Feb 02

Demystifying Discounts


Discounts for lack of marketability and lack of control or minority interest are essential elements of the valuation of stock or other interests in a closely-held business.  They are factors which a prospective buyer will consider in determining how much to offer for such an interest.  Discounts also reduce the value of taxable gifts of closely-held business interests for federal gift tax purposes and the value of these interests at death for federal estate tax purposes.

Co-owners of closely-held businesses often enter into agreements such as shareholders’ agreements, partnership agreements and operating agreements for limited liability companies which include provisions that require or authorize the estate of a deceased owner or an owner who is affected by another “triggering event” such as disability, bankruptcy, divorce or retirement to offer his or her interests in the business to the other owners.  Provisions of this type are called “buy-sell” provisions.

Buy-sell provisions usually provide the manner in which the purchase price is determined upon the occurrence of a triggering event.  There are a variety of ways in which the purchase price can be determined but a typical definition of the purchase price is “fair market value” as determined by an appraiser or by one or more appraisers.  Where the term “fair market value” is used to determine the purchase price, that term must be defined.  If the term is not clearly defined, the co-owners could find themselves in a dispute.

In a recent Pennsylvania Orphans’ Court case[1] the executors of the estate sold the decedent’s shares in two closely-held private family businesses to the other shareholders on the basis of the buy-sell provisions in a shareholders’ agreement.  The purchase price was to be based on fair market value but the provisions did not state specifically whether or not valuation discounts were to be considered by the appraiser.  The executors took into account the discounts and sold the stocks to the other shareholders based on the discounted appraised values.

The beneficiaries of the estate objected to the sale claiming that because the buy-sell provisions did not provide that discounts must be taken into consideration in determining fair market value, no discounts were allowed and the purchaser therefore paid too little for the decedent’s shares.  The beneficiaries sued on the basis of breach of “duty of care” owed by the executors.

The Court acknowledged the ambiguity of the shareholders agreement but based on expert testimony – primarily that of a former Chief of the Pennsylvania Department of Revenue – held that under the buy-sell provisions the fair market value of the decedent’s shares was to be determined taking into account the applicable discounts.

The takeaway from this decision is that buy-sell provisions in shareholders’ and other agreements among co-owners of a business are not boilerplate provisions.  They must be reviewed by all parties and their counsel and they must reflect the considered agreement of the co-owners.  All terms must be clearly defined and if “fair market value” is to be determined with regard to valuation discounts or other specific factors, that should be specified.  The more clarity the agreement provides, the less likely it is there will be a dispute following the owner’s death.

[1] Bittner Estate, 5 Fiduc. Rep. 3d 242 (O.C. Div. Bedford).

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