Revenue Ruling 59-60: Factors for Business Valuation

Revenue Ruling 59-60, issued by the Internal Revenue Service (IRS), outlines the approach, methods, and factors for valuing the capital stock of closely held corporations, specifically for federal estate and gift tax purposes. A closely held corporation is a company whose shares are owned by a small number of people and are not publicly traded, making their value difficult to determine. The guidance emerged to address the challenge of assigning a value to something with no ready market. While originally intended for tax matters governed by Internal Revenue Code sections 2031 and 2512, its principles now inform valuations for mergers, acquisitions, and various legal disputes.

The Fair Market Value Standard

At the core of Revenue Ruling 59-60 is the concept of “Fair Market Value” (FMV). The ruling defines FMV as the price at which a property would change hands between a hypothetical willing buyer and a hypothetical willing seller. This transaction assumes that neither party is under any compulsion to act, meaning the buyer is not desperate to acquire the asset and the seller is not forced to dispose of it. This standard imagines an ideal negotiation where both parties are armed with reasonable knowledge of all relevant facts about the company and its industry.

The “willing buyer, willing seller” principle is designed to ensure the valuation is objective and grounded in economic reality, rather than being influenced by the specific circumstances or motivations of any actual individuals. It removes personal interests and pressures from the equation, focusing instead on what a typical, informed market participant would conclude. This standard provides a consistent and uniform basis for valuation for the equitable administration of tax law.

The Eight Valuation Factors

Revenue Ruling 59-60 mandates that a valuation must be comprehensive, considering all relevant information. It specifically lists eight factors that require careful analysis to arrive at a defensible conclusion of value. These factors provide a structured approach to ensure no significant aspect of the business is overlooked.

The first factor is the nature of the business and the history of the enterprise from its inception. This involves understanding what the company does, its operational stability, its growth trajectory, and the risks inherent in its business model. An analysis would review the company’s origins and its evolution to gauge its position in the marketplace.

A second consideration is the economic outlook in general and the condition of the specific industry. A company’s performance is tied to broader economic trends and the health of its sector. This analysis involves assessing interest rates, economic growth projections, and competitive pressures within the industry to understand the external forces affecting the company’s future.

The book value of the stock and the financial condition of the business represent the third factor. Book value is an accounting measure derived from the company’s balance sheet. An analyst examines financial statements from prior years to assess liquidity, solvency, and the overall financial health of the enterprise.

The fourth factor is the earning capacity of the company. For many businesses, particularly those that provide services or manufacture goods, this is a primary driver of value. This analysis involves scrutinizing past income statements to identify trends in revenue and profitability to forecast the company’s potential to generate future earnings.

Dividend-paying capacity is the fifth factor. This is distinct from a company’s history of actual dividend payments. The focus is on the company’s financial ability to pay dividends, considering its earnings, cash flow, and need for reinvestment.

The analysis must also determine whether the enterprise has goodwill or other intangible value. This sixth factor accounts for value that is not captured on the balance sheet, such as a strong brand name, a loyal customer base, or proprietary technology. The existence of these assets can mean the company’s value is significantly higher than its tangible asset value suggests.

Sales of the stock and the size of the block of stock to be valued constitute the seventh factor. Any prior transactions in the company’s own stock can be a strong indicator of value, provided they were arm’s-length transactions. The size of the block being valued is also important, as a controlling interest often commands a premium.

The final factor is the market price of stocks of corporations engaged in the same or a similar line of business. This involves finding publicly traded companies that are comparable to the private company being valued. By analyzing the market multiples of these public “comps,” an appraiser can derive an indication of value for the subject company.

Weighting the Factors in Practice

The eight factors outlined in Revenue Ruling 59-60 are not applied as a rigid checklist where each item carries equal importance. The ruling emphasizes that the weight accorded to each factor depends heavily on the specific circumstances and the nature of the business being valued. Valuation requires informed professional judgment to determine which factors are most relevant.

For an operating company, such as a manufacturing firm or a service business, its ability to generate profits is paramount. In this context, an appraiser would place the most significant weight on the company’s earning capacity and its dividend-paying capacity. The value of such a business is primarily derived from the future income stream it can produce.

Conversely, for a business that functions as an investment or real estate holding company, the focus shifts. The value of these entities lies in the market value of their underlying assets. Therefore, an appraiser would give the most weight to the book value of the stock and the financial condition of the business, adjusted to reflect the fair market value of the assets it holds.

Common Valuation Adjustments

After a preliminary value is determined by analyzing and weighting the eight factors, the valuation process is often not complete. For closely held companies, appraisers apply adjustments to reflect the specific characteristics of the ownership interest being valued. These adjustments account for the differences between a minority, non-marketable interest in a private company and a freely traded share of a public corporation.

One of the most common adjustments is the Discount for Lack of Control (DLOC). This discount is applied when valuing a minority ownership stake. A minority shareholder cannot direct company policy, dictate dividend payments, or decide to sell the company. Because these rights are valuable, a controlling interest is worth more per share than a minority interest, and the DLOC quantifies that difference.

A second adjustment is the Discount for Lack of Marketability (DLOM). Shares in a private company cannot be sold as easily or quickly as shares on a public stock exchange. There is no ready market, and finding a buyer can be a lengthy and uncertain process. The DLOM reflects this illiquidity, reducing the value of the private shares to account for the difficulty of converting them to cash.