FAQs about valuations of ESOPs

Some FAQ's for Employee Stock Option Plans (ESOP)
...Why do we need to engage an outside party to value our ESOP shares?
From a strictly regulatory standpoint, a valuation of ESOP shares by an independent third party is required by the Department of Labor (DOL) and the Internal Revenue Service (IRS).  The regulatory requirement stems from the practical need to insure that the value is determined by a party who does not have a personal or financial interest in the valuation result.  The valuation, moreover, should be performed on behalf of the ESOP trustee since it is the duty of the trustee to insure that transactions with the ESOP are consummated at “fair market value.”

What is meant by “fair market value”?
Fair Market Value (FMV) is a concept and not a price that emerges from application of some standard formula.  In simple terms, FMV is the price for which property would sell under the existing market conditions for such property as established in arms-length negotiations between knowledgeable and independent parties.  The “market” implied in definitions of FMV encompasses all potential buyers and sellers of the property involved. 

How is “fair market value” determined?
There are many method used in the determination of FMV.  The nature of the property being evaluated determines what methods are appropriate.  For example, the FMV of a single family home is determined by the price for which similar property is selling in the area in which such property is located.  The FMV of business interests that is generating earnings, however, is determined to a large degree on the basis of what a knowledgeable buyer would be willing to pay for the earnings stream considering available rates of return on relatively risk-free investments and the risks associated with the investment being appraised.  Although not the only method that might be considered, the present value of future earnings using a risk adjusted market rate is one of the most common approaches, referred to in business valuations as Discounted Future Earnings (DFE).

Reference to the results of mathematical formulas is not the sole determinant of FMV.  The judgment and experience of the valuation analyst is also a critical element since there can be many factors that can not be quantified by reference to the underlying financial information alone.

What is meant by a “control premium”?
A control premium is that amount which a buyer may be willing to pay to acquire a controlling interest in a business over and above the value of the interest based solely on the underlying financial factors.  The element of control, in this case, has a value which is added to the value that can otherwise be ascribed to the assets and earnings of the business.  The payment of a control premium in the purchase of a business does not necessarily add any value to the business.  Synergy value, unlike control, is susceptible to being measured in more concrete terms of increased financial benefits to the buyer over and above those being enjoyed by the selling parties.  Examples are the prospects of increased sales of the buyer’s products to the seller’s customer base or lower overall materials costs due to volume purchase discounts, etc.  Whether or not a control premium is appropriate in the purchase of shares by an ESOP must be determined on the facts in the individual case.  Moreover, since the ESOP generally doesn’t control a company itself, there is much debate as to whether or not an ESOP can pay a control premium for shares purchased, even if purchasing a controlling percentage.

How do ESOP valuations differ from valuations for other purposes?
Because of the regulatory requirement established in the Employee Retirement & Income Security Act of 1974 (ERISA) that an ESOP pay no more than “adequate consideration” in the purchase of employer securities, ESOP valuations must support the decisions of the trustees and must also withstand review by DOL and the IRS.  Valuations that are subject to being reviewed by third parties, whether for ESOP or other purposes, must include considerable discussions on the methods and factors employed as well as explanatory information on the sponsoring company’s financial and operating history and the industry in which it competes.  For similar reasons, valuations supporting tax related values for gift and estate or charitable deduction purposes must also include considerable background detail so that potential third party reviewers will have a clear understanding of the process leading up to the value conclusion.  In addition, ESOP regulations place various obligations on the sponsoring employer and allow for limitation of the voting rights of ESOP shares.  These, and other features specific to the ESOP require special consideration in the determination of the fair market value of ESOP owned securities of privately held companies...

Source is this firm GROCO CPA 

IRS Guidelines for reviewing ESOP Valuations

4.72.8.1  (09-01-2006)
Overview

1. Guidance is provided on valuing assets in a qualified retirement plan.
2. An accurate assessment of fair market value (FMV) is essential to a plan’s ability to comply with the Internal Revenue Code requirements and Title I of ERISA. For instance, the FMV of assets must be accurately determined to preclude a(n)—
   • Prohibited transaction;
   • Exclusive benefit violation under IRC 401(a);
   • Violation of the limitation on benefits and contributions under IRC 415;
   • Excess deduction under IRC 404;
   • Violation of the minimum funding requirements under IRC 412; or
   • Discrimination violation under IRC 401(a)(4).

4.72.8.1.1  (09-01-2006)
Valuation in Different Types of Plans

1. In a defined benefit plan, the valuation of trust assets will determine if the plan is adequately funded and if the plan’s funding assumptions are reasonable. This, in turn, will affect the employer’s deduction.
2. In a profit sharing, money purchase, or stock bonus plan, the valuation of assets will determine the value of a participant’s account, and ultimately, a participant’s distribution.
3. In an Employee Stock Ownership Plan (ESOP), the valuation will affect both the deduction and distribution. Also, IRC 401(a)(28)(C) requires an ESOP to obtain valuations by an independent appraiser of employer securities which are not readily tradeable on an established securities market, with respect to activities carried on by the plan.

4.72.8.1.2  (09-01-2006)
Formality of Valuation

1. Whether a formal valuation is required will depend on the transactions that occur with the plan and the form of the plan.
   • For example, the valuation in a single participant plan, a self-directed account, or frozen plan can be less formal in a year in which the plan or self-directed account receives no contribution and makes no distribution or change in investment.
2. The reasonableness of the method for valuing plan assets is based on the surrounding facts and circumstances. Except for certain employer securities held by an ESOP, there is no absolute requirement the annual valuation be based on an independent appraisal. On the other hand, it may be reasonable for an agent to request an appraisal for hard-to-value assets under certain circumstances, such as when distributions are made to plan participants.

4.72.8.2  (09-01-2006)
Form 5500 Information

1. Form 5500 requires a statement of plan assets valued at FMV as of the beginning and end of the current plan year.
2. The income statement on Form 5500 asks for unrealized appreciation or depreciation in plan assets.
3. A question on Form 5500 asks whether any non-cash contributions (real estate, collectibles, and closely held stock, etc.) were made to the plan, the value of which was set without an appraisal by an independent third party.

