Privately-held businesses are generally entitled to receive two types of valuation discounts. One is the discount for lack of marketability (DLOM) and the other is the discount for lack of control(DLOC). We explored the DLOM in more detail in part one of this blog post series here. Part two will focus on the DLOC, which is available for privately-held business valuations when a non-controlling interest in the business is being transferred.
Between these two types of discounts, the DLOC is generally easier to understand. It represents are duction in value due to a shareholder’s inability to unilaterality make decisions impacting the business. If you were offered a controlling interest in a business versus a non-controlling interest stake, the price per share that you would be willing to pay for the non-controlling interest would understandably be lower. The controlling shareholder (or shareholders) maintain the ability to change/appoint management, pay shareholder dividends, change the bylaws of the company, and potentially sell or liquidate the company. As a minority stakeholder, you are subject to the decisions of the majority owners or a sole shareholder who owns a controlling stake.
Unfortunately, there is no standard formula to determine how large or small the discount for lack of control should be for a particular business. Studies have shown that discounts for lack of control can range from 10 percent to more than 50 percent. Ultimately, the discount taken should be based on the facts and circumstance for each situation and business. For most estate and gift tax purposes a discount from 15 percent to 20 percent is generally appropriate. A larger discount could be challenged by the Internal Revenue Service if the associated tax filing is examined.
Both the marketability discount and the control discount have enabled privately-held owners to transfer an ownership interest in the business at a discounted value and potentially receive favorable tax benefits. This is the reason privately-held business owners use gifting in connection with their estate planning years in advance of a third-party sale of their company. This technique allows the owner to utilize less of their lifetime estate tax credit by 1) transferring the stock before it appreciates further, and 2) using the discounts for lack of control and lack of marketability.
If you would like to learn more about private company valuation discounts, particularly the role they play in estate planning or gifting, please contact your Kreischer Miller relationship professional or any member of our team.
Brian J. Sharkey is a Director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at bsharkey@kmco.com.