Valuation Basics For Charitable Gifting

October 2016       Download PDF      Print

When many business owners think about giving to charity, a traditional cash donation is their first thought. For some potential donors, however, a meaningful cash donation may not be feasible. One alternative is gifting a portion of their business, in the form of company stock, to a charitable organization. Business owners may not be aware that private companies of nearly any size can take advantage of this gifting opportunity.

There are many options available to maximize benefits for both the donor and the charity. Arrangements can even be made to ensure that the donee will receive a lifetime income stream. When considering gifting stock, business owners should consult with their legal and tax professionals to decide what their best options are.

After the terms of the gift have been finalized, an agreement is created to complete the transaction. The gift agreement will outline the rights and responsibilities of both the donor (business owner) and donee (charitable organization). A business appraisal may be performed if required by the owner of if the gift exceeds the IRS-mandated value of $10,000. The date of the gift agreement becomes the effective date of the appraisal. Accordingly, only information available on or before the effective date can be considered in determining the value of a gifted interest. Appraisals for the IRS must be performed by qualified appraisers which the IRS defines as an appraiser who has been accredited by a national appraisal organization and regularly receives compensation for performing valuations.

Gifts of closely held stock are generally minority interests. As such, the final value of the gifted stock will generally be less than the pro-rata share of a 100 percent interest in the company. The reason for this is that minority shares have an inherent lack of control and lack of marketability. To account for these characteristics, certain discounts are applied to determine the fair market value of the minority interest. The two discounts most commonly applied are a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).

Discount for lack of control (DLOC)

The DLOC reflects the lower value associated with ownership interests that cannot directly influence daily activities or policy decisions of a company. Because the minority interest does not have control over major decisions that can drastically impact the company's performance, its shares have a lesser value. The DLOC reflects this lowered value and brings the value of the shares closer to fair market value. The DLOC is lower when the business owner provides the minority interest with some control attributes, such as the power to elect directors or managers, requiring consent from minority interests to amend an operating agreement, providing the minority interest with a first right of refusal, and giving the interest sufficient votes to block certain actions.

Discount for lack of marketability (DLOM)

The DLOM is used to compensate for the difficulty of liquidating an interest in a privately held company. While shares of a public company can be traded on an exchange, minority shares in a closely held company are difficult to sell. The DLOM is intended to reflect the market's perceived reduction in value for not providing liquidity to the investor.

The DLOM is lower when the gift agreement affords the minority interest with attributes that make it easier to liquidate. Perhaps the most significant of these possible attributes is a 'put option,' a clause that allows the minority shareholder to sell its shares back to the company at any time. Assuming the put option has a reasonable prospect of being enforced and funded, it can dramatically reduce the DLOM since it provides an instant market for the minority interest. Other factors that may decrease the DLOM include: an existing market for the interest being valued or an imminent sale of the company, demonstrated integrity of the controlling shareholder, removal of any restrictions on transferring interests, and a history of meaningful dividends or distributions to shareholders.

Additionally, buy-sell agreements can either reduce or increase the DLOM, depending on their terms. The agreement can guarantee a market for the stock, making it more marketable, or it can put restrictions on the sale, making the stock less marketable.

Conclusion

As with all valuation discounts, determining an appropriate DLOM and DLOC requires thorough research and analysis of economic, industry, and company-specific factors. The business appraiser performing the valuation must consider all of these as well as other quantitative and qualitative factors when determining the appropriate value of a company's stock.

It is important to remember that there are many factors that will influence a company's value and the associated benefits of a stock contribution. Business owners wishing to contribute to a charitable cause should discuss the potential benefits of gifting with their professional advisors.