   Note:

   The Service’s position is that contributions of property to pension plans and certain other defined contribution plans are prohibited transactions if they are not covered by a statutory or administrative exemption. The Supreme Court ruled in favor of the Service inKeystone Consolidated Industries v. Commissioner, 508 U.S. 152 (1993).
4. A question on Form 5500 asks whether the plan holds any nonpublicly traded securities that were not appraised by an independent third-party appraiser.

4.72.8.2.1  (09-01-2006)
Examination Steps

1. A valuation problem may exist if any of these items are found on Form 5500.
2. Determine whether the plan reports assets with level values in successive years.
   1. If the same value for an asset was reported on Form 5500 for the prior year, it may indicate a yearly valuation was not performed, requiring further examination.
   2. The value of some types of investments may not change each year, e.g., certificates of deposit and U.S. government securities.
3. Determine whether there is a sudden jump in plan asset values in the same year a large distribution is made to highly compensated employees. The plan assets may not have been revalued in prior years, when distributions were being made to only nonhighly compensated employees, indicating there might be discrimination under IRC 401(a)(4).
   1. In the case of a plan termination, review Form 6088, Distributable Benefits from Employees Pension Benefit Plan, to determine whether only the accounts of highly compensated employees remain at plan termination. Compare it to Form 5500 for the current year to determine whether any nonhighly compensated employees participate in the plan. If none participate, look at Form 5500 for prior years to determine whether distributions were made to only nonhighly compensated employees in such years.
   2. If the plan is not terminating, check Schedule SSA, Annual Registration Statement Identifying Separated Participants With Deferred Vested Benefits, to determine whether mostly the accounts of highly compensated employees who have separated from service remain in the trust.
4. Refer to the question on Form 5500 on unrealized appreciation/depreciation. A valuation problem may exist if there is no response to this question when the plan reports investments in any corporate stock or security.
5. Look at the Form 5500 question on non-cash contributions. If there is an exempt contribution of property, determine whether and by whom the property was valued in the year of the contribution.
6. Look at the Form 5500 question on nonpublicly traded securities. If the plan purchased or received any nonpublicly traded securities not appraised by an independent third-party appraiser, determine whether the securities were valued that year and by whom.

4.72.8.3  (09-01-2006)
Timing of Asset Valuations

1. In a defined contribution plan, Rev. Rul. 80–155, 1980–1 C.B. 84, provides that since amounts allocated or distributed to a participant must be ascertainable, the plans must value their trust investments—
   • at least once a year,
   • on a specified date,
   • in accordance with a method consistently followed and uniformly applied.
2. In a defined benefit plan, IRC 412 requires yearly valuations of plan assets for funding purposes. These valuations must be based on reasonable actuarial assumptions. See Reg. 1.401–2(b).
3. As provided under Rev. Rul. 69–494, 1969–2 C.B. 88, when employer securities are acquired or sold, the securities must be valued at the time of the transaction.

4.72.8.3.1  (09-01-2006)
Interim Valuations

1. Under Rev. Rul. 80–155, in addition to the required annual valuation, interim valuations are permitted. Thus, a plan provision allowing interim valuations at a trustee’s discretion is permitted as long as these valuations are not discriminatory under IRC 401(a)(4).
   1. A plan with a valuation date of January 1, the first day of the plan year, which also requires interim valuations at the end of each month in which significant market fluctuations (as defined in the plan) have taken place, would not be discriminatory on its face.
   2. However, if a defined contribution plan was amended to provide for interim valuations during a time in which plan asset values were rising and in which highly compensated employees were receiving distributions, the plan could violate IRC 401(a)(4).
2. A decrease in benefits caused by a change in the date for valuing plan assets is not necessarily a decrease in benefits prohibited by IRC 411(d)(6). See Reg. 1.411(d)–4, Q& A –1(d)(8).

4.72.8.3.2  (09-01-2006)
Examination Steps

1. Determine whether there has been an annual valuation of plan assets at FMV.
2. If there are interim valuations, determine that the plan has an annual valuation date and permits interim valuations.
3. Check whether interim valuations are discriminatory under IRC 401(a)(4). See, for example, Rev. Rul. 80–155.

4.72.8.4  (09-01-2006)
Determining Asset Values

1. Rev. Rul. 59–60, 1959–1 C.B. 237, provides guidance for determining the value of plan assets. Although Rev. Rul. 59–60 provides methods for valuing shares of stock of closely held corporations for estate and gift tax purposes, the factors may be used to determine values of assets in qualified plans.
   1. The factors in Rev. Rul. 59–60 are not an exclusive list of factors for valuing closely-held employer securities. Other factors may be included where appropriate. Also, not all of the listed factors will be relevant to all companies and transactions.
2. The detail of the plan’s valuation should be examined in light of the plan assets involved.
   • For example, the valuation should contain substantial detail if it values a limited partnership interest or a closely held corporation.
3. Where appropriate, stock values should be discounted due to a lack of marketability and, if appropriate, a control premium should be added to the stock value.

4.72.8.4.1  (09-01-2006)
Factors for Determining Value

1. There are a number of factors to consider when determining the value of an asset, for example:
   1. Nature and history of the business issuing the security
   2. General economic outlook and the outlook for the specific industry
   3. Book value of the securities and the financial condition of the business
   4. Company’s earning capacity
   5. Company’s dividend paying capacity
   6. Goodwill value
   7. Recent stock sales

4.72.8.4.2  (09-01-2006)
ERISA 3(18)

1. ERISA 3(18) applies for purposes of some prohibited transaction exemptions under both ERISA and the Code.
2. ERISA 3(18) defines the term adequate consideration for " assets other than a security for which there is a generally recognized market " as the FMV of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.
3. Proposed DOL Reg. 2510.3–18(b)(2) defines "fair market value" as the price at which an asset would change hands between a willing buyer and a willing seller when either party is not under any compulsion to enter into the transaction.

