When a minority interest in a privately-held company is transferred, a discount from the value of the entire company is calculated to reflect the lack of marketability of such an interest. These marketability discounts are important in many estate plans and related transfers. These discounts for lack of marketability (DLOM) should be calculated by a qualified business appraiser in a way to withstand the IRS’s scrutiny.
In August, 2011, the IRS publicly released a lengthy practice aid that described its view of the primary tools and methodologies used to calculate DLOMs. The report is entitled Discount for Lack of Marketability – Job Aid for IRS Valuation Professionals. It provides the IRS’ contentions regarding appraisal weaknesses, including:
- Inappropriate use of restricted stock studies – The restricted stock studies measure the lack of marketability by comparing the sale price of publicly traded shares to the sale price of restricted shares of the same company. The IRS complains that (i) these studies cannot be used without a detailed analysis and comparison of the specific facts and circumstances involving the transactions in these studies to subject interest, and (ii) the transactions that are the starting point for the comparisons need to be relatively recent.
- Use of analytical or theoretical models without market data support – The analytical methods generally use option pricing theory. The IRS contends that this methodology should be used only as a secondary valuation method, and that these models cannot be used without considering other qualitative factors before reaching a conclusion. Stated otherwise, the analytical model must be validated using actual current market data.
- Reliance on court case results to support appraisal conclusions – According to the IRS, court cases can be an excellent source of information when legal precedent is in question, but judges are not appraisers. The IRS states it is not bound by a court’s particular factual determination about a discount in any case or group of cases.
DLOMs have always been challenging for appraisers because (i) the facts of each company are often different, and (ii) the studies prepared to date are limited by the available data. In this practice aid, the IRS summarizes challenges with the methods that have obtained general acceptance in the appraisal community. In so doing, the IRS explains what they think cannot be done. However, the IRS does NOT provide acceptable alternatives. Consequently, the IRS leaves the impression that (i) no meaningful DLOM is acceptable and (ii) the obviously too-small DLOMs that the IRS normally advocates must be the preferred alternative. In this sense, the IRS practice aid fails to meaningfully advance the knowledge base in the DLOM area.
Fulcrum Inquiry performs business valuations, including analyses of marketability discounts.