In valuing the stock of closely-held corporations, or the stock of
corporations where market quotations are not available, all other available
financial data, as well as all relevant factors affecting the fair market
value must be considered for estate tax and gift tax purposes. No general
formula may be given that is applicable to the many different valuation
situations arising in the valuation of such stock. However, the general
approach, methods and factors which must be considered in valuing such
securities are outlined.
Section 1. Purpose.
The purpose of this Revenue Ruling is to outline and review in general
the approach, methods and factors to be considered in valuing shares of
the capital stock of closely-held corporations for estate tax and gift
tax purposes. The methods discussed herein will apply likewise to the
valuation of corporate stocks on which market quotations are either unavailable
or are of such scarcity that they do not reflect the fair market value.
Section 2. Background and definitions.
- Closely-held corporations are those corporations the shares of which
are owned by a relatively limited number of stockholders. Often the
entire stock issue is held by one family. The result of this situation
is that little, if any, trading in the shares takes place. There is,
therefore, no established market for the stock and such sales as occur
at irregular intervals seldom reflect all of the elements of a representative
transaction as defined by the term "fair market value."
Section 3. Approach to valuation.
- A determination of fair market value, being a question of fact, will
depend upon the circumstances in each case. No formula can be devised
that will be generally applicable to the multitude of different valuation
issues arising in estate and gift tax cases. Often, an appraiser will
find wide differences of opinion as to the fair market value of a particular
stock. In resolving such differences, he should maintain a reasonable
attitude in recognition of the fact that valuation is not an exact science.
A sound valuation will be based upon all the relevant facts, but the
elements of common sense, informed judgment and reasonableness must
enter into the process of weighing those facts and determining their
aggregate significance.
- The fair market value of specific shares of stock will vary as general
economic conditions change from "normal" to "boom"
or "depression," that is according to the degree of optimism
or pessimism with which the investing public regards the future at the
required date of appraisal. Uncertainty as to the stability or continuity
of the future income from a property decreases its value by increasing
the risk of loss of earnings and value in the future. The value of shares
of stock of a company with very uncertain future prospects is highly
speculative. The appraiser must exercise his judgment as to the degree
of risk attaching to the business of the corporation which issued the
stock, but that judgment must be related to all of the other factors
affecting value.
- Valuation of securities is, in essence, a prophecy as to the future
and must be based on facts available at the required date of appraisal.
As a generalization, the prices of stocks which are traded in volume
in a free and active market by informed persons best reflect the consensus
of the investing public as to what the future holds for the corporations
and industries represented. When a stock is closely held, is traded
infrequently, or is traded in an erratic market, some other measure
of value must be used. In many instances, the next best measure may
be found in the prices at which the stocks of companies engaged in the
same or similar line of business are selling in a free and open market.
Section 4. Factors to consider.
- It is advisable to emphasize that in the valuation of the stock of
closely-held corporations or the stock of corporations where market
quotations are either lacking or too scarce to be recognized, all available
financial data, as well as all relevant factors affecting the fair market
value, should be considered. The following factors, although not all-inclusive,
are fundamental and require careful analysis in each case:
- 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 stock and the financial condition of the business.
- The earning capacity of the company.
- The dividend-paying capacity.
- Whether or not the enterprise had goodwill or other intangible value.
- Sales of the 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 having their stocks actively traded in
a free and open market, either on an exchange or over-the-counter.
- The following is a brief discussion of each of the foregoing factors:
- The history of corporate enterprise will show its past stability
or instability, its growth or lack of growth, the diversity or lack
of diversity of its operations, and other facts needed to form an
opinion of the degree of risk involved in the business. For an enterprise
which changed its form of organization but carried on the same or
closely similar operations of its predecessor, the history of the
former enterprise should be considered. The detail to be considered
should increase with approach to the required date of appraisal, since
recent events are of greatest help in predicting the future; but a
study of gross and net income, and of dividends covering a long prior
period, is highly desirable. The history to be studied should include,
but need not be limited to, the nature of the business, its products
or services, its operating and investment assets, capital structure,
plant facilities, sales records and management, all of which should
be considered as of the date of the appraisal, with due regard for
recent significant changes. Events of the past that are unlikely to
recur in the future should be discounted, since value has a close
relation to future expectancy.
- A sound appraisal of a closely-held stock must consider current
and prospective economic conditions as of the date of appraisal, both
in the national economy and in the industry or industries with which
the corporation is allied. It is important to know that the company
is more or less successful than its competitors in the same industry,
or that it is maintaining a stable position with respect to competitors.
Equal or even greater significance may attach to the ability of the
industry with which the company is allied to compete with other industries.