4.72.8.4.3  (09-01-2006)
Examination Steps

1. After careful review of the plan asset valuation, determine if the value assigned to an asset differs from what you expect.
2. Determine the value of publicly traded securities by checking their price as reported in a newspaper on the valuation date. A local business library has books that publish daily stock prices of all publicly traded companies, and may have a researcher who will provide market values in response to a telephone call as a public service.
3. In determining the FMV of closely held stock, determine how closely held company shares were valued.
   1. Check whether the share prices as reported on Form 5500 rise and fall with its earnings. If the company’s earnings have fallen but the report says the price per share has risen or remained constant, it may indicate an incorrect valuation. Request an explanation.
   2. Determine whether there have been any recent sales of the company’s stock. Check to ensure the sales price is consistent with the valuation.
   3. If the current valuation relies on a previous valuation, check the employer’s audit report to see if the company’s earnings have fallen since the valuation report was written. If they have, it is likely the value of the shares should also have fallen. The plan fiduciary can no longer rely on the price per share from the valuation report because the facts on which it was based have changed. Similar principles apply if the company’s earnings have risen since the valuation report was written.
   4. Other factors to be used in determining the FMV of closely held stock include their book value, dividend paying capacity, and the goodwill value of the company.
4. In an investment or holding company, determine whether the valuation gave the greatest weight to the assets underlying the security to be valued. In a company which sells products or services, determine whether the valuation gave the greatest weight to earnings.
5. If the valuation appears to be inadequate, its accuracy should be verified by asking for another valuation from a fiduciary or qualified appraiser.

4.72.8.5  (09-01-2006)
Types of Plan Assets

1. Plans may invest a portion of their assets in limited partnerships and invest directly in real property, or in mortgages on real property.
2. Plans may also invest in life insurance contracts. Described below is a safe harbor that may be used when such contracts are distributed.

4.72.8.5.1  (09-01-2006)
Partnerships

1. The partnership itself can invest in virtually any type of asset.
2. Generally, limited partnership interests are not listed on national securities exchanges.
3. The valuation of a plan’s interest in a partnership is especially important in a year in which the plan is making a distribution.

4.72.8.5.1.1  (09-01-2006)
Examination Steps

1. Ask for information regarding how and when the FMV of the partnership was determined.
   1. Ask whether there were sales of or offers for the partnership interests, secondary market trades or quotes, and whether the fiduciary used the general partner’s valuation.
   2. Determine the basis for the valuation of the partnership, i.e., if the partnership’s value was based on the original cost of the investment, or the capital account (reported on the Schedule K–1, which shows the partner’s pro rata share of the partnership’s income, losses, credits and deductions). Such valuations may not reflect the FMV of the partnership.
2. The fact a partnership has had no earnings may indicate the partnership is worthless. To determine whether the partnership had earnings, request the plan’s K–1’s. Depending on the circumstances, the specialist may want to request K–1’s for prior years.

4.72.8.5.2  (09-01-2006)
Real Estate

1. Mortgages valued at cost may be incorrectly valued if based solely on the purchase price of the real estate.
2. Under special circumstances, the mortgage’s valuation should reflect the current value of the real property.
   • For example, if the FMV of property held for investment by the plan is lower than the indebtedness secured by the property, the value of the mortgage should be marked down. Also, the value of the mortgage is based on the loan balance.

4.72.8.5.2.1  (09-01-2006)
Examination Steps

1. To ascertain the value of real estate held by the plan, check the appraisal report, tax assessment document, and the property insurance policy.
2. Compare the loan or mortgage balance to the appraised value of the property.
3. The property’s best use is one criteria in valuing the asset. Determine what the property is actually used for. If the property’s best use is different than the property’s actual use, the property may not have been properly valued.
4. In a defined contribution plan, ascertain if any sudden increases in value coincided with distributions to highly compensated employees.

4.72.8.5.3  (09-01-2006)
Life Insurance Contracts

1. Section 1.402(a)-1(a)(1)(iii) of the Income Tax Regulations provides, in general, that a distribution of property by a qualified plan is taken into account by the distributee at its "fair market value" . Prior to its amendment, section 1.402(a)-1(a)(2) provided, in general, that upon distribution of a retirement income, endowment, or other life insurance contract, the "entire cash value" at the time of distribution must be included in the distributee's income. Amendments to the regulations under §402 were proposed on February 13, 2004, to state that the fair market value standard controls when such a contract is distributed or sold. Final regulations, adopting the fair market value standard, were issued on August 29, 2005. The final regulations provide that the amendments to section 1.402(a)-1(a) are effective for distributions occurring on or after February 13, 2004. The final regulations under section 1.402(a)-1(a)(1)(iii) also include special effective date provisions for bargain sales of these contracts
2. Q&A-10 of Notice 89-25,1989-1 C.B. 662, described a distribution from a qualified plan of a life insurance policy with a value substantially higher than the cash surrender value stated in the policy. The notice concluded that the practice of using cash surrender value as fair market value is not appropriate where the total policy reserves, including life insurance reserves (if any) computed under §807(d), together with any reserves for advance premiums, dividend accumulations, etc., represent a much more accurate approximation of the policy's fair market value.
3. Since Notice 89-25 was issued, life insurance contracts have been marketed that are structured in a manner which results in a temporary period during which neither a contract's reserves nor its cash surrender value represent the fair market value of the contract. For example, some life insurance contracts may provide for large surrender charges and other charges that are not expected to be paid because they are expected to be eliminated or reversed in the future (under the contract or under another contract for which the first contract is exchanged), but this future elimination or reversal is not always reflected in the calculation of the contract's reserve. If such a contract is distributed prior to the elimination or reversal of those charges, both the cash surrender value and the reserve under the contract could significantly understate the fair market value of the contract. Thus, in some cases, it would not be appropriate to use either the net surrender value (i.e. the contract's cash value after reduction for any surrender charges) or, because of the unusual nature of the contract, the contract's reserves to determine the fair market value of the contract.
4. Rev. Proc. 2004-16, 2004-10 I.R.B. 559, provided a safe harbor for determining fair market value of variable and non-variable contracts for purposes of applying the rules under the proposed regulations issued under §402(a).
5. Rev. Proc. 2004-16 was modified and superseded by Rev. Proc. 2005-25, 2005-17 I.R.B. 962, which provides two safe harbor formulas that, if used to determine the value of an insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection that is distributed or otherwise transferred from a qualified plan, will meet the definition of fair market value for purposes of §402(a). These safe harbor formulas will also meet the definition of fair market value for purposes of §402(b) and, in addition, will meet the definition of vested accrued benefit for purposes of §402(b)(4)(A).
6. Rev. Proc. 2005-25 applies to distributions, sales, and other transfers made from an exempt employee's trust on or after February 13, 2004, and to non-exempt employees' trusts under §402(b) for periods on or after February 13, 2004. Taxpayers may also rely on the safe harbors of Rev. Proc. 2005-25 for periods before May 1, 2005. Taxpayers may also rely on the safe harbors in Rev. Proc. 2004-16 for periods on or after February 13, 2004, and before May 1, 2005.

