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Estate Planning Secret: How to Use Lack of Marketability

Owners of closely held companies often work diligently for 25 years or more to build the value of their business. But as these owners near retirement, all of their hard work—and the resulting increase in the value of their business—creates an estate-planning dilemma.

Without an effective estate plan, a closely held business owner's estate often has significant tax liabilities that can cause many unforeseen problems—leaving a large portion of the owner's legacy to Uncle Sam. Estate planning can help you stay in control of the legacy of your hard work.

In effective estate plan can include the gifting or sale of minority equity interests in a closely held business. When equity interests are transferred, tax law requires the interest's "fair market value" to be determined.

Why is fair market value key to an estate plan?

The discount for lack of marketability is often the largest dollar discount factor in the valuation of a minority interest in a business. Thus, when an owner transfers a minority interest in a closely held business, it is usually subject to a significant discount for lack of marketability, as defined by the fair market value standard.

As taxes are paid on the value of the holdings of an estate, a discount to this value results in lower taxes. Under the definition of fair market value, it is generally accepted that minority equity interests in closely held companies are relatively illiquid. So, if an owner transfers a minority equity interest in his closely held company, the interest should likely be discounted due to a lack of marketability.

What is a discount for lack of marketability?

The discount for lack of marketability in the valuation of a closely held business entity reflects the higher investment risk due to the absence of a ready market in which to liquidate an investment in a company that is not publicly traded.

If a stock that lacks marketability does sell, it usually does so at a price significantly lower than an otherwise comparable publicly traded stock. This is the conceptual basis for the discount for lack of marketability: The owner of a nonpublicly traded stock doesn't know when, or for how much, that stock can be sold.

Studies support lack-of-marketability discount

There have been many empirical studies supporting and quantifying a discount due to lack of marketability. Two of these, the restricted stock studies and the pre-initial public offering (IPO) studies are widely recognized to provide market evidence of the difference between the price of a publicly traded stock and that of a comparable stock that is not eligible for public trading. Table 1 summarizes several restricted stock studies performed by various entities; Table 2 summarizes several pre-IPO studies performed by John D. Emory.

Tax court rules on lack of marketability discount

The tax court has readily accepted discounts for lack of marketability for interests in closely held businesses. A review of court cases since 1990 suggests that lack-of-marketability discounts ranging from 7.5% to 50% might be applicable, while the average discount awarded has been approximately 26%.

More important than the average discounts allowed are the factors that the courts have found relevant in determining a lack-of-marketability discount. Some factors cited in court decisions include:

• Results from empirical studies of illiquidity-e.g., restricted stock studies, pre-IPO studies, etc.
• Outlook for the industry and specific company
• Historical financial performance of the subject company
• Flotation costs for an initial public offering
• Strength of company management
• Expected holding period of the subject stock
• Frequency of transactions of the subject stock
• Expected future dividend and redemption policy
• Amount of control in the subject interest
• Resale restrictions or limitations

How to Use the Lack-of-Marketability Discount

If you are a business owner who doesn't want to pay unnecessary taxes, consult your estate planning advisor for help in tailoring a plan that best suits your objectives while minimizing taxes. Often, this plan will include a transfer of a minority interest in your company.

To best utilize a discount for lack of marketability, select an appropriate business appraiser to determine the fair market value of the minority interest. Be sure the business appraiser fully understands:?

• The fair market value standard and how a discount for lack of marketability applies
• The empirical studies quantifying the lack of marketability discount and how to use them to support conclusions of fair market value
• The findings of the tax court and how to use this knowledge to support a lack-of-marketability discount

Have you protected the investment you've made in your business? Now is the time to ensure that your estate plan takes advantage of the discount due to a lack of marketability—and safeguards your legacy.

Questions about discounts for lack of marketability?
Contact Rich Lies at 312-980-2922.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.