Article: How Much Is Your Minority Share Really Worth


	Lynn Westergard

How much is your minority share really worth?

Ignoring the discounted values of minority ownership can create a devastating (and avoidable) tax burden

The concept of "fair market value" is commonly used to determine the value of assets and businesses that are subject to acquisition, estate planning, estate taxation, buy-sell agreements, ownership dissolution and other situations.

The IRS and the courts define fair market value as "the price at which the property would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act."

In the absence of willing buyers and sellers, establishing a company’s fair market value requires the assistance of a valuation professional who recognizes which valuation methods to apply to a given situation; understands how any of a long list of factors may affect a company’s value; and can apply common sense, informed judgment and a reasonable approach to the valuation process.

The human qualities inherent in the process underscore the subjective nature of business valuation and the resulting fact that no single approach can be applied to every situation.

Valuation approaches. There are three basic approaches to valuing a business, any two or all three of which may be used to establish value.

The market approach generally values a business as a going concern. It involves determining the representative earnings and/or cash flow levels of the company and applying multiples based on the value of publicly traded stock (or of private transactions, if available) of comparable companies.
The income approach also values the business as a going concern, estimating the present value of an investment by discounting all future economic income by a rate of return known as a discount rate.
The asset approach can be used to value the business either as a going concern or on a liquidation basis. It focuses on the company's balance sheet rather than its income or cash flow. The asset approach is useful for a business that has substantial tangible and intangible assets and whose recent earnings do not reflect its intrinsic value (e.g., real estate holding companies, banks and start-up businesses). The approach consists of determining the fair market value of the company's individual assets and subtracting the fair market value of the company's liabilities.

Levels of business value. A key element in determining value is the level of ownership that a given interest represents. There are three primary levels, listed in order of declining value:

controlling interest, which carries with it the power to influence strategy, structure and policy;
marketable minority interest, which is highly liquid but carries little or no control; and
non-marketable minority interest, which is typical of minority interests in closely held businesses.

Discounted value. Non-marketable minority interests are subject to two types of discounts that decrease value: (1) a discount for lack of control and (2) a discount for lack of marketability. These discounts reduce the value of an ownership interest below its pro rata share of the business’s overall value. Thus, how a company’s ownership is divided can have a major impact on its cumulative market value and the value of any ownership interest.

Consider this example: As a going concern, Jones, Inc., is worth $10 million. Its stock is equally divided among the founder’s five children, none of whom can sell his stock without his siblings’ consent. While simple arithmetic would suggest that each shareholder’s 20% ownership is worth $2 million, the realities of business valuation depress the value of each interest below its apparent worth.

This phenomenon was recognized in Ward v. Commissioner (87T.C.78, 109 (1986): "[T]he shares of stock of a corporation which represent a minority interest are usually worth less than a proportionate share of the value of the assets of the corporation. The minority discount is recognized because the holder of a minority interest lacks control over corporate policy, cannot direct the payments of dividends, and cannot compel a liquidation of corporate assets."

Various factors influence how much of a discount should be applied to minority interests such as those held by the Joneses. A discount of roughly 35% would be typical, but determining with certainty a precise discounted value is a major challenge for a valuation professional.

A plus in estate planning. Discounting the value of his interests is a mixed blessing for the minority owner. If his goal is to liquidate his investment, he may find it difficult to sell his stock for what he thinks it’s worth. But if his goal is to reduce the size of his taxable estate by making gifts of stock to family members, the discounted value allows him to accelerate the number of shares that he and his spouse can give away under the $10,000 per person annual limit or each of their $600,000 lifetime exemptions (increasing to $1,000,000 by 2006).

Caution. Overlooking the impact of minority discounts can devastate an otherwise well-conceived estate plan, buy-sell arrangement or other initiative, leaving the business owner and his descendants with a costly burden that could have been avoided with the proper professional assistance.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.