4.72.8.5.3.1  (09-01-2006)
Examination Steps

1. Determine whether a life insurance policy being distributed by a plan is valued properly:
   1. In the case of a non-variable life insurance contract, compare the premiums paid with the value of the contract. Generally, the value of a non-variable life insurance contract should be close to the premiums paid under the contract accumulated at a reasonable rate of interest (at least 2 or 3 percent) less reasonable cost of insurance charges (generally, except for very high ages, less than $5,000 per $1 million of death benefit) less reasonable policy expenses (generally, less than $1,000 per $1 million of death benefit).
   2. In the case of a variable life insurance contract, the actual investment return should be considered. Generally the value of a variable life insurance contract should be close to the premiums paid under the contract accumulated at the actualinvestment return rate earned by the contact (which can vary widely because the premiums paid under such contracts are generally invested in mutual fund like instruments) less reasonable cost of insurance charges (generally, except for very high ages, of less than 5,000 per $1 million of death benefit) less reasonable policy expenses (generally, less than $2,000 per $1 million of death benefit).
   3. Protect the statute of limitations on the related Form 1040 resulting from any adjustments to the recipient's taxable income. See the Discrepancy Adjustment Procedures in IRM 4.71.4.

4.72.8.6  (09-01-2006)
Effects of Improper Valuation

1. Rev. Rul. 80–155 requires that a defined contribution plan’s assets be revalued at least annually. If the requirements of Rev. Rul. 80–155 are not met, the plan is not qualified.
2. If assets are valued more frequently than annually in a way that favors distributions to highly compensated employees, prohibited discrimination under IRC 401(a)(4) could occur.
3. An improper valuation of qualified plan assets can cause a plan to exceed the limitations on benefits and contributions under IRC 415.
   • This could occur, for example, if there was an exempt contribution of undervalued property to a plan and the resulting annual additions to participant accounts based on the improper valuation are within the limits of IRC 415, but the annual additions based on FMV of the contributed property would exceed the IRC 415 limits.
   • Similarly, there could be excess annual additions if property were sold by the plan for more than FMV.
4. In extreme cases, an exclusive benefit violation under IRC 401(a)(2) may occur if a qualified plan engages in a prohibited transaction in which it acquires property for more than FMV.

4.72.8.6.1  (09-01-2006)
Funding and Deductions

1. Although a contribution of property to a plan may be a prohibited transaction if it is not subject to an exemption, a contribution need not be paid in cash to be deductible under IRC 404. If overvalued property is contributed to the plan, the employer may have deducted an amount in excess of that allowed under IRC 404.
2. Another possible result of contributing overvalued property either to a money purchase pension plan or a defined benefit plan is the plan may not satisfy the minimum funding standards of IRC 412. This may cause the plan to have an accumulated funding deficiency subject to IRC 4971, the two-tier excise tax.

4.72.8.6.2  (09-01-2006)
Prohibited Transactions

1. Under IRC 4975(d)(13) and ERISA 408(e), a plan may acquire and hold qualifying employer securities and qualifying employer real property.
2. The acquisition of qualifying employer securities or qualifying employer real property is exempt under IRC 4975(d)(13), only if the securities or real property is sold or acquired for "adequate consideration" as defined under ERISA 3(18). This requires a proper valuation. See IRM 4.72.11, Prohibited Transactions.

4.72.8.6.3  (09-01-2006)
Examination Steps

1. Evaluate purchases of employer securities and employer real property for compliance with prohibited transaction exemption requirements and the exclusive benefit requirements.
2. If a contribution of property to a plan is subject to a prohibited transaction exemption, determine whether an employer exceeded contribution or deduction limitations by contributing undervalued property to a qualified defined contribution plan. The IRC 4972 excise tax may apply.
3. Determine whether an improper valuation has caused the plan to violate IRC 415.

4.72.8.7  (09-01-2006)
ESOP Issues

1. ESOPs must satisfy the annual valuation requirements of Rev. Rul. 80–155 for defined contribution plans.
2. ESOPs have special valuation rules in certain circumstances. See IRM 4.72.4.

