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Valuation of Securities for Estate Tax Purposes

In 2001, Congress passed legislation incrementally increasing the amount exempt from federal estate taxes and completely eliminating estate taxes in the year 2010. However, the legislation contains a “sunset” provision whereby estate taxes are reinstated at prior rates in 2011 unless Congress acts affirmatively to make the repeal permanent. The administrator or other representative of an estate has a duty to inventory and assign a value to estate assets for estate tax purposes.

Federal tax laws require each asset generally be listed at its “fair market value” (FMV) as of the date of death, subject to exceptions. FMV is defined by the Internal Revenue Service (IRS) as “the price at which a property would change hands between a willing buyer and a willing seller, neither being under any compulsion to sell and both having a reasonable knowledge of relevant facts.”

Valuation Methodology

Estates often include stocks and other securities. If the stock is traded on a national exchange (NYSE, NASDAQ, etc.) or “over the counter,” valuation can be fairly straight forward; the market price determines the FMV. Stock of many entities is not publicly traded, however. Many companies do not have the resources to register their shares with the Securities Exchange Commission (SEC), necessary before public sale, and/or the company is intentionally “closely-held” (having a limited number of shareholders) or family owned.

Without a market to fix the value of such stock, experts are typically hired (by both the estate and the IRS) to appraise the stock. Usually the appraisers begin by valuing the entity, then extrapolate a share price from that value. Appraisal of an entity is far from an exact science and experts often reach results that vary significantly from one another. There is also no one approved valuation method. The following methods of appraisal have been used singly or in conjunction:

  • Asset value or liquidation method, where the assets of the company are valued at their FMV, then the estate’s fractional ownership interest is calculated.
  • “Guideline company” method, where one or several comparable, publicly traded companies are selected and their share prices provide a basis for valuation, subject to discounts. This is the approved method by the IRS, where feasible.
  • Discounted cash flow method, requiring projection of future cash flow for the entity over a period of time, then application of a discount percentage rate to reach the present value of that stream. The discount reflects that $20 received in five years is worth less than the present value of $20 now, due to inflation and other factors.
  • Income capitalization method, similar to the discounted cash flow method, but the cash flow of only one future period (e.g., a year) is estimated and discounted to net present value.

IRS Guidelines for Valuation

In determining valuation, the IRS, through written guidance such as “revenue rulings,” suggests that various documents from the company be reviewed, such as balance sheets, stock purchase agreements, etc. Relevant factors affecting market value should be considered, including the following:

  • The nature and history of the entity and its business from inception.
  • The economic outlook in general and of the specific industry of the entity.
  • Book value of the stock and the financial condition of the entity.
  • Earnings and dividend paying capacity of the entity.
  • Whether the entity has goodwill or other intangible value.
  • Any sales of stock and the size of the block of stock to be valued.
  • The market price of stocks of corporations engaged in the same or a similar line of business, which have freely traded stocks on the market.

Discounts for Share Price

Once the entity is valued and a per share price assigned, this price can be subject to a “discount” for a number of reasons, including lack of marketability for the stock and lack of control of the entity (to force liquidation). The rationale is that a willing buyer would pay less than FMV because of such factors and demand a discounted price. Additionally many stocks are subject to “restrictions” on sale or resale that may reduce value. For example:

  • Stock purchased directly from the entity in a private sale may not be eligible for public sale under U.S. securities laws, without meeting certain conditions.
  • Some shares of public companies may not be registered, and therefore may not be eligible for public trading; the sale price will be lower than the publicly traded shares.
  • Stock owned by the entity’s officers, directors, or certain other related persons may be subject to sale restrictions under applicable securities laws.
  • When a company registers stock for public sale, the underwriter may require present shareholders to agree not to sell their shares for a set period of time, which is often called a “lock-up” agreement.
  • Shares may be subject to a shareholder or other agreement restricting sales, often by giving other shareholders or entities a right to purchase first at set prices.

The “Korbel” Case

Valuation of shares in a closely-held business or entity whose shares are not freely traded has frequently been the subject of dispute between estates and the IRS. When Ritchie Heck died on February 15, 1995, he owned 630 shares, or 39.62%, of the stock of F. Korbel & Bros., Inc., the well-known makers of Korbel champagne. The stock was not publicly traded and the estate valued it at $16,380, 000, or $26,000 per share. The IRS valued it at $30,177,000, or $47,900 per share. Both relied on expert appraisals and testimony in affixing the value of the stock.

The IRS expert/appraiser applied the “guideline company method,” using publicly traded Robert Mondavi (wine) Corp. as the similar company. The Tax Court agreed with the estate’s expert that the two companies were not sufficiently similar. Both the IRS and the estate also used the discounted cash flow method, although applying different discount rates and disagreeing about includable assets of the company. The Tax Court basically sided with the estate’s expert, valuing the stock at $20,269,736, or $32,174 per share.

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