We often hear about gift and estate taxes in the context of transferring assets for gifting and estate planning purposes. But what exactly are gift and estate taxes?

In simple terms, gift and estate taxes are transfer taxes imposed by the government when assets are transferred between individuals or trusts. When business interests are being transferred for estate or gift purposes, it is necessary to file gift and estate tax returns and assess the value of the transferred business interest — a process called valuation.

One of the most important elements of valuation is understanding valuation discounts, which can be applied to the value of privately-held businesses. Let’s explore what these discounts are and how they can help companies like yours value your business for estate planning purposes.

What Are Valuation Discounts

Valuation discounts are percentages that can be used to lower the value of the business interest being transferred, provided certain criteria are met. If applicable, they can lower the potential transfer taxes involved with gift or estate planning transactions.

Valuation discounts can range from 10 to 45 percent, depending on various factors, and can provide a significant benefit when utilized in estate and gift tax planning involving ownership interest transfers of privately-held businesses.

Common Types of Valuation Discounts

The most common types of valuation discounts are the discount for lack of marketability and the discount for lack of control. Because they differ, we’ll break down how each works.

Discount For Lack of Marketability

Discounts for lack of marketability (DLOM) refer to the method used to help calculate the value of closely held and restricted shares. The theory behind DLOM is that a valuation discount exists between a stock that is publicly-traded and, thus, has a market vs. a privately-held stock. (The market for privately-held stock often has little, if any, open marketplace).

To better understand this discount, it is important to know that “fair market value” is the valuation standard of a business interest for gift and estate tax purposes.

Fair market value is defined by the IRS as "the price that property would sell for on the open market. It is the price that would be agreed upon between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of relevant facts."

The key element of this definition is “on the open market.” Unlike publicly-traded company stocks, privately-held business ownership cannot be traded in a readily available marketplace and cannot be easily transferred without considerable time, effort, and cost. Therefore, the fair market value of an ownership interest in a privately-held business is considered lower than that of publicly-traded company stock.

Discount For Lack of Control

A discount for lack of control (DLOC) is a discount applied to a non-controlling ownership interest in a small to mid-sized business.

This discount refers to the reduction in the value of an equity interest due to an owner's lack of ability to exert control over the company. Minority owners usually do not have the power to make decisions regarding the company's operations or strategies. Minority owners also may not be able to receive distributions from the business, since this decision may be at the discretion of the majority owner. These limitations inherently decrease the value a third-party would be willing to pay for a minority ownership interest.

Additionally, the discount for lack of control applies to the specific block of equity being transferred. For example, if a 90 percent owner of a business is looking to transfer 10 percent of their ownership interest, the discount for lack of control would apply to the transfer, since the hypothetical owner of the 10 percent interest following the transfer would represent a minority interest.

Calculating Your Valuation Discounts for Gift or Estate Tax Planning

Valuation discounts are undoubtedly important in valuations for gift and estate purposes. However, to properly value an ownership interest in a privately-held business, it is important to consider the level of control and marketability of the equity interest being transferred when conducting gifting and estate planning.

Consulting with a valuation analyst or an estate planner can help determine the applicability and level of discounting that may apply to your business or your circumstances.

Business Valuation Services for Privately-Held Companies

Whether you are looking to get the most value out of your business during a business transfer or better plan for the future, our business valuation and estate planning specialists and here to help.

Explore our Business Valuation service page or learn more about Tax Planning for Estates, Trusts, & Gifts, today.