Shifting Sands in Valuation: Change May Be Coming for Valuing Family-Owned Businesses

I will freely admit writing a light, easy read on potential changes to Treasury Regulations as it pertains to valuing ownership interests in family-owned businesses may not really be a thing, but, in our minds, it is front and center. If you are not in the field of financial and estate planning, this issue may not be on your radar, but for folks out there who own or are actively involved in a family enterprise, it should be.business_1

The Issue: On August 4, 2016, The Treasury Department and the IRS issued long awaited proposed regulations under Code Section 2704. The proposed regulations deal specifically with the valuation of family controlled entities (Corporations, LLCs and Partnerships) for certain intra- family transfers. If you have done some estate and transfer planning in the past, you are familiar with the typical requirement for a formal valuation or appraisal of business and/or family interests to determine the fair market value for estate, gift and generation–skipping tax purposes when there is an intra-family transfer.

To arrive at fair market value, it has been a commonly accepted practice of valuation professionals (traditional valuation standard) to apply a valuation discount for lack of control when a minority interest is being valued. The purpose of this discount is to reflect the fact that a minority interest in an entity does not typically give the give the holder of the interest the power to control the governance of the entity (operations, salaries, direction, distributions, liquidation, etc.). Additionally, it is also common practice to apply a discount to the interest being valued to reflect the fact that there is not a ready market for that interest (marketability discount). As you might assume, the process of arriving at a reasonable (and defensible) discounted value is undertaken to reflect the fair market value of the transfer interest after taking into consideration all of the inherent restrictions and limitations that would impact value to the recipient.

A Little Background: Section 2704 governs the valuation of corporate, LLC and partnership interests. More specifically, Section 2704 deals with the treatment of lapsed voting or liquidation rights as valuationwell as when certain restrictions on liquidation are to be disregarded for valuation purposes. The proposed regulations are designed to close perceived tax loopholes in this section that some in the Treasury Department believe may result in the understatement of the fair market value of a transferred interest. The hope was that the proposed regulations would only deal with certain lapsing rights or liquidation restrictions that were deemed to be illusory and abusive. However, the proposed regulations, as they stand, are interpreted by many professionals to have a broader impact and will affect the valuation of all intra-family transfers of family controlled entities.

The Rub: Most valuation practitioners and commenters that have reviewed the proposed regulations believe that, if implemented as they were issued, the proposed regulations will drastically change the valuation world as we know it today. The discount for lack of control (minority interest) may be drastically reduced or eliminated altogether when valuing an interest for an intra-family transfer. Several practitioners and commenters also suggest that the proposed regulations may even restrict or eliminate discounts for lack of marketability as well, though, there appears to be less certainty in this area.

Take Away: If you are considering a transfer (gift or sale) of a family controlled entity to a family member in the near future, you may wish to complete the process sooner rather than later (ASAP to be safe). The proposed regulations are not effective until they are finalized (or, for some provisions, until 30 days after they are finalized). Given the industry commentary and response to the proposed regulations, it is highly unlikely that implementation of the proposed regulation is going to occur before year-end. At the very least, the proposed regulations will require substantial clarification from the IRS and Treasury Department before they are implemented.

One Final Note: There is a bit of encouraging news… companion bills have recently been introduced in the House and Senate that would prevent implementation of the proposed regulations. As you can see, this is still unsettled ground with the conclusion yet to be written, but we wanted to bring this issue forward in the event the more draconian interpretation of these proposed regulations do in fact play out.


peterPeter Clarke
Chief Operating Officer
The Baldwin & Clarke Companies

About the author:
Peter is the Chief Operating Officer of The Baldwin & Clarke Companies and a Senior Associate with Baldwin & Clarke’s investment banking practice. Peter spent over 10 years as a financial analyst in the private equity industry space before joining Baldwin & Clarke to further support the firm’s capabilities working with entrepreneurial clients.