Baldwin Haspel Burke & Mayer LLC

Valuation of Closely Held Family Businesses

John Rouchell - 

Article Updated: October 22, 2012


The closely-held, family business often is the most significant asset of the business owner’s estate, both from the point of view of valuation for transfer tax purposes as well as for family business succession.

Closely-held, family businesses represent a significant contribution to the Nation’s gross national product and job creation. However, less than one (1) in three (3) closely-held, family businesses survive to the second generation and only twelve (12%) percent survive from the first to the third generation.

Valuation of the closely-held, family business is often an estate planning issue but valuation issues can arise in a number of legal settings, including shareholder litigation, divorce and legal separation, contributions to qualified retirement plans including ESOP’s, transfers to charitable and non-charitable unitrusts, estate partitions, etc.

Valuation of a closely-held, family business is, at best, an inexact science, and can be a daunting challenge to the estate planner and family advisor.

Valuation for Transfer Tax Purposes

The vast majority of jurisprudence involving valuation of closely-held businesses are federal transfer tax cases, most of which are lodged in the United States Tax Court.

Unless a transfer is subject to one of the special valuation provisions set forth in Chapter 14 of the Internal Revenue Code, the standard of valuation for federal transfer tax purposes is “fair market value”, defined as the price at which property would change hands between a willing buyer and a willing seller, neither of whom is under any compulsion to buy or sell, and both of whom have a reasonable knowledge of all relevant facts.

The Treasury Regulations state that the best evidence of fair market value is actual arm’s length sales during the normal course of business within a reasonable period of time before or after the valuation date. Unfortunately, by definition, closely-held, family owned businesses have no established market and, if there are any sales on or about the valuation date, those sales will often involve family members which IRS naturally will consider not at arm’s length.

When there are no recent sales, fair market value must be determined by an appraisal which must take into consideration a number of factors set forth in the Treasury Regulations and in Rev. Rul. 59-60, a public ruling of the IRS which purports to set forth general standards for valuing interests in closely-held family businesses. These relevant factors include the following:

  • The nature of the business and the history of the enterprise from its inception;
  • The economic outlook in general and the condition and outlook of the specific industry in particular;
  • The book value of the equity interest and the financial condition of the business;
  • The earning capacity of the business;
  • The dividend-paying capacity of the business;
  • Whether the business has good will or other intangible value;
  • Sales of equity interests and the size of the block of the interest to be valued; and
  • The market price of stocks of corporations engaged in the same or a similar line of business which are actively traded on an open market.

Rev. Rul. 59-60 indicates that some of the factors may be more important than others, depending on the circumstances.

Valuation Methodology

Although Rev. Rul. 59-60 sets forth the basic blueprint for valuing closely-held businesses and suggests a number of methodologies, the ruling clearly states that there is no single correct method for accomplishing the task. All of the facts and circumstances of each particular business must be carefully analyzed to determine value. A number of different methods may be utilized. Some of these methods include the following:

A. Net Asset Value. Book value is nothing more than a continuing record of the historical cost of an entity’s assets, less accumulated depreciation. Although commonly used for cost accounting purposes, the relationship between book value and fair market value is purely accidental. However, Rev. Rul. 59-60 indicates that some type of net asset value approach is most representative of fair market value for holding companies or investment companies which do not involve an active trade or business. In those instances, the book value approach must be modified to reflect current fair market value by substituting the appraised value for the historical cost of the underlying assets and to reflect good will and other intangible assets such as any intellectual property owned. The net asset value approach is essentially a liquidation model.

B. The Earnings Approach. Under this methodology, the fair market value of the closely-held business is a reflection of the entity’s future earning power and is most relevant to operating companies with an active trade or business. A projection is made of the future earnings capacity of the business based upon its current financial status, taking into consideration trends and past earnings which can result in different years earnings being given different weights. 

C. Dividend Paying Capacity. Under this valuation methodology, the dividend paying capacity (rather than actual dividend payment history) is studied and capitalized by multiplying such capacity by a factor derived from the dividend yields of comparable publically traded companies. Under this approach, overall profitability as well as the current future capital needs of the entity should be carefully examined.

D. The Market Approach. This approach assumes that the value of a closely-held, family business is analogous to similarly situated, publically traded companies in the same line of business. This particular approach is the only valuation method specifically endorsed in the Internal Revenue Code in IRC §2031(b). Furthermore, the market approach has long been accepted in the jurisprudence, although other approaches may more accurately reflect fair market value under the particular facts and circumstances.