4.72.8.7.1  (09-01-2006)
Independent Appraiser Rules

1. IRC 401(a)(28)(C) provides that an ESOP is not a qualified plan unless all valuations of employer securities that are not readily tradeable on an established securities market, with respect to activities carried on by the ESOP, are performed by an independent appraiser.
   1. Valuation by an independent appraiser is not required by IRC 401(a)(28)(C) in the case of employer securities that are readily tradeable on an established securities market (as defined at Reg. 54.4975–7(b)(1)(iv)). See IRM 4.72.4, ESOP Examination Guidelines on valuation of employer securities that are readily tradeable.
   2. Valuation by an independent appraiser is not required unless the ESOP holds employer securities acquired after 12/31/86.
2. An appraiser is independent if requirements similar to those found under IRC 170(a)(1) for a "qualified appraiser" are satisfied. Reg. 1.170A–13(c)(5) provides that a "qualified appraiser " must make a declaration on the appraisal summary that the appraiser:
   1. Holds himself/herself out to the public as an appraiser or performs appraisals on a regular basis;
   2. Is qualified to make appraisals of the type of property being valued; and provides a description of his/her qualifications pursuant to Reg. 1.170A–13(c)(3)(ii)(F).
3. An appraiser is not independent if:
   1. The appraiser is the taxpayer that maintains the ESOP (or a member of the controlled group of corporations that includes such taxpayer);
   2. The appraiser is a party to the transaction in which the ESOP acquired the property;
   3. The appraiser is employed by the taxpayer maintaining the ESOP (or any entity described in subparagraphs a. or b., above);
   4. The appraiser is regularly used by any entity described above and does not perform a majority of his/her appraisals for entities other than those described above.
      Example: An employer maintaining an ESOP uses a large, national accounting firm for its auditing and tax requirements. The accounting firm proposes to use its valuation division to perform an appraisal for the ESOP. The valuation division is qualified to perform appraisals of the property and holds itself out to the public as an appraiser. Is the accounting firm’s valuation division an " independent appraiser" for purposes of IRC 401(a)(28)(C)? As long as the accounting firm’s valuation division performs a majority of its appraisals for entities other than the employer maintaining the ESOP or entities related to it, the valuation division is an "independent appraiser " .
4. A valuation of employer securities by an independent appraiser is required with respect to any activities carried on by the plan. These activities include the contribution of employer securities to an ESOP, the purchase of employer securities by an ESOP and distributions to participants.
   1. Employer securities are not necessarily required to be valued by IRC 401(a)(28)(C) as of the date of the plan activity. The plan can generally use the most recent annual valuation done on the plan’s valuation date by an independent appraiser.
   2. Plan activities requiring valuations also include the offer of employer securities to the employer by a participant under a right of first refusal, the exercise of a put option by a participant to sell shares to the employer and the allocation of assets to participants’ accounts. See Reg. 54.4975–11(d)(5).
   3. A participant’s diversification election under IRC 401(a)(28)(B) is a plan activity requiring a valuation by an independent appraiser.

4.72.8.7.2  (09-01-2006)
Examination Steps

1. Review Form 5500 to see if a current appraisal of employer securities was made immediately before such stock was contributed to or purchased by an ESOP for the plan year.
   1. If the answer is "no" , a valuation problem may be indicated and the plan may be disqualified.
   2. If the answer is "yes" , check Form 5500 to see if the appraisal was made by an unrelated third party. If the answer is "no" , a valuation problem may be indicated and the plan may be disqualified.
2. Make sure the appraiser is an "independent appraiser" within the meaning of IRC 401(a)(28)(C)

ERISA rules for ESOP Valuations and discount calculations

This article written by ValueMetrics Corp provides an excellent overview of the rules governing the valuation of ESOPs

ESOP VALUATIONS NEW DEVELOPMENTS

An ESOP (Employee Stock Ownership Plan) is a defined contribution pension plan, authorized by ERISA (Employee Retirement Income Security Act) similar to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes shares of its own stock or cash to buy shares of its stock.  The purpose is to provide liquidity to owners of closely held companies who desire to exit and an investment in the company to covered employees.  Congress made employee ownership a priority goal, and provided a number of tax benefits to facilitate and encourage ESOPs.

The ESOP is funded by the company, not the employees.  The ESOP can borrow money to buy shares, with the company making cash contributions to the plan to enable it to repay the loan.  The company may also be required to guarantee the loan by the lender.

Regardless of how the plan acquires stock, company contributions to the trust are tax- deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts.  As employees  accumulate seniority within the company, they acquire an increasing right to the shares in their account, a process known as vesting.  Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual. When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (discounted) or fair value (undiscounted) as per provisions in the plan, unless there is a public market for the shares.  They may, in the alternative, receive a cash buyout of the appraised value of their interest.  Private companies must have an annual ERISA compliant independent valuation to determine the price of their shares.  In private companies, ESOP employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through other voting rights, such as voting for the board of directors, or other issues. In public companies, employees must be able to vote all issues.

 

Department of Commerce figures show that there are in excess of 170,000 companies in the U. S. with 20 to 999 employees, which are potentially suitable for ESOPs.  These are virtually all privately held. The National Center for Employee Ownership shows that there are only about 11,000 ESOPs amongst this group.  Thus the penetration is about 6.5%.  With the virtual collapse of credit markets in 2008, exit opportunities for owners of small businesses have been dramatically and negatively impacted.  Selling a company to an outside party may not be feasible both for tax reasons and availability of financing. However in some cases an ESOP is feasible because the seller can carry back a note for all or part of the purchase price from an ESOP.  This can be combined with institutional debt and possible investment by private equity, to form a new capital structure that effectively “buys out” the selling shareholder. Thus a significant increase of ESOPs is expected over the next several years as retiring “baby boomers” attempt to exit their businesses in this environment.

TAX CONSIDERATIONS

Without use of an ESOP, the selling owner can expect serious tax implications.  In a C- corporation he will be double taxed, with the Federal capital gains rate expected to return to 20% as the Bush tax cuts expire in 2011.  State capital gains tax treatment differs. Some, like California, do not provide for capital gain treatment and tax as ordinary income.  The C-corporation taxes, plus brokerage commissions, other selling costs, and personal income taxes can reduce the net on the sale by 60% to 70% (depending on the state) or more. S-corporation owner’s fare better on a sale, but the total cost of sale is still expected to be 30% to 40% or so, depending on the state. Both C-corporations and S-corporations can sponsor ESOPs however the tax advantages to the owners differ, but in both cases may provide significant benefits.  

A C corporation shareholder, who sells at least a 30% interest to an ESOP, can roll the net sales proceeds into investments in qualified public securities without any income tax liability.  An S-corporation seller does not get this advantage; however, for S corporations there is no income tax liability for income allocated to the ESOP.  There are many other tax considerations, but the details of tax treatment are beyond the scope of this paper.

