How Revenue Ruling 83-59 Affects Stock Valuation

Revenue Ruling 83-120 is guidance from the Internal Revenue Service (IRS) that outlines how to determine the fair market value of preferred and common stock in a closely held corporation. The ruling’s purpose is to establish a framework ensuring that the value of stock exchanged in these transactions is equivalent, which helps prevent unintended tax consequences. It provides a consistent methodology for valuation when stock is not publicly traded and its value is not easily determined. Following this guidance helps business owners navigate complex transactions involving their company’s stock.

The Valuation Factors of Revenue Ruling 83-120

Revenue Ruling 83-120 provides a multi-faceted approach to valuing preferred stock, moving beyond a simple reliance on its par or face value. The guidance specifies several factors that must be analyzed together to determine fair market value, reflecting the security’s economic substance. The factors are not a rigid formula but a set of guiding principles. The weight given to each factor can vary depending on the specific facts of the company and the terms of the preferred stock itself.

Yield

A consideration in valuing preferred stock is its dividend yield, the annual dividend payment expressed as a percentage of the stock’s par value. To assess its adequacy, this yield is compared to the yields on high-quality preferred stocks of publicly traded companies or high-grade corporate bonds. If the dividend rate on the closely held preferred stock is lower than these market comparables, its fair market value will likely be less than its par value. The analysis must also account for risk, as a closely held company is riskier than a public corporation. Its preferred stock should offer a higher yield to compensate, and a discount from par value is warranted if the rate does not reflect this increased risk.

Dividend Coverage

Dividend coverage refers to the corporation’s actual ability to pay its stated dividend, assessing earnings and cash flow relative to its dividend obligation. Strong and consistent historical earnings that exceed the annual dividend requirement suggest a high likelihood of payment, supporting a higher valuation. Valuators examine financial statements and future earnings projections to gauge the sustainability of these payments. A company with volatile earnings or a thin margin for covering its dividends presents a greater risk, which negatively impacts the stock’s value.

Protection of Liquidation Preference

Another factor is the protection of the preferred stockholders’ liquidation preference. This is the right to receive the stock’s par value, plus any unpaid dividends, before common stockholders in a company sale or liquidation. This protection is evaluated by comparing the total value of the liquidation preference to the company’s net asset value. A strong balance sheet with a high level of net assets relative to total debt and the preferred stock obligation indicates strong protection. Conversely, if a company is highly leveraged with significant debt that ranks senior to the preferred stock, the protection is weaker, reducing the stock’s fair market value.

Voting Rights

The presence or absence of voting rights affects the value of preferred stock. If the preferred stock carries voting rights sufficient to influence corporate policy or elect directors, it holds more value than non-voting stock. Control or influence over a company’s management and strategic decisions is an attractive feature for an investor. In many recapitalizations, the preferred stock is intentionally made non-voting to shift control to the common stockholders. A lack of voting power is a negative attribute that must be factored into the valuation.

Redemption Provisions

Redemption provisions define how and when the stock can be repurchased by the corporation or sold by the shareholder. A mandatory redemption date, which requires the company to buy back the stock at a specific future date, provides certainty to the investor and supports a value closer to par. This feature operates much like a maturity date on a bond. Conversely, if the company has a call provision giving it the option to redeem the stock, this introduces uncertainty and can reduce its value. A “put” option, which allows the shareholder to force the company to redeem the stock, is a valuable feature that enhances liquidity and increases the stock’s value.

Application in Corporate Recapitalizations

Revenue Ruling 83-120 is frequently applied in a corporate recapitalization, a strategy used in business succession and estate planning. This transaction, sometimes called an “estate freeze,” involves restructuring the company’s equity. An older-generation owner exchanges their common stock for newly issued preferred stock, while the common stock, carrying future appreciation potential, is transferred to younger family members or key employees. This transaction “freezes” the value of the older owner’s interest at the fixed par value of the preferred stock.

The objective of applying the valuation factors from Revenue Ruling 83-120 is to ensure a value-for-value exchange. The fair market value of the new preferred stock must be equivalent to the fair market value of the common stock surrendered. If the values are not aligned, the transaction can trigger adverse tax consequences. The valuation validates the recapitalization’s structure by analyzing the preferred stock’s features to prevent its artificial overvaluation, a practice the IRS scrutinizes.

Gift Tax Implications of Valuation

The valuation performed under Revenue Ruling 83-120 has direct gift tax implications. If the analysis concludes that the fair market value of the preferred stock received is less than the value of the common stock given up, the IRS will assert that a “deemed gift” has occurred. This shortfall in value is considered a taxable transfer to the younger generation who now holds the appreciating common stock. The IRS views this as a method of passing wealth that must be subject to gift tax rules.

For example, a business owner exchanges common stock valued at $2,000,000 for newly issued preferred stock with a par value of $2,000,000. A subsequent valuation using the 83-120 factors determines that due to a low dividend rate and weak redemption features, the preferred stock’s actual fair market value is only $1,500,000. In this situation, the IRS would determine that a deemed gift of $500,000 was made to the common stockholders. This amount would be subject to federal gift tax, potentially requiring the owner to pay tax or use their lifetime gift and estate tax exemption.

Relationship to Modern Estate Planning Rules

The application of Revenue Ruling 83-120 in family-based recapitalizations was affected by the enactment of Internal Revenue Code Section 2701 in 1990. This legislation introduced more restrictive valuation rules for transfers of interests between family members to curb abuses in estate freeze transactions. Under Section 2701, certain rights retained by the senior generation, such as discretionary liquidation rights, are assigned a value of zero for gift tax purposes unless they meet strict criteria. This “zero-value rule” can increase the value of the gift of the common stock, making the classic estate freeze more complex.

This does not render Revenue Ruling 83-120 obsolete. The ruling’s factors for valuing preferred stock—yield, coverage, and liquidation protection—are still necessary to determine the value of a “qualified payment right” under Section 2701. Furthermore, the principles of Revenue Ruling 83-120 continue to be the primary guidance for valuing preferred stock in transactions that fall outside the scope of Section 2701, such as those involving non-family members.