The earnings approach is also subject to a number of different variations. For example, one variation involves projecting future earnings from prior years and discounting the future expected earnings to present value using a reasonable discount rate which should equate to the rate of return that an investor would expect to receive from an investment in that business. Discounted cash flow methods also result in a residual value for the business at the end of the projected period of time which is then added back to the discounted expected future earnings to arrive at current fair market value.

Another variation involves the capitalization of earnings. Under this variation, recent earnings of the entity are multiplied by a factor, usually derived from the price/earnings ratios of comparable publically traded companies, which results in current fair market value.

Rev. Rul. 59-60 states that the selection of the appropriate capitalization rate for either the earnings or dividend approaches is one of the most difficult tasks involved in the valuation process and that there is no particular formula or table which will apply in all instances.

Under the market approach, comparable publically trade companies are selected based upon a number of factors which include the same line of business, similar markets, the position the company within the industry, company earnings, product lines and competition. Appropriate adjustments are then made between the price earnings ratios of the selected comparables to arrive at an accurate fair market value for the subject closely-held entity.

Valuation Adjustments

The various methods each result in a valuation for a 100% interest in the entity, often referred to as the entity’s “enterprise value”. A number of recognized adjustments (often referred to as “discounts”) are applicable and appropriate in arriving at the fair market value of the interest.

A. Lack of Marketability. Methodologies that compare the closely-held, family business to comparable publically traded companies require adjustment to reflect the fact that there is no ready market for the shares of a closely-held business. A closely-held family business, in all likelihood, has no reasonable prospect of going public. In most cases, the issue is not whether such an adjustment is appropriate but how deep the discount should be. Often analysis focuses on the difference between the value of stock both before and after a public stock offering as well as the loss in value of publically traded shares whose transferability is restricted because of federal and state securities laws.

Recent Tax Court jurisprudence has not only looked to discounts for restricted stock and public stock offerings but also to a number of factors created by the Court, many of which are similar to the factors set forth in the Regulations and Rev. Rul. 59-60.

The adjustment for lack of marketability is often the largest adjustment and can range from 30% to 40%, depending upon the facts and circumstances.

B. Minority Interest. In most instances, particularly in community property states, the interest to be valued is a minority interest. Even in a fact pattern where the decedent is the sole shareholder of a corporation, his 50% interest in a community property state is considered to be a non-marketable, minority interest. The adjustment for a minority interest reflects the fact that a minority equity holder cannot force either current or liquidating dividends. As a result, a hypothetical willing buyer would take this into consideration and pay less for such an interest.

These adjustments are appropriate even in a family setting when the only potential buyers are other family members. This is true because the hypothetical willing buyer has no identity and is specifically not to be considered a member of the decedent’s family. There is no family attribution for transfer tax valuation purposes.

It is important to note that valuation methodologies utilizing comparisons to comparably traded public companies may already have a minority interest adjustment built into the calculation because stock quotes on established securities markets are of minority interests.

C. Voting/Non-Voting. Just as a willing buyer might pay more than the pro rata value of voting stock in order to achieve control, the same willing buyer would pay less for non-voting stock and, consequently, a valuation adjustment would be appropriate under the circumstances, in either direction. The appropriate adjustment will depend on the ratio of the outstanding shares of voting equity interests to non-voting interests.

D. Loss of Key Person. The death of a key person, particularly the founding entrepreneur, can have a negative impact on value, particularly if that loss is not compensated for by key man life insurance. Under these circumstances, an adjustment is appropriate.

E. Built in Capital Gain. For those entities that are either holding companies or whose assets are mainly investments rather than an active trade or business, the net asset value approach may require adjustment to take into consideration the fact that a willing buyer purchasing an interest in the entity will have to liquidate the entity in order to acquire its assets and will, thereby, incur federal and state income tax. If no entity existed, the willing buyer could purchase the same net assets on the open market directly without incurring those taxes. As a result, an adjustment for that tax liability is appropriate.

IRS contested this particular valuation adjustment for many years but has finally acquiesced that the transfer tax value of a closely-held business interest can be reduced for the capital gains potential, at least when the entity is a “C” corporation.

The Role of Buy-Sell Agreements and Fixing Value

Treasury Regulations and Rev. Rul. 59-60 take the position that a buy-sell agreement is just one factor to be considered in valuing a closely-held business interest, depending upon the circumstances of a particular case.