Prospective competition which has not been a factor in prior years
should be given careful attention. For example, high profits due to
the novelty of its product and the lack of competition often lead
to increasing competition. The public's appraisal of the future prospects
of competitive industries or of competitors within an industry may
be indicated by price trends in the markets for commodities and for
securities. The loss of the manager of a so-called "one-man"
business may have a depressing effect upon the value of the stock
of such business, particularly if there is a lack of trained personnel
capable of succeeding to the management of the enterprise. In valuing
the stock of this type of business, therefore, the effect of the loss
of the manager on the future expectancy of the business, and the absence
of management-succession potentialities are pertinent factors to be
taken into consideration. On the other hand, there may be factors
which offset, in whole or in part, the loss of the manager's services.
For instance, the nature of the business and of its assets may be
such that they will not be impaired by the loss of the manager. Furthermore,
the loss may be adequately covered by life insurance, or competent
management might be employed on the basis of the consideration paid
for the former manager's services. These, or other offsetting factors,
if found to exist, should be carefully weighed against the loss of
the manager's services in valuing the stock of the enterprise.
- Balance sheets should be obtained, preferably in the form of comparative
annual statements for two or more years immediately preceding the
date of appraisal, together with a balance sheet at the end of the
month preceding that date, if corporate accounting will permit. Any
balance sheet descriptions that are not self-explanatory, and balance
sheet items comprehending diverse assets or liabilities, should be
clarified in essential detail by supporting supplemental schedules.
These statements usually will disclose to the appraiser (1) liquid
position (ratio of current assets to current liabilities); (2) gross
and net book value of principal classes of fixed assets; (3) working
capital; (4) long-term indebtedness; (5) capital structure; and (6)
net worth. Consideration also should be given to any assets not essential
to the operation of the business, such as investments in securities,
real estate, etc. In general, such nonoperating assets will command
a lower rate of return than do the operating assets, although in exceptional
cases the reverse may be true. In computing the book value per share
of stock, assets of the investment type should be revalued on the
basis of their market price and book value adjusted accordingly. Comparison
of the company's balance sheets over several years may reveal, among
other facts, such developments as the acquisition of additional production
facilities or subsidiary companies, improvement in financial position,
and details as to recapitalizations and other changes in the capital
structure of the corporation. If the corporation has more than one
class of stock outstanding, the charter or certificate of incorporation
should be examined to ascertain the explicit rights and privileges
of the various stock issues including: (1) voting powers, (2) preference
as to dividends, and (3) preference as to assets in the event of liquidation.
- Detailed profit-and-loss statements should be obtained and considered
for a representative period immediately prior to the required date
of appraisal, preferably five or more years. Such statements should
show (1) gross income by principal items; (2) principal deductions
from gross income including major prior items of operating expenses,
interest and other expense on each item of long-term debt, depreciation
and depletion if such deductions are made, officers' salaries, in
total if they appear to be reasonable or in detail if they seem to
be excessive, contributions (whether or not deductible for tax purposes)
that the nature of its business and its community position require
the corporation to make, and taxes by principal items, including income
and excess profits taxes; (3) net income available for dividends;
(4) rates and amounts of dividends paid on each class of stock; (5)
surplus as stated on the balance sheet. With profit and loss statements
of this character available, the appraiser should be able to separate
recurrent from nonrecurrent items of income and expense, to distinguish
between operating income and investment income, and to ascertain whether
or not any line of business in which the company is engaged is operated
consistently at a loss and might be abandoned with benefit to the
company. The percentage of earnings retained for business expansion
should be noted when dividend-paying capacity is considered. Potential
future income is a major factor in many valuations of closely-held
stocks, and all information concerning past income which will be helpful
in predicting the future should be secured. Prior earnings records
usually are the most reliable guide as to the future expectancy, but
to resort to arbitrary five-or-ten year averages without regard to
current trends or future prospects will not produce a realistic valuation.
If, for instance, a record of progressively increasing or decreasing
net income is found, then greater weight may be accorded the most
recent years' profits in estimating earning power. It will be helpful,
in judging risk and the extent to which a business is a marginal operator,
to consider deductions from income and net income in terms of percentage
of sales. Major categories of cost and expense to be so analyzed include
the consumption of raw materials and supplies in the case of manufacturers,
processors and fabricators; the cost of purchased merchandise in the
case of merchants; utility services; insurance; taxes; depletion or
depreciation; and interest.
- Primary consideration should be given to the dividend-paying capacity
of the company, rather than to dividends actually paid in the past.
Recognition must be given to the necessity of retaining a reasonable
portion of profits in a company to meet competition. Dividend-paying
capacity is a factor that must be considered in an appraisal, but
dividends actually paid in the past may not have any relation to dividend-paying
capacity. Specifically, the dividends paid by a closely-held family
company may be measured by the income needs of the stockholders or
by their desire to avoid taxes on dividend receipts, instead of by
the ability of the company to pay dividends. Where an actual or effective
controlling interest in a corporation is to be valued, the dividend
factor is not a material element, since the payment of such dividends
is discretionary with the controlling stockholders. The individual
or group in control can substitute salaries and bonuses for dividends,
thus reducing net income and understating the dividend-paying capacity
of the company. It follows, therefore, that dividends are less reliable
criteria of fair market value than other applicable factors.
