reflects the reduced value of an interest due to the inability to control business decisions and policies.
Understanding valuation discounts is crucial for accurately valuing closely held businesses. While these discounts are often associated with corporate entities, they can also have implications for certain trusts, such as Spousal Lifetime Access Trusts (SLATs).
Discount for Lack of Marketability (DLOM)
DLOM (Discount for Lack of Marketability) is a discount applied to closely-held businesses because their shares are harder to sell than those of public companies. The DLOM accounts for the difficulty and time required to sell such interests, making it a critical factor in estate and gift valuations. Factors that can influence the DLOM include:
- Transfer Restrictions: Legal or contractual restrictions on the transferability of shares can significantly increase the DLOM.
- Company Performance: Lack of profitability or future earnings potential can increase the perceived risk and, consequently, the DLOM.
- Liquidity: Companies with higher liquidity, such as those with substantial cash reserves or easily marketable securities, may have a lower DLOM.
- Unstable Market Conditions: General economic conditions and industry-specific trends can affect the marketability of a business interest.
Discount for Lack of Control (DLOC)
DLOC (Discount for Lack of Control) is a discount applied to minority ownership in a company. Because a minority interest lacks the ability to control or influence the company’s management and policies, their shares are worth less than those of a controlling shareholder. Several factors can impact the DLOC, including:
- Limited Voting Rights: Shares with limited or no voting rights typically have a higher DLOC.
- Lack of Board Representation: The inability to appoint or influence the board of directors can reduce the level of control, and consequently increase the DLOC.
- Minimal Decision-Making Power: A minority interest without the power to influence key decisions such as mergers, acquisitions, and dividend policies may be eligible for a higher DLOC.
- Ownership Structure: The overall ownership structure and distribution of shares within the company impacts a subject interest’s ability to make decisions or sway a vote.
Consider how these factors come into play for your clients’ businesses to get a sense of how much money your client could save.
How Valuation Discounts are Determined
Business appraisers select discounts by analyzing various factors that affect a company’s value and supporting research.
- A DLOC is often derived from empirical studies, control premium analyses, and comparisons with minority interest transactions
- A DLOM is typically assessed through prior tax court decisions, market studies, restricted stock studies, and option pricing models
The most important thing to know—there is no “right” answer when selecting a discount. Three appraisers valuing the same interest would most likely select three different discounts. An experienced independent valuation firm must analyze the company’s operating agreement and fully explain the specific rights the owner of the subject interest has to support the selected discounts.
How to Apply Valuation Discounts for Gift and Estate Taxes
Valuation discounts are multiplicative, not additive. This means you don’t simply add the percentages together. For example:
- Kate’s Interest:
- Kate owns 10% of a business valued at $1,000,000.
- Her interest has a pro-rata value of $100,000 (10% of $1,000,000).
- Discounts: After an independent appraisal, the following reasonable discounts were determined to reflect the fair market value of her interest:
- DLOC: 10%
- DLOM: 20%
- Combined Discount Calculation:
- Instead of adding 10% and 20% to get 30%, you multiply the remaining values: 1 – [(1 – DLOC) x (1 – DLOM)])
- The combined discount is 28%.
- Adjusted Value:
- After applying the 28% discount to Kate’s $100,000 share, the fair market value of Kate’s interest is $72,000.
- These discounts reduce the taxable value by $28,000.
The calculation of value and combined discount is presented below.
Don’t Overstate the Valuation Discounts!
There are many studies that appraisers can use to justify the DLOC and DLOM selected for a valuation. However, it’s very important to make sure the combined discount is appropriate and not overstated to reduce attracting IRS attention. There is some overlap between DLOM and DLOC, and a valuation professional must be careful to avoid double-counting or misrepresenting the value.
For estate valuations, the IRS has up to three years to audit an estate’s Form 706 (US Estate (and Generation-Skipping Transfer) Tax Return) from the date it was filed. The last thing you or your client wants is to be audited years down the road and have to defend or change your valuation because of aggressive discounts.
Unfortunately, sometimes audits are unavoidable. We’ve found that the IRS may still may and dispute well-supported discounts, especially in certain situations such as:
- When the size of an estate or gift is close to the exemption limit and a change in the discount may result in additional taxes
- When the ownership interests are over 50%
The IRS has not published guidelines on a “magic number” that they deem to be appropriate; however, in our experience, combined DLOC/DLOM discounts between 20%-30% are most common.
Maximize Tax Savings with a Valuation Advisor
While the calculations above can give you a sense of how valuation discounts work, we don’t recommend DIYing this process. Valuation discounts, especially in estate tax situations, are subject to IRS scrutiny. An experienced appraiser can help ensure that the valuation is well-supported by sound principles and documentation, to protect your business in IRS disputes.
Applying valuation discounts means walking a fine line between reducing the taxable value for your client and maintaining a reasonable valuation. And when the IRS is involved, you want an expert in your corner! If you’re looking for a better valuation experience for your clients, contact us today. We’d love to chat and figure out how we can help you use valuation discounts to your advantage.
