The eight sections of Revenue Ruling 59-60 govern the valuation of private businesses. The IRS recognizes there is room for many different approaches and therefore sets out overarching principles which the Valuator much follow:
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.
Sec. 2. Background
and definitions.
.01 All valuations
must be made in accordance with the applicable provisions of the Internal
Revenue Code of 1954 and the Federal Estate Tax and Gift Tax Regulations.
Sections 2031(a), 2032 and 2512(a) of the 1954 Code (sections 811 and 1005 of
the 1939 Code) require that the property to be included in the gross estate, or
made the subject of a gift, shall be taxed on the basis of the value of the
property at the time of death of the decedent, the alternate date if so
elected, or the date of gift.
.02 Section
20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax
Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section
86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the
price at which the property would change hands between a willing buyer and a
willing seller when the former is not under any compulsion to buy and the
latter is not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts. Court decisions frequently state in addition that
the hypothetical buyer and seller are assumed to be able, as well as willing,
to trade and to be well informed about the property and concerning the market
for such property.
.03 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 is
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."
Sec. 3. Approach to
valuation.
.01 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.
.02 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.
.03 Valuation of
securities is, in essence, a prophesy 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 a similar line of business are selling in a free and open market.
Sec. 4. Factors to
consider.
.01 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 has 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.
.02 The following is
a brief discussion of each of the foregoing factors:
The history of a
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 the 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:
Gross income by
principal items;
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;
Net income available
for dividends;
Rates and amounts of
dividends paid on each class of stock;
Remaining amount
carried to surplus; and
Adjustments to, and
reconciliation with, 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 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 in 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, yet 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.
Sec. 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 of 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 the 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.
Sec. 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 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.
Sec. 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.
Sec. 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. See Rev. Rul. 54-76, C.B. 1954-1, 194. However, in such case 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. In this connection
see Rev. Rul. 157 C.B. 1953-2, 255, and Rev. Rul. 189, C.B. 1953-2, 294.