- In the final analysis, goodwill is based upon earning capacity.
The presence of goodwill and its value, therefore, rests upon the
excess of net earnings over and above a fair return on the net tangible
assets. While the element of goodwill may be based primarily on earnings,
such factors as the prestige and renown of the business, the ownership
of a trade or brand name, and a record of successful operation over
a prolonged period in a particular locality, also may furnish support
for the inclusion of intangible value. In some instances it may not
be possible to make a separate appraisal of the tangible and intangible
assets of the business. The enterprise has a value as an entity. Whatever
intangible value there is, which is supportable by the facts, may
be measured by the amount by which the appraised value of the tangible
assets exceeds the net book value of such assets.
- Sales of stock of a closely-held corporation should be carefully
investigated to determine whether they represent transactions at arm's
length. Forced or distress sales do not ordinarily reflect fair market
value, nor do isolated sales in small amounts necessarily control
as the measure of value. This is especially true in the valuation
of a controlling interest in a corporation. Since, in the case of
closely-held stocks, no prevailing market prices are available, there
is no basis for making an adjustment for blockage. It follows, therefore,
that such stocks should be valued upon a consideration of all the
evidence affecting the fair market value. The size of the block of
stock itself is a relevant factor to be considered. Although it is
true that a minority interest in an unlisted corporation's stock is
more difficult to sell than a similar block of listed stock, it is
equally true that control of a corporation, either actual or in effect,
representing as it does an added element of value, may justify a higher
value for a specific block of stock.
- Section 2031 (b) of the Code states, in effect, that in valuing
unlisted securities the value of stock or securities of corporations
engaged in the same or a similar line of business which are listed
on an exchange should be taken into consideration along with all other
factors. An important consideration is that the corporations to be
used for comparisons have capital stocks which are actively traded
by the public. In accordance with Section 2031 (b) of the Code, stocks
listed on an exchange are to be considered first. However, if sufficient
comparable companies whose stocks are listed on an exchange cannot
be found, other comparable companies which have stocks actively traded
on the over-the-counter market also may be used. The essential factor
is that whether the stocks are sold on an exchange or over-the-counter
there is evidence of an active, free public market for the stock as
of the valuation date. In selecting corporations for comparative purposes,
care should be taken to use only comparable companies. Although the
only restrictive requirement as to comparable corporations specified
in the statute is that their lines of business be the same or similar,
it is obvious that consideration must be given to other relevant factors
in order that the most valid comparison possible will be obtained.
For illustration, a corporation having one or more issues of preferred
stock, bonds or debentures in addition to its common stock should
not be considered to be directly comparable to one having only common
stock outstanding. In like manner, a company with a declining business
and decreasing markets is not comparable to one with a record of current
progress and market expansion.
Section 5. Weight to be accorded various factors.
The valuation of closely-held corporate stock entails the consideration
of all relevant factors as stated in Section 4. Depending upon the circumstances
in each case, certain factors may carry more weight than others because
the nature of the company's business. To illustrate:
-
- Earnings may be the most important criterion of value in some
cases, whereas asset value will receive primary consideration in
others. In general, the appraiser will accord primary consideration
to earnings when valuing stocks of companies which sell products
or services to the public; conversely, in the investment or holding
type of company, the appraiser may accord the greatest weight to
the assets underlying the security to be valued.
- The value of the stock of a closely-held investment or real estate
holding company, whether or not family owned, is closely related
to the value of the assets underlying the stock. For companies of
this type the appraiser should determine the fair market values
of the assets of the company. Operating expenses of such a company
and cost of liquidating it, if any, merit consideration when appraising
the relative values of the stock and the underlying assets.The market
values of the underlying assets give due weight to potential earnings
and dividends of the particular items of property underlying the
stock, capitalized at rates deemed proper by the investing public
at the date of appraisal. A current appraisal by the investing public
should be superior to the retrospective opinion of an individual.
For these reasons, adjusted net worth should be accorded greater
weight in valuing the stock of a closely-held investment or real
estate holding company, whether or not family owned, than any of
the other customary yardsticks of appraisal, such as earnings and
dividend-paying capacity.
Section 6. Capitalization rates.
In the application of certain fundamental valuation factors, such as
earnings and dividends, it is necessary to capitalize the average or current
results at some appropriate rate. A determination of the proper capitalization
rate presents one of the most difficult problems in valuation. That there
is no ready or simple solution will become apparent by a cursory check
of the rates of return and dividend yields in terms of the selling prices
of the corporate shares listed on the major exchanges of the country.
