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Changes in political leadership, such as those that have taken place at the federal level in recent months, invariably lead to questions about possible changes in tax law. While income and corporate taxes attract the most media attention, it’s important to remember that gift and estate taxes can also have a profound impact on an individual’s long-term financial planning. If an individual has an interest in a related party, the valuation of that business for gift and estate tax reporting purposes and the impact of that valuation on their tax burden should be carefully considered.
When evaluating related company shares for gift and estate tax purposes, it is important to consider the following five factors:
- Valuations for gift and estate tax purposes must comply with the principles set out in IRS Revenue Ruling 59-60. Revenue Ruling 59-60, first set out in 1959, describes the approaches, methods and factors to be considered in valuing related company stocks where market listings are either unavailable or based on tight deals. The following factors should be considered under Revenue Ruling 59-60:
- The nature of the business and the history of the company from the start.
- The economic outlook in general and the state and prospects of each industry.
- The book value of the stock and the company’s financial situation.
- The employability of the company.
- The dividend payout capacity.
- Whether or not the company has goodwill or some other intangible asset.
- Sale of the inventory and size of the inventory block to be valued.
- The market price of shares of companies that operate in the same or a similar industry and whose shares are actively traded on a free and open market, either on a stock exchange or over the counter.
- In tax assessments, great emphasis is placed on the quality of the narrative report. This report should detail the approaches and assumptions used and discuss how the Revenue Ruling 59-60 factors above were taken into account.
- Various valuation approaches should be considered in the valuation of related parties, including an analysis of the income approach via discounted cash flows and the market approach via guidelines for public companies and / or guidelines for transaction multiples.
- Haircuts applied in estimating the fair value of the interest in question, which could represent a marketability discount or a lack of control discount, should be based on the facts and circumstances of the company being valued, as well as the size of the block of shares being valued become. Such discounts should be based on market-based data.
- The process of valuing closely managed businesses for gift and estate tax reporting purposes is not a one-size-fits-all exercise. The analysis should be carried out with great care, both quantitatively and qualitatively. Every company is different, and even every company has different classes and blocks of stocks.
With increasing awareness of the potential for changes in gift and estate tax law, the valuations of closely managed companies are also being considered for gift and estate tax reporting. Individuals in need of evaluations for this purpose should be provided with defensible, supportable analysis that can withstand IRS scrutiny.
Kevin Cannon is a director in the valuation practice for Opportune LLP.