A drawback of selling to an ESOP may be that the shares are subject to a minority discount to meet the “adequate consideration” conditions, thus providing a lower gross price per share than the gross sales price to competitive outside buyers. But after the comparative tax consequences are analyzed it is quite probable that the net after-tax proceeds of the sale could be significantly higher with a sale to an ESOP.

VALUATION – AN ESSENTIAL COMPONENT OF AN ESOP

IRS Code Section 401(a)(28)(C) requires a non-publicly traded company to obtain a qualified appraisal of the ESOP shares:

Each time the plan acquires shares, and At the end of each plan year thereafter.

The Pension Protection Act of 2006 requires such appraisals, and the appraisers to be

qualified under its regulations.  The applicable standard is Fair Market Value. The two significant issues affecting compliance with ERISA are the concept of “adequate consideration” and appropriate discounts in value for lack of marketability (DLOM).

“Adequate consideration” means that the ESOP may not pay more than qualified Fair Market Value for shares it acquires for the ESOP.  Both ERISA (Department of Labor) and the IRS acknowledge that these shares should be discounted in value for lack of control, and for lack of marketability if appropriate.  A “control” interest is problematic in that though the ESOP may obtain numerical control, it may not be able to practically act on such control due to limitations imposed by the ESOP or other corporate documents.  For instance, though the trust may represent a majority interest, the covered employees may not be able to vote on significant issues by limitation of the ESOP or other documentation.  Further, because the ESOP’s interest is voted by the trustee, there may be no way the employees can vote to determine the trustee’s action, nor to remove the trustee. The effect of this is that the appraiser must take into account a number of issues which have been more or less “codified” by applicable court decisions:

Adjustment for excess compensation to employees.  Because the IRS permits large tax deductable contributions to the plan, which effectively increase employee costs for tax purposes, an analysis must be made to determine if a premium exists, and to appropriately adjust the income statement upon which the basic appraisal of the company is made.  If this is not done, the basic fair value equity may be significantly understated.

Complete analysis of the control and marketability issues. Many appraisals, especially in the past, dealt with the concept of “control premiums.” This concept comes from analysis of publicly traded securities, and really has no relevance to exempt private securities. In these securities the fair value equity of the stock (without discounts) automatically reflects control.  

In privately held companies, the control premium is merely the difference between the fair value equity (equity value of 100% ownership) and the value of minority interests after discounts are applied. Also, stock of the same class may be issued with or without voting rights.  Lack of voting rights can cause impairment in value.

The question of de facto control vs. numerical control must be thoroughly addressed.  For instance, even though an ESOP may hold a majority interest in the number of outstanding shares, the question of who is empowered to vote those shares arises.  The employees usually have no say in the selection of the trustee. And the trustee may be a controlling officer of the company, which could present a potential conflict of interest.

REQUIREMENTS OF ERISA AND PROPOSED REGULATIONS

ERISA sets forth requirements for the trustee to exercise due diligence and good faith in valuation of assets for which there is no active market. Proposed Regulation 2510.318(b) and proposed 29 CFR 2510.3-18 to ERISA expand on the definition of “adequate consideration”, and though not yet officially enacted, industry and government almost universally adopted the same criteria to use until enacted.

Under ERISA, “adequate consideration” means the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the plan and in accordance with regulations promulgated by the Secretary of Labor.

The proposed regulation delineates the scope of this regulation by establishing two criteria, both of which must be met for a valid determination of adequate consideration.

First, the value assigned to an asset must reflect its fair market value as determined pursuant to proposed § 2510.3-18(b) 

Second, the value assigned to an asset must be the product of a determination made by the fiduciary in good faith as defined in proposed §2510.3-18(b) .

For the first criterion the definition of fair market value is set forth as: “…the price at which an asset 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, and both parties are able, as well as willing, to trade and are well- informed about the asset and the market for the asset.” (It should be noted that this definition is consistent with that adopted by most appraisal organizations, and is also consistent with the IRS code and IRS Revenue Ruling 59-60, and the Uniform Standards for Professional Appraisal Practice.)

The second criterion sets forth the following:

The valuation must be set forth in a written document

the “good faith” requirement establishes an objective standard of conduct, rather than an inquiry into the state of mind of the Trustee

the fiduciary making the valuation must itself either be independent of all the parties to the transaction or must rely on the report of an appraiser who is independent of all the parties

if donated property, the valuation should follow Rev. Proc 66-49 (IRS Revenue Ruling 83-20) which sets forth the format required by the IRS for valuation of donated property, or

If the property is to be purchased, it requires that Revenue Ruling 59-60 shall apply.

This documentation must contain, at minimum

a. A summary of the qualifications of the appraiser,

b. A statement of the asset’s value and a statement of the methods used in determining that value, and the reasons used to determine the value,

c. A full description of the asset being valued,

d. The factors taken into account in making the valuation, including any restrictions understandings, agreement or obligations limiting the use or disposition of the property,

e. The purpose for which the valuation was made,

f. The relevance or significance accorded to the valuation methodologies taken into account,

g. The nature of the business and the history of the enterprise from its inception,

h. The economic outlook in general, and the outlook for the specific industry in particular,

i. The book value of the securities and the financial condition of the business,

j. The earning capacity of the company,

k. The dividend-paying capacity of the company,

l. Whether or not the enterprise has goodwill or other intangible value,

m. The market price of securities of corporations engaged in the same or a similar line of business (later expanded to include similar fee holdings),

n. The marketability of the securities, or lack thereof,

o. Whether or not the Seller would be able to obtain a control premium from a third party.

Under the Pension Protection Act of 2006, and in ERISA regulations, the appraisal procedures must be in strict compliance with the Uniform Standards for Professional Appraisal Practice, (“USPAP”) Standards 9 and 10 which apply to Business Appraisal procedures, and Business Appraisal Reports, respectively.

MINORITY DISCOUNTS

ESOP fiduciaries and financial professionals involved with the administration of the ESOP need to be aware of the effects of court cases relating to the valuation of minority interests in small businesses and related securities.  Cases brought to the Tax court in recent years have shed light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests.  The cases will be pointed out in this article.

