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TVG prepares its partnership valuations in accordance with the guidelines established by IRS Revenue Ruling 59-60. This ruling, although specifically created to provide guidelines for the valuation of closely held corporations, provides insight as to the approach taken by the IRS in its review of valuations related to non-traded partnerships. Additionally, Revenue Ruling 59-60 provides the framework for valuation guidelines referenced in IRS Revenue Announcement 92-182 and in pending Department of Labor Regulation 2510.3-18.
The purpose of Revenue Ruling 59-60 was "to outline and review in general the approach, methods, and factors to be considered in valuing shares of capital stock of closely held corporations for estate tax and gift tax purposes. The methods discussed herein will apply likewise to the valuation of corporate stocks on which market quotations are either unavailable or are of such scarcity that they do not reflect fair market value."
This ruling states that "a sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance". According to the Ruling, factors to be included in the valuator's analysis include:
- The nature of the business and the history of the enterprise.
- The economic outlook in general and the condition and outlook of the specific industry in particular.
- The book value of the stock and the financial condition of the business.
- The earning capacity of the company.
- The dividend paying capacity of the company.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of the stock and the size of the block to be valued.
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks traded in a free and open market, either on an exchange or over-the-counter.
Below, we have excerpted specific detail related to each of these factors directly from Revenue Ruling 59-60:
Factor One: The nature of the business and the history of the enterprise from its inception.
The history of a corporate enterprise will show its past stability or instability, its growth or lack of growth, the diversity or lack of diversity of its operations, and other facts needed to form an opinion to the degree of risk involved in the business. For an enterprise which changed its form of organization but carried on the same or very similar operations of its predecessor, the history of the former enterprise should be considered. The detail to be considered should increase with approach to the required date of appraisal, since recent events are of greatest help in predicting the future; but a study of gross and net income, and of dividends covering a long prior period, is highly desirable. The history to be studied should include, but need not be limited to, the nature of the business, its products or services, it operating and investment assets, capital structure, plant facilities, sales records and management, all of which should be considered as of the date of the appraisal, with due regard for recent significant changes. Events of the past that are unlikely to recur in the future should be discounted, since value has a close relation to future expectancy.
Factor Two: The economic outlook in general and the condition and outlook of the specific industry, in particular.
A sound appraisal of a closely held stock must consider current and prospective economic conditions as of the date of appraisal, both in the national economy and in the industry or industries with which the corporation is allied. It is important to know that the company is more or less successful than its competitors in the same industry, or that it is maintaining a stable position with respect to competitors. Equal or even greater significance may attach to the ability of the industry with which the company is allied to compete with other industries. The public's appraisal of the future prospects of competitive industries or of competitors within an industry may be indicated by price trends in the markets for commodities and for securities.
Factor Three: The book value of the stock and the financial condition of the business.
Balance sheets should be obtained, preferably in the form of comparative annual statements for two or more years immediately preceding the date of appraisal, together with a balance sheet at the end of the month preceding that date, if corporate accounting will permit. Any balance sheet descriptions that are not self-explanatory, and balance sheet items comprehending diverse assets or liabilities, should be clarified in essential detail by supporting supplemental schedules. These statements usually will disclose to the appraiser:
- Liquid position (ratio of current assets to current liabilities)
- Gross and net book value of principal classes of fixed assets
- Working capital
- Long-term indebtedness
- Capital structure
- Net worth
Consideration should also be given to any assets not essential to the operation of the business, such as investments in securities, real estate, etc. In computing the book value per share of stock, assets of the investment type should be re-valued on the basis of their market price and the book value adjusted accordingly.
Factor Four: The earning capacity of the company.
Detailed profit-and-loss statements should be obtained and considered for a representative period immediately prior to the required date of appraisal, preferably five or more years. Such statements should show i) gross income by principal items; ii) principal deductions from gross income including major prior items of operating expenses, interest and other expense on each item of long term debt, depreciation and depletion if such deductions are made, officers' salaries, in total if they appear to be reasonable; iii) cash flow available for dividends, and; iv) rates and amounts of dividends paid on each class of stock.
Factor Five: The dividend-paying capacity.
Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. Recognition must be given to the necessity of retaining a reasonable portion of profits in a company to meet competition. Dividend-paying capacity is a factor that must be considered in an appraisal, but dividends actually paid in the past may not have any relation to dividend-paying capacity. Specifically, the dividends paid by a closely held family company may be measured by the income needs of the stockholders or by their desire to avoid taxes on dividend receipts, instead of by the ability of the company to pay dividends. Where an actual or effective controlling interest in a corporation is to be valued, the dividend factor is not a material element, since the payment of such dividends is discretionary with the controlling stockholders. The individual or group in control can substitute salaries and bonuses for dividends, thus reducing net income and understating the dividend-paying capacity of the company. It follows, therefore, that dividends are less reliable criteria of fair market value than other applicable factors.
Factor Six: Whether or not the enterprise has goodwill or other intangible value.
In the final analysis, good will is based upon earning capacity. The presence of good will and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of good will may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value of such assets.
Factor Seven: Sales of the stock and the size of the block of stock to be valued.
Sales of stock of a closely held corporation should be carefully investigated to determine whether they represent transactions at arm's length. Forced or distress sales do not ordinarily reflect fair market value nor do isolated sales in small amounts necessarily control the measure of value. This is especially true in the valuation of a controlling interest in a corporation. Since in the case of closely held stocks, no prevailing market prices are available, there is no basis for making an adjustment for blockage. If follows, therefore, that such stocks should be valued upon a consideration of all the evidence affecting the fair market value. The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minority interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock.
Factor Eight: The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
Section 2031b of the Code state, in effect, that in valuing unlisted securities the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchanged, should be taken into consideration along with all other factors. An important consideration is that the corporations to be used for comparisons have capital stocks which are actively traded by the public. The essential factor is that whether the stocks are sold on an exchange or over-the-counter, there is evidence of an active, free public market for the stock as of the valuation date. In selecting corporations for comparative purposes, care should be taken to use only comparable companies. Although, the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible is obtained. A company with a declining business and decreasing markets is not comparable to one with a record of current progress and market expansion.
TVG, while considering all of the factors noted above, attributes varying weights to each factor depending upon the particular circumstances unique to each partnership evaluated. In any case, it is important that all of the relevant factors be considered in the valuation process.
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