How to Value Stock Using IRS Revenue Ruling 79-16

The Internal Revenue Service (IRS) provides guidance for valuing a company’s stock when it is not publicly traded through Revenue Ruling 59-60. This ruling establishes principles for determining fair market value for federal tax purposes, especially when no recent sales have occurred. Fair market value is the price at which property would change hands between a willing buyer and seller, where neither is under compulsion to act and both have reasonable knowledge of relevant facts. The methodology is not a rigid formula but an approach based on informed judgment, comparing the unlisted company to similar, publicly traded businesses.

Determining Applicability

IRS valuation principles are most frequently triggered by two federal tax events: transferring stock as a gift and including stock in a decedent’s estate. For a gift, the stock’s value is needed to file a gift tax return. When a person dies owning such stock, its value is needed to calculate the gross estate for estate tax purposes. Both scenarios require calculating the stock’s fair market value on a specific date.

These rules apply to the stock of “closely held” or “unlisted” corporations. A closely held corporation is owned by a few shareholders, while an unlisted company’s shares are not traded on a public exchange. Without readily available market prices, fair market value must be determined through detailed analysis.

Key Valuation Factors to Consider

The IRS mandates considering several factors to determine the fair market value of closely held stock. A sound valuation rests on a balanced consideration of all these elements, with the weight given to each depending on the specific nature of the business.

Nature and History of the Business

This factor requires examining the company’s history, including its stability, growth, and operational diversity. A business with a long, consistent history may be valued differently than a newer company in a volatile industry. The analysis also assesses the management team’s experience and the potential impact of losing a key person.

Economic and Industry Outlook

A company’s value is linked to its economic environment. The analysis considers the general economic outlook and trends specific to the business’s industry. This includes the level of competition, the company’s market position, and industry-wide trends that could affect future performance.

Book Value and Financial Condition

The stock’s book value, derived from the company’s balance sheet, is a starting point for valuation. This involves analyzing assets and liabilities to determine net worth by reviewing financial statements from the preceding two to five years. The value of non-operating assets, such as excess real estate or investments not essential to core operations, must also be considered.

Earning Capacity

A company’s earning capacity is a significant driver of its value. This factor involves reviewing historical earnings from profit and loss statements, often from the preceding five years, to identify trends and forecast future potential. The analysis determines the company’s ability to generate future profits.

Dividend-Paying Capacity

This factor focuses on the company’s ability to pay dividends, not its history of paying them. In a closely held company, dividend policy may be influenced by controlling shareholders rather than the capacity to distribute earnings. The analysis considers earnings, capital needs for growth, and financial health to determine what an investor would expect as a return.

Goodwill and Intangible Value

Goodwill and other intangible assets represent business value not attributable to tangible assets, such as brand recognition, a loyal customer base, or proprietary technology. Significant goodwill suggests earning power is greater than what physical assets alone would indicate. Valuing these intangibles involves assessing the company’s excess earnings compared to a normal return on its tangible assets.

Previous Sales of Stock

This factor considers the price of the company’s stock in past sales. Recent, arm’s-length transactions between unrelated parties can be a strong indicator of fair market value. The analysis must review the circumstances of these sales, including the number of shares sold and the relationship between the parties, to determine their relevance.

Market Price of Comparable Stocks

A key component of valuation is comparing the company to publicly traded businesses in a similar industry. This involves identifying comparable companies and analyzing their financial data and stock prices to find businesses similar in size and market position. The market values of these public companies are used to develop valuation multiples, like price-to-earnings ratios, that can be applied to the subject company.

Required Information and Documentation

A credible valuation requires substantial documentation to support the final conclusion of value. This information provides the factual basis for the assumptions made during the analysis. Key documents include:

• Internal financial documents for the five years preceding the valuation date, which provide a detailed picture of profitability and financial health. This includes annual income statements, balance sheets, and statements of cash flow.
• Corporate governance documents that can impact stock value, such as articles of incorporation, bylaws, and any shareholder or buy-sell agreements that contain transfer restrictions.
• Business operations information to assess competitive advantages and risks. This includes business plans, marketing materials, and information on the management team, key customers, and suppliers.
• External market data to understand broader trends. This includes industry reports, economic forecasts, and financial data for comparable publicly traded companies used in the analysis.

The Valuation Analysis Process

The valuation analysis involves applying established methodologies to the gathered information. It combines quantitative calculations and qualitative judgments to arrive at a defensible conclusion of value by considering and reconciling multiple valuation approaches.

The analysis often begins by selecting appropriate comparable public companies and calculating relevant valuation multiples, such as the price-to-earnings ratio. These multiples are then applied to the subject company’s financial data to derive an initial indication of its value. The selection of companies and multiples should be documented with a clear rationale.

A key part of the process for a closely held company is applying valuation adjustments. The discount for lack of marketability (DLOM) reflects that a private company interest is less liquid than a publicly traded stock. The discount for lack of control (DLOC) is applied to minority interests to reflect their inability to influence corporate decisions. The size of these discounts must be supported by empirical data and analysis.

Reporting the Valuation for Tax Purposes

After the analysis, the value must be reported for federal tax purposes. This requires attaching a formal valuation report or detailed statement to the relevant tax return. This documentation substantiates the reported value and explains how it was determined.

The tax form used depends on the transfer type. For a gift of stock, the value is reported on Form 709, United States Gift Tax Return. If the stock is part of an estate, its value is reported on Form 706, United States Estate Tax Return. Both forms require a description of the property and its value on the transfer date.

The attachment to the tax return must be a comprehensive document detailing the valuation methodology. It should state the purpose of the valuation, the valuation date, and the standard of value used. The report must describe how each of the relevant factors from Revenue Ruling 59-60 was considered in the analysis.

The documentation must also provide specifics about the analysis itself. This includes identifying the comparable companies used, showing the calculation of valuation multiples, and justifying any adjustments applied. The goal is to provide the IRS with a clear explanation of the process, demonstrating the final value is well-reasoned.