Prior to these cases, appraisers generally treated valuation of such discounts as a relatively minor adjunct to the valuation of the basic (majority) position.  Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies which can be sold, usually at a discount, from their unrestricted brethren, and by IPO studies of stock values before and after the Initial Public Offering. The courts have virtually all rejected such valuations in the case of closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation.  And, if litigated it should significantly enhance the chances of winning.
Further, some valuators argued that because ERISA provides an implied “Put” option for the employee to sell his stock back to the company, that there is no minority interest generated impairment of value to the ESOP.  This is wrong because the Put is a contract between the company and the employee, not the ESOP and the employee; and the ESOP has no right to put the stock to the company.

VALUATION PRINCIPLES

All appraisals are a defensible opinion of value, prepared by an expert, for an ownership interest.  Such an ownership interest is often referred to as a “bundle of rights.” Normally ownership in fee contains the most valuable bundle of rights, and lesser forms such as ownership of a security interest, lease, license, minority interest, or other such instrument will reduce the bundle of rights – and hence the value.  Further, contractual restrictions on marketability or control of such minority interests results in a reduction of value. If the asset to be valued is a minority interest, and/or if it is subject to restricted marketability, and/or lack of control, appropriate discounts to value must be applied.

Over the years, many appraisers have adopted policies that separated the lack of control discount from the lack of liquidity or marketability discount.  However, this appears to be a difference without a distinction.  All discounts from value appear to be, in the end, evidence of impairments in marketability.  The fact that such discounts, even if treated as separate discounts, are multiplicands which are multiplied by each other to derive a final discount figure illustrates this point.

Though the appropriateness of applying such discounts in these situations has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying the appropriate discounts. (IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but  it is silent on “exempted securities,” which make up the vast majority of privately held securities.  Both are defined and described in the Securities Act of 1933.) The cases indicate a complete analysis is required.

To quantify the “marketability discount,” because of a lack of available specific data, some appraisers have been relying on two sources of data from public company transactions: Initial Public Offering Studies, and Restricted Stock Studies to defend their discount opinion.  The “standard” discount often derived from these studies is typically between 30% to 40%.  Three cases against the Commissioner in 2003 found that such studies, based upon data from public companies, were not sufficient basis to value closely held private (exempt and unregistered) ownership.  Upon a deeper look the reasons are fairly obvious:

Initial Public Offering Studies (IPO) show the difference in the price of a stock before the offering and after, and an appraiser may attempt to infer that this is direct evidence to support a marketability discount for an exempt security.  This is erroneous for the following reasons:

Stock values of privately held companies typically are based upon investment value – that is, an investor will be interested in both the current return, and the amortization factor (risk abatement factor) which indicates how long it will take to recover the initial investment.  This is necessary because of the high degree of illiquidity of non-public securities.

 

The IPO price, on the other hand, reflects a speculative value – that is, the investor is looking mainly towards price appreciation.  By its nature once publicly traded, the stock should have high liquidity, so recovery of the investment is not an investment concern.  Thus, this study is relevant only to companies anticipating an IPO.  Unfortunately these companies represent less than 1% of the companies extant in the U.S. Restricted Stock Studies deal with stocks of public companies that have been temporarily restricted from sale for two years (later for one year) in the public markets (usually by virtue of securities regulations under Rule 144). Nonetheless, there is no prohibition in selling these securities in private transactions where they usually sell at an average of 30% or so less than publicly traded stock.  But these are applicable only to normally publicly traded stocks that have only a temporary restriction from public markets, and not on the general ”permanent” illiquidity problem faced by small privately held companies which would make them far less marketable.

Control discounts, (or more appropriately control-based marketability discounts) for privately held companies exist because in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company.  Without control, an investor does not have the right to exercise this option.  Thus minority interests in closely held companies are very difficult to sell and even some majority (by percentage ownership) interests which have their control impaired by agreement have a much lower market value than those which are not impaired.  In practice, in the past appraisers have often attempted to base discounts for lack of control on control premium studies of public companies.  But they are not the same as for private companies at all, and the dynamics of value discounts are not appropriate for them.

The case of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use of irrelevant data is unacceptable, and sets forth some basic factors which might comprise the discount, but specified that this list was not exclusive, and other factors may (and should) apply as the situation dictates.  It basically states that a complete analysis must be done which is relevant to the subject.  The factors listed to be evaluated included but were not limited to:

Private vs. public sales of stock

Financial statement analysis

Dividend policy

Nature of the company, history, position in the industry and economic outlook

Management

Amount of control in transferred shares

Restrictions on transferability of stock

Company’s redemption policy

Costs associated with making a public offering

IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities”, but it is silent on “exempted securities,” which make up the vast majority of privately held securities.  Both are defined and described in the Securities Act of 1933.

ASSESSING EFFECTS ON SMALL VERSUS LARGE COMPANIES

To put this in perspective the following table shows the number of businesses in each group by employee size extracted from County Business Patterns, 2007, published by the Bureau of Census, for the USA (total of 7.5-million companies).  It shows the overwhelming proportion of small (usually SEC exempt) companies.

Less than 10 employees 79.0%        

Less than 20 employees 90.0%        

Less than 100 employees 99.0%        

Less than 500 employees 99.7%        

More than 500 employees 0.3 %               

The dynamics of marketability discounts for the 99% of small businesses with less than 100 employees is simply not reflected in the studies based upon public companies.  The cases of McCord v. Commissioner, 120 T.C. 358-2003, Lappo v. Commissioner, T.C.M 2003- 258 and Peracchio v. Commissioner, T.C.M 2003-280 all rejected the “cookie cutter” approach to discounts based upon data from public companies.

Discount data from public companies is available, and there are several studies available which document appropriate discount rates for them.  However for small, closely held companies, this data is not available.  Minority interests in such companies are extremely difficult to sell and there are virtually no active markets.

