Rev Rul 59-60 and Its 8 Valuation Factors

Revenue Ruling 59-60 is an Internal Revenue Service (IRS) document providing guidance for valuing the stock of closely held corporations. A closely held corporation has a limited number of shareholders and its stock is not publicly traded, making valuation complex. The ruling’s primary purpose is to establish a framework for these valuations for federal estate and gift tax purposes, though its principles are now widely applied in business scenarios like mergers and acquisitions.

The ruling is not a rigid mathematical formula but a set of guiding principles. It defines fair market value as the price at which property would change hands between a willing buyer and a willing seller, where neither is under compulsion to act and both have reasonable knowledge of relevant facts. This guidance helps determine a company’s worth when a public market price is unavailable.

The Eight Valuation Factors

The Nature and History of the Business

This factor involves reviewing the company’s operational history, stability, and growth patterns. An appraiser examines the risks inherent in the business and its products or services. A long-established business with a consistent record of profitability may be valued more favorably than a newer company in a volatile market. This historical context helps an appraiser assess the overall quality of the enterprise.

The Economic and Industry Outlook

A company’s value is influenced by the economic environment and its specific industry. This factor requires an analysis of the overall economic outlook, including interest rates, inflation, and market trends. An appraiser also reviews the company’s competitive landscape, industry growth prospects, and any technological or regulatory changes that could impact future performance.

Book Value and Financial Condition

The book value of a company’s stock is calculated from its balance sheet (assets minus liabilities). This factor requires a review of financial statements to assess financial health, including liquidity, solvency, and the value of underlying assets. Book value is often different from fair market value, especially for companies with significant intangible assets not reflected on the balance sheet.

Earning Capacity of the Company

For most operating businesses, earning capacity is a primary driver of value. This factor focuses on the company’s ability to generate future profits. Appraisers analyze historical earnings over several years to identify trends and normalize for non-recurring events. The analysis is used to forecast expected future earnings, which helps determine what a buyer would pay for that stream of profits.

Dividend-Paying Capacity

This factor considers the company’s ability to pay dividends, which is distinct from its actual history of payments. In a closely held company, dividend policy is at the discretion of the owners and may not reflect the true capacity to distribute cash. An appraiser analyzes earnings, cash flow, and capital needs to determine the potential for future dividend payments, which is relevant for investors seeking a return through distributions.

Goodwill or Other Intangible Value

This factor accounts for the existence of goodwill and other intangible assets not always recorded on the balance sheet. Goodwill can represent a company’s established reputation, strong customer relationships, or a skilled workforce. Other identifiable intangibles might include patents, trademarks, proprietary technology, or valuable contracts that contribute to the company’s earning power.

Prior Sales of Stock

Previous sales of the company’s stock can indicate its value. This factor examines the price and terms of past transactions, which must be scrutinized to ensure they were “arm’s-length” transactions between independent parties. A sale to a family member at a discount, for example, is not a reliable indicator of fair market value. The size of the stock block sold is also considered, as a minority interest may trade at a different price per share than a controlling block.

Market Price of Comparable Public Stocks

To estimate value when a direct market price is unavailable, an appraiser can look at similar, publicly traded companies. This involves identifying corporations in a similar line of business and analyzing their stock prices. Appraisers use valuation multiples, like the price-to-earnings ratio, from these companies and apply them to the subject company’s metrics. Adjustments are necessary to account for differences in size, growth, and risk.

Weighting the Factors for Analysis

After analyzing all eight factors, an appraiser must determine how much weight to assign to each one. This weighting is not uniform and depends entirely on the specific facts and circumstances of the business being valued, as no single factor is universally dominant. The appraiser must provide a clear and defensible rationale for the weights assigned.

The nature of the business is a primary determinant in this process. For an operating company, such as a manufacturer or retail store, the capacity to generate earnings is often the most significant factor. For these businesses, factors like earning capacity and dividend-paying capacity will receive greater weight.

For a business that primarily holds investments, such as a real estate holding company, the analysis shifts. In these asset-based enterprises, the underlying value of the assets is paramount. Therefore, the book value of the stock and the company’s financial condition will be given the most weight, as value is derived from what the assets are worth, rather than the income the company generates.

Key Valuation Discounts

Discount for Lack of Marketability

After a preliminary value is determined, adjustments are often necessary to reflect the realities of a closely held stock. One of the most significant is the Discount for Lack of Marketability (DLOM). This discount accounts for the fact that an interest in a private company cannot be converted to cash as quickly or easily as a share of a publicly traded stock. An owner cannot simply call a broker and sell the shares on an open market.

The DLOM reflects the absence of a ready market for the stock. Selling a private company interest can be a lengthy and costly process, involving finding a buyer and negotiating a price. This inherent illiquidity makes the investment less attractive than a similar, publicly traded security. The size of the discount can vary significantly, often ranging from 15% to 35% or more, depending on the company’s circumstances.

Discount for Lack of Control

Another common adjustment is the Discount for Lack of Control (DLOC), which applies when valuing a minority interest in a company. A minority shareholder does not have the power to direct company policy, dictate dividend payments, or force a sale of the company’s assets. This lack of control makes a minority block of stock less valuable on a per-share basis than a controlling interest.

An investor with a controlling interest can make strategic decisions that impact profitability, such as hiring management or setting compensation. A minority owner is a passive investor, subject to the decisions made by the controlling shareholders. The DLOC quantifies this disadvantage, with the discount amount depending on the degree of control held by the majority and the rights granted to minority shareholders.