The Value of Valuation Discounts in Transferring Ownership of Family Owned Businesses

Valuation discounts, often utilized in connection with the transfer of ownership interests in family-owned or closely-held businesses, are a valuable estate planning tool. These discounts have gotten a good deal of press lately.

Last September, the Build Back Better Act (BBBA) (H.R. 5376) was introduced in the House of Representatives. In its original form, the proposed legislation included a provision which would have effectively eliminated valuation discounts on the transfer of entities that hold “nonbusiness” or “passive” assets, including cash, stocks, bonds and real estate not used in an “active trade or business.” This was not the first legislative assault on valuation discounts. In fact, there have been repeated efforts to eliminate this tool either legislatively or through regulatory processes since the 1970s. As with other attempts, the 2021 effort to severely limit the use of such discounts failed—being left on the cutting room floor prior to the final bill ultimately being passed by the House. As you likely know, the BBBA, sans the discounting rule modifications, never made it to a vote in the Senate — largely due to the widely-reported opposition to the bill by Democratic Senators Joe Manchin and Kyrsten Sinema.

It would be reasonable to believe, while valuation discounts are still available to business owners and their estate planning attorneys and financial advisors, that such discounts have not stared down the executioner for the last time. In its never-ending quest for additional tax revenues, it is likely that a future Congress will once again look to modify or eliminate the current valuation discount laws and regulations. In addition, it is very likely that the unified credit, which in 2022 allows an individual to gift during his or her lifetime or upon death a total of $12.06 million without paying gift or estate taxes ($24.12 million for a married couple), will be reduced significantly in the next few years. Under current law, the credit is scheduled to revert to its pre-2018 level of $5 million, as adjusted for inflation, at the end of 2025, but many expect it to be reduced in a future spending bill prior to that. When the unified credit is reduced, those who have not used the “extra” exemption will lose it forever. Taken together, the possibility (some might say probability) of changes to both valuation discounts and the unified credit in the next few years makes it especially important for owners of sizable businesses to consider revisions to their estate plans and the utilization of valuation discounts to transfer ownership to the next generation.

The goal of applying discounts with family or closely-held businesses is typically to reduce valuations for estate tax purposes while allowing gifts of an ownership percentage to children or grandchildren at a reduced rate. Oftentimes these ownership interests are placed and held in limited liability companies or family limited partnerships.

The standard valuation of a business interest for gift and estate tax purposes is “fair market value”—generally defined as the hypothetical price arrived at for a business between a willing buyer and a willing seller, neither being under any compulsion to sell and both having reasonable knowledge of relevant facts.

To receive a valuation discount, a business owner would typically split up the ownership interests in the business and gift or sell such partial interests to children or irrevocable trusts established for the benefit of those children.

The most common valuation discounts used in transferring ownership interests in family owned businesses are those for lack of marketability, lack of control and minority interest or share. These discounts, alone or in combination, may range from 10% to 50% or higher depending on a number of factors. The discounts are not routinely stacked on top of one another, meaning that successive discounts are applied to an already discounted number, e.g. if an ownership interest is valued at $10 million and the first discount is 20%, a second discount of 20% would be applied against an $8 million valuation, the original valuation already having been reduced by $2 million.

Lack of Marketability. This discount is often called a liquidity discount and reflects the fact that unlike publicly traded companies, interests in closely-held businesses have no ready market. The discount is the difference between the value of a stock that is publicly traded (and has a market) and privately held stock which has little or no market. Various methods may be employed in determining an appropriate lack of marketability discount and discounts in the 25% range are not out of the ordinary where a compelling case is made.

Lack of Control. This discount is applied when the ownership interest is noncontrolling or consists of non-voting shares and reflects the fact that owners of such interests are unable to make business decisions such as, determining compensation, declaring dividends and deciding to sell or liquidate. The discount reflects the difference in value between an ownership interest with those qualities and one without. Depending on the facts and circumstances, and what other discounts are claimed, the discount for lack of control may also be as much as 25% or more.

Minority Interest. This discount reflects that a partial ownership interest may be less than its proportional share, i.e. a 49% interest may be worth less than 49% of the company’s overall value because the minority interest has no ability to control management or other critical aspects of the business. Discounts for minority interest are often in the 25% range, again depending on the unique circumstances of the company and ownership interest.

Here is an example of how these discounts might be applied together to substantially reduce the amount of the lifetime estate exemption used (thus preserving the “discounted” amount for additional and future gifting):

Bob owns 49% of a family limited partnership (“FLP”). He is not the manager. The FLP owns a large commercial farm valued at $8 million. It also owns $10 million in liquid investments and another $20 million of private equity interests spread across a number of medical device companies. All in, the FLP is valued at $38 million with Bob’s fully valued 49% interest equaling $18,620,000. Bob has chosen to gift his shares to his children. He may avail himself to at least three discounts.

Bob may receive a discount for lack of marketability since as a minority shareholder he would likely have difficulty selling his share since he has no control over the underlying investments. For illustration purposes, let’s say that discount is 25%

As a non-managing owner, Bob may also be entitled to a lack of control discount which may be another 20%.

As a minority shareholder, Bob may be entitled yet another discount. This final discount might further reduce the already discounted value by 10%.

If Bob gifted his 49% interest in the FLP in 2022, without using valuation discounts, the value of the gift would be equal to his 49% interest, or $18,620,000. This would result in a gift tax owing (by Bob) of $2,624,000 ($18.62M minus his $12.06M lifetime exemption amount multiplied by 40% (the gift tax owing on gifts made in excess of the 2022 exemption amount)). Furthermore, Bob would have to use his entire gift and estate tax exemption and all future gifts during Bob’s lifetime or upon his death would be subject to a 40% tax.

In our example above, by utilizing the three valuation discounts, Bob is able to gift his entire interest in the FLP (at a 46% cumulative discount) to his children estate and gift tax free, and use only $10,054,800 of his lifetime exemption. If he had not previously used any of his exemption and made the gifts in 2022, he would still be able to gift another $2,005,200 estate and gift tax free at some point in the future.

As you can see, valuation discounts can have a tremendous impact on preserving family wealth and facilitating the transfer of family owned businesses from one generation to the next. If you are a business owner who would like to see it remain in the family and expect to have a taxable estate, now would be a good time to review some ownership transfer and valuation discount options with your financial advisor and estate planning attorney.