CONTROL DISCOUNTS AS APPLIED TO FAMILY MEMBERS OWNING SHARES

IRS Revenue Ruling 93-12 applies in this instance.  Prior to the issuance of Revenue  Ruling 93-12, the IRS held a position that when transfers of stock comprised a controlling interest within the family unit as a whole, even though individual gifts of stock might not grant a controlling interest, per se, that discounts in value for the lack of control were not allowed. IRS Revenue Ruling 93-12 reversed this position, and holds that in the case of gifts of stock the following policy is in effect:

"If a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family is not considered in valuing each transferred interest for purposes of Section 2512 of the Code, for Estate and Gift Tax purposes, the Service will follow Bright, Propstra, Andrews and Lee in not assuming that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.  Consequently a minority discount will not be disallowed (emphasis added) solely because a transferred interest, when aggregated with interest held by family members, would be part of a controlling interest.”

This would be the case whether the donor held 100 percent or some lesser percentage of the stock immediately before the gift.  In appraisal practice, the appropriate discounts for Lack of Control and Restricted Marketability are applied consecutively and cumulatively. 

BUILT IN CAPITAL GAINS

The case of Estate of Dunn v. Commissioner, 301F 3rd 339 (5thCir. 2002) reversed a previously held notion that a built in capital gains tax which is attendant to a low-basis high asset value situation established that the value should be reduced dollar for dollar for the capital gains tax liability.  Estate of Jelke v. Commissioner, T.C.M 3512-03 U.S. App 11 th Cir. 2007) found an assumption must be made for immediate liquidation rather than spreading the gain over the expected life of the investment.  This now places four Circuit Court of Appeals on the side of taking a dollar for dollar deduction for Built-In Capital Gains tax in a Corporation.  See Estate of Eisenberg v. Commissioner, 74 T.C.M. (CCH) 1046 (2 nd Cir. 1997), Estate of Welsh v. Commissioner, 208 F. 3d 213 (6 th Cir. 2000), Estate of Jameson v. Commissioner, 267 F. 3d 366 (5th Cir. 2001), Estate of Dunn v. Commissioner, 301 F. 3d 339 (5th Cir. 2002), and Estate of Jelke v. Commissioner,T.C.M 3512-03 U.S. App (11th Cir. 2007).  The question of the proper way to reflect this deduction was not determined.  There are two possibilities, (1) show marketability discount in value, or (2) reflect a contingent liability in the amount of the allowance for Built in Gains tax on the balance sheet.

CONCLUSIONS REGARDING DISCOUNTS

The courts have indicated that a complete and defensible analysis of the applicable issues must be made from which an appraiser bases his decision.  Because transfers of minority interests in closely held companies are very rare, and there are no historical data sources available for these discounts, the appraiser must rely upon his experience and judgment in determining the appropriate discounts based upon a hypothetical analysis.

The IRS states that valuation is a question of fact and the trier of fact must weigh all relevant evidence to draw the appropriate inferences.  This begs the question of how can an appraiser draw inferences if there is no published data.

Conventional statistical analysis will neither be appropriate nor possible in this situation.  There is, however, an available methodology called “heuristics” or the “heuristic paradigm”.

The vast majority of people are not familiar with the term “heuristics,” though we all use heuristics, probably without being conscious of it.  The word is derived from the Greek  word “Eureka” meaning “I have found it.” In the past twenty years it has been refined into a modern problem solving and analysis methodology, usually associated with “systems science.” It has been developed to deal with decision-making and judgment- making involving complex systems where specific reliable data is not available, and the time and cost of obtaining such data necessary for a conventional statistical analysis is simply not feasible.

Basically heuristics is the art of drawing inferences when faced with limited, incomplete or fuzzy data.  It is based upon the innate human ability to recognize patterns.  We do this spontaneously.  Even reading the words on this page is a heuristic endeavor.  The reader is not interpreting literally the meaning of each word (which itself is a heuristic endeavor), but is recognizing the pattern of ideas which the words convey. To employ the heuristic approach requires two things:

A human mind, which is genetically disposed to recognize patterns;

and

it must be a mind with, Significant experience in the general subject matter from which to recognize patterns.

Employing these attributes will allow an appraiser to collect heuristic data points, none of which in itself will permit a specific and defensible inference, but all of which serve to frame an array which can be judged for their apparent relevance, weighting them and ranking them to provide insights into the probable effect of specific issues that, in the case of discounts, would foster a reduction of value.  It takes expert experience to do this well. This is likely the reason for the minimum two-years experience in valuing the type of asset being appraised as set forth in the Pension Protection Act of 2006 – which now governs appraisals of this type.

A complete discussion of heuristics is beyond the scope of this article. The purpose here is to introduce the concept so that the reader may understand that such a methodology is not only available, but scientifically defensible, and to look deeper into it. Googling the word “heuristics” will lead to a number of sites, including Wikipedia, which can shed some light on this. But the important point to remember is that as a result of the recent court cases, the analysis of discounts must be as complete and defensible as the analysis of the basic (majority interest) of the security. Rules of thumb won’t work.

CONCLUSIONS

Under ERISA and IRS regulations there are severe potential penalties for improperly determining “adequate consideration” and damages from litigation can be significant (see Reich v. Valley National Bank of Arizona (the “Kroy case”) where damages were $17,500,000 resulting from the ESOP paying more than “adequate consideration” for shares to the detriment of employees. There are likewise serious potential administrative penalties if tax deductibility is denied resulting from improper valuation.  This can arise when the transaction becomes a “prohibited transaction” under ERISA and IRS regulations, and the tax benefits could be disallowed – resulting in penalties and interest, not to mention the payment of taxes. Therefore it is of the utmost importance that all of the parties involved with the administration of an ESOP (the trustee, the company owner, the lender, if there is one, the appraiser, the tax accountant, and the ERISA compliance attorney) be in coordination, and be aware of how the valuation issues affect the situation. And, most importantly, to avoid serious financial risks and penalties, the valuation report itself must address all the nuances engendered by the ESOP, and the enabling legislation, so that the valuation is relevant, defensible, and complete.

Source American ValueMetrics Corp

by Gerald W. Barney 
   Melisa Silverman