Despite that position, the jurisprudence has acknowledged that a buy-sell agreement can fix the estate tax value of the interest, even if that value is lower than it otherwise would have been in the absence of an agreement, if:

The Revenue Reconciliation Act of 1990 created new IRC §2703 as part of the special valuation provisions of Chapter 14 of the Code. For buy-sell agreements created on or after October 9, 1990, or substantially modified on or after that date, an additional requirement to fix the estate tax value is that the buy-sell agreement’s terms must be comparable to similar arrangements entered into in arm’s length transactions. If actual comparable arrangements cannot be found, the Regulations introduce a “fair bargain” test which is whether the right or restriction in the buy-sell agreement is one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm’s length.

Importance of a Qualified Appraiser

As can be readily seen from the foregoing, the appraisal of the fair market value of a closely- held, family business is an art and not a science.

A number of subjective decisions need to be made in the valuation process including appropriate capitalization rates, the selection of comparable publically traded companies, the appropriateness and size of adjustments, etc. Clearly, no significant transaction should be entered into without the assistance of a competent, qualified appraiser.

If the transaction involves a transfer subject to federal transfer tax requiring the filing a gift tax return, the Treasury Regulations concerning adequate disclosure to begin the running of the statute of limitations require a detailed description of the method used to determine fair market value of the property transferred, including any financial data that was used to determine the value of the interest, any restrictions on the transfer of property that were considered in determining the fair market value of the property and a description of any discounts claimed in valuing the property. Furthermore, if the value of the entity is determined based upon the net asset value method, a statement must be provided regarding the fair market value of the enterprise value determined without regard to any discounts. These requirements should be satisfied if a qualified appraisal prepared by a qualified appraiser is used and attached to the return. An appraisal also will assist the taxpayer in meeting the substantiation and record-keeping requirements for shifting the burden of proof to IRS.

Since there is no judicially recognized appraiser-client privilege, it may be appropriate for the attorney handling the transaction to engage the appraiser directly in order to bring the discussions and work product of the appraiser within the attorney-client privilege.

If the matter involved is headed for litigation, the qualifications of the appraiser are particularly important if he is to serve as an expert witness. The Federal Rules of Evidence which apply in both Federal District Court and the Tax Court utilize the Daubert rule which could cause an appraiser to be excluded as an expert witness if the appraiser’s method or technique has not been tested in his field of expertise, has not be the subject of a peer review, is not subject to any standards of control for use and accuracy, or has not been generally accepted in the relevant technical community.

Furthermore, in valuation cases in the Tax Court, appraisers are often required by the judge to submit reports critiquing the expert appraisal report of the opposing party. Furthermore, in the Tax Court, the judge is free to accept either party’s expert report, in whole or in part, to accept portions of each expert’s report or to reject both experts in their entirety.

When an expert takes the stand in the Tax Court, his expert report is admitted into evidence without direct testimony. As a result, the expert’s first testimony will be on cross examination by the opponent. Consequently, the first impression made with the judge will be one of the expert under attack. The report should be complete and require no further explanation. Every prospective expert appraiser should be carefully reviewed and auditioned with these factors in mind.


One of the many issues facing a closely-held business owner is the proper valuation of a family business which often is the dominant asset of the owner’s estate, both financially and emotionally. The issue of valuation can arise in many legal contexts, but most often for transfer tax purposes. A qualified business appraiser always should be utilized as an integral part of the process.

1 Reg. §20.2031-1(b); Reg. §25.2512-1.
2 Reg. §20.2031-2(b); Reg. §25.2512-2(b).
3 Reg. §20.2031-2(f); Reg. §25.2512-2(f); Rev. Rul. 59-60,1959-1 CB 237.
4 Mandlebaum, TCM 1995-255, affirmed, 91 F.3d 124 (3d Cir. 1996).
5 Estate of Bright, 658 F. 2d 999 (5th Cir. 1981); Rev. Rul. 93-12, 1993-1 CB 202.
6 Ibid.
7 See, for example, Estate of Simplot, 112 TC 130 (1999).
8 Estate of Huntsman, 66 tc 861 (1976); Estate of Feldman, TCM 1988-429;Furman, 110 TC 530 (1998).
9 Estate of Davis, 110 TC 530 (1998); Eisenberg, 155 F. 3d 50 (2d Cir. 1998); 1999-4 IRB 4.
10 Reg. §20.2031-2(h); Rev. Rul. 59-60, 1959-1 CB 237.
11 See, for example, Elvie Cobb, 49 TCM 1364 (1985).
12 Reg. §25.2703-1(b)(4)(i).
13 Reg. §301.6501(c) – 1(f)(3)(i).
14 IRC §7491(a)(2).
 Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993);Kumho Tire Co. v. Carmichael, U. S. 137 (1999).
16 Kosman, 71 TCM 2356 (1996).
17 Tax Court Rule 143(f).



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