January 2012

Evaluating Discounts for Lack of Marketability: IRS Releases Internal “Job Aid”

While it holds little new information for valuation professionals, a recently released IRS publication can help attorneys and accountants
increase their understanding of valuation methodology

“The establishment of a discount for lack of marketability is a factually intensive endeavor that is heavily dependent on the experience and capability of the valuator.” – Discount for Lack of Marketability Job Aid for IRS Valuation Professionals, September 25, 2009

One of the fundamental purposes of business valuation is to determine a reasonable fair market value (FMV) for companies that are not traded on an active market. Business valuation professionals look to the public markets as a proxy for the rates of return that investors require for the use of their funds. For enterprises that are not publicly traded, the consensus is that investors require a higher rate of return in exchange for the additional risk assumed as a result of not being able to readily convert their investment into cash. This is the essence of marketability, as defined in the International Glossary of Business Valuation Terms.

In many cases, in order for investors to achieve these higher rates of return, the value of the purchased interest must be discounted from its proportionate share of net asset value. The “amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability”[1] is also known as the “discount for lack of marketability” (DLOM).

These discounts, particularly when applied in gift or estate tax valuation, have long been an area of controversy between the taxpayer and the IRS. In June 2008, the IRS established a team to explore and develop information to assist internal IRS valuators as they review the DLOM in valuation reports. The results of their efforts were published in the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals. The IRS distributed the “Job Aid” internally in September 2009 and made it available to the public in the summer of 2011.

Not surprisingly, as the Job Aid is written for internal IRS purposes, the conceptual framework begins with the idea that the DLOM should begin at zero, as can be seen in the latter part of the guide:

“[I]t is often helpful to start with a basic question as relates to DLOM. That question is: ‘Under the prevailing facts and circumstances and considering the nature of the interest to be valued why is the DLOM not zero?’"

The guide goes on to say that:

"[A] common mistake among valuators considering DLOM ... is to concentrate almost exclusively on the viewpoint of the hypothetical buyer who will be pushing at all times for larger discounts while ignoring the viewpoint of the hypothetical seller.”

The implication is that, while an investor may be willing to buy the interest at a deeply discounted price, a hypothetical seller may not be willing to sell at that price. As FMV requires the consummation of a hypothetical sale, excessive reliance on the viewpoint of the buyer leads to a price upon which no sale would occur, thus violating the underlying premise of the standard of value. Although unseasoned review appraisers may need to be reminded that the perspective of the seller should also be considered, a competent business appraiser should always be fully aware that the viewpoint and economic considerations of the seller need to be contemplated.

However, the notion that the seller is not going to simply “give away” the business interest does not eliminate the underlying foundation of why a discount is applied: the holder of the interest cannot immediately liquidate the investment if the need arose. This lack of an active market increases the risk and, by extension, the required rate of return that often necessitates a discounted value of an investment in a privately held company. The competent appraiser seeks to find a balance of viewpoints of both the buyer and seller, and, consequently, the appraiser estimates the discount that results in a price and a return to the investor that make sense from both perspectives.

More general criticism of common practices in valuation reports relate to sole reliance on court decisions and the use of:

• pre-IPO studies,

• simple averages or medians from Restricted Stock Studies,

• study results without relating it to the subject interest, and

• study results that are not supported by market data.

While the Job Aid provides a good overview and critique of each of the commonly used methods to estimate the DLOM, none of the methods presented have been dismissed outright by the reviewers. The relative strengths and weaknesses highlighted are also not new to seasoned valuators. Furthermore, the Job Aid does not provide any new alternative approaches or methodologies for quantifying the DLOM.

Appraiser response to release of the Job Aid has been mixed; a recent BV Resources survey indicated that 53% of respondents believed that the Job Aid adds nothing new to the discussion, but nearly 73% believed that it provided a broad overview of DLOM methods.

Further, while the Job Aid may not be groundbreaking for valuation professionals, it can be a helpful resource for attorneys and accountants seeking to increase their understanding of valuation methodology. ■

For more information on issues related to discounts for lack of marketability and other estate and gift tax issues, contact Lynton Kotzin.