Wide variations will be found even for companies in the same industry.
Moreover, the ratio will fluctuate from year to year depending upon economic
conditions. Thus, no standard tables of capitalization rates applicable
to closely held corporations can be formulated. Among the more important
factors to be taken into consideration in deciding upon a capitalization
rate in a particular case are: (1) the nature of the business; (2) the
risk involved; and (3) the stability or irregularity of earnings.
Section 7. Average of factors.
Because valuations cannot be made on the basis of a prescribed formula,
there is no means whereby the various applicable factors in a particular
case can be assigned mathematical weights in deriving the fair market
value. For this reason, no useful purpose is served by taking an average
of several factors (for example, book value, capitalized earnings and
capitalized dividends) and basing the valuation on the result. Such a
process excludes active consideration of other pertinent factors, and
the end result cannot be supported by a realistic application of the significant
facts in the case except by mere chance.
Section 8. Restrictive agreements.
Frequently, in the valuation of closely-held stock for estate and gift
tax purposes, it will be found that the stock is subject to an agreement
restricting its sale or transfer. Where shares of stock were acquired
by a decedent subject to an option reserved by the issuing corporation
to repurchase at a certain price, the option price is usually accepted
as the fair market value for estate tax purposes. However, in such cases
the option price is not determinative of fair market value for gift tax
purposes. Where the option, or buy and sell agreement, is the result of
voluntary action by the stockholders and is binding during the life as
well as at the death of the stockholders, such agreement may or may not,
depending upon the circumstances of each case, fix the value for estate
tax purposes. However, such agreement is a factor to be considered, with
other relevant factors, in determining fair market value. Where the stockholder
is free to dispose of his shares during life and the option is to become
effective only upon his death, the fair market value is not limited to
the option price. It is always necessary to consider the relationship
of the parties, the relative number of shares held by the decedent, and
other material facts, to determine whether the agreement represents a
bona fide business arrangement or is a device to pass the decedent's shares
to the natural objects of his bounty for less than an adequate and full
consideration in money or money's worth.
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Adjustment for blockage
All relevant factors
Amounts of dividends
Appraisal
Appraisal of a closely-held stock
Appraised value
Appraiser
Block of stock
Bona fide business arrangement
Book value of the stock
Book value per share of stock
Buy and sell agreement
Capital stock
Capital stock
Capital structure
Capitalization rate
Capitalization rates
Class of stock
Closely-held corporation
Closely-held corporations
Closely-held family company
Closely-held stocks
Common sense
Common stock
Common stock outstanding
Comparable companies
Comparable corporations
Competitive industries
Competitors within an industry
Control of a corporation
Controlling interest
Controlling stockholders
Criteria of fair market value
Date of appraisal
Death of the stockholders
Decedent
Degree of risk
Detailed profit-and-loss
statements
Determination of fair market
value
Dividend yields
Dividend-paying capacity
Dividend-paying capacity
Earning capacity of the company
Economic outlook in general
Element of goodwill
Estate and gift tax cases
Estate tax
Estate tax
Factors affecting value
Fair market
Financial condition of the business
Free and active market
Free public market
Future income
General economic conditions
Gift tax
History of corporate enterprise
History of the enterprise
Holding type of company
Informed judgment
Intangible assets
Intangible value
Investments in securities
Limited number of stockholders
Market price of stocks
Measure of value
Minority interest
Nature of the business
Net book value
Net income available for dividends
Net tangible assets
Net worth
No established market
Nonoperating assets
Operating income
Other relevant factors
Outlook in the specific industry
Over-the-counter
Over-the-counter market
Percentage of earnings
Potential future income
Preferred stock
Presence of goodwill
Prices of stocks
Prior earning records
Problems in valuation
Property underlying the stock
Rates of return
Realistic valuation
Recapitalization
Required date of appraisal
Revenue Ruling
Risk of loss
Section 2031 (b)
Securities of corporations
Security to be valued
Separate appraisal
Shares of stock
Similar line of business
Size of the block
Sound valuation
Stock is closely held
Stock of a closely-held
corporation
Stock of a closely-held investment
Stock of a company
Stock of closely-held corporations
Stock of corporation
Stock of the enterprise
Stocks of companies
Study of gross and net income
Term “fair market value”
Transactions at arm’s length
Unlisted corporation’s stock
Valuation
Valuation date
Valuation issues
Valuation of a controlling interest
Valuation of closely-held corporate stock
Valuation of closely-held stock
Valuation of corporate stocks
Valuation of securities
Valuations of closely-held stocks
Value
Value as an entity
Value for estate tax
Value of shares
Valuing shares
Valuing stocks of companies
Valuing the stock
Valuing the stock
Valuing unlisted securities
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