927 / How are interests in a closely-held business valued for federal transfer tax purposes?

(1)     The value of all the assets of the business, tangible and intangible, including goodwill;

(2)     The demonstrated earning capacity of the business; and

(3)     The other factors set forth in the regulations¹ relating to the valuation of corporate stock, to the extent applicable (see Q 929).

Special attention should be given to determining an adequate value of the goodwill of the business. Complete financial and other data upon which the valuation is based should be submitted with the return, including copies of reports of examinations of the business made by accountants, engineers, or any technical experts as of or near the applicable valuation date.²

For additional special valuation rules contained in IRC Chapter 14, see Q 934 to Q 944.

Approach of the Courts

The appraisal community, courts, taxpayers, and the IRS generally follow the principles laid out in Revenue Ruling 59-60 when valuing the stock of a closely-held corporation or the stock of corporations where market quotations are not available. Revenue Ruling 59-60 can also apply to value interests in closely-held partnerships or LLCs for gift tax or estate tax purposes. However, Revenue Ruling 59-60 does not discuss in detail valuation discounts for lack of control or lack of marketability. Thus, other sources must be relied upon for these critical components of valuation.

Historically, in valuation cases, the courts have tended to strike a compromise between the values asserted by the contending parties. But in many cases, courts are more willing to adopt one party’s value. The credit for this “winner take all” approach must be given to former Chief Judge of the Tax Court, Theodore Tannenwald. After years of experience, Judge Tannenwald found that the “compromise the difference” approach of the courts merely encouraged the parties to assert extreme values. In a 1980 valuation decision, Buffalo Tool & Die Manufacturing Company, Inc. v. Commissioner,³ Judge Tannenwald took the occasion to admonish the parties thus:

“We are convinced that the valuation issue is capable of resolution by the parties themselves through an agreement which will reflect a compromise Solomon-like adjustment, thereby saving the expenditure of time, effort, and money by the parties and the court–a process not likely to produce a better result. Indeed, each of the parties should keep in mind that, in the final analysis, the court may find the evidence of valuation by one of the parties sufficiently more convincing than that of the other party, so that the final result will produce a significant financial defeat for one or the other, rather than a middle-of-the-road compromise which we suspect each of the parties expects the court to reach.”
(At page 452).

This approach is reflected in a number of valuation decisions.⁴