What Is a Closely Held Business for Tax Purposes?

A closely held business is a company with a small number of owners whose shares are not available on public stock exchanges. The concentration of ownership can range from a single family to a small group of partners, and these entities are managed directly by their owners. This structure allows for direct involvement in decision-making and a high degree of operational flexibility, which differs from widely-held public corporations.

Defining Ownership Concentration

For tax purposes, the Internal Revenue Service (IRS) provides a precise definition of a closely held corporation. According to Internal Revenue Code Section 542, a corporation is considered closely held if it meets a specific ownership test at any point during the last half of the tax year. The test requires that more than 50% of the value of the company’s outstanding stock must be owned by five or fewer individuals. The IRS specifies that this measurement is based on the value of the stock, not the number of shares.

Ownership can be either direct or indirect. Direct ownership refers to stock registered in an individual’s name, while indirect ownership is more complex and includes shares owned by family members, such as siblings, spouses, ancestors, and lineal descendants. It also encompasses stock owned through other entities like corporations or trusts, in proportion to an individual’s stake.

This rule prevents owners from circumventing the concentration test by distributing shares among relatives or controlled entities. This definition is primarily applied to C-corporations to determine if they are subject to rules designed to prevent tax avoidance strategies, such as using the corporate structure to shelter income.

Common Business Structures

The term “closely held” describes an ownership characteristic rather than a formal legal business structure. Various legal entities can function as closely held businesses, provided their ownership is concentrated and their stock is not publicly traded. The most common structures are C-corporations, S-corporations, and Limited Liability Companies (LLCs).

A C-corporation can be closely held if it meets the IRS’s ownership test. While C-corporations have no theoretical limit on the number of shareholders, many are owned by a small group of founders or a single family. These entities are subject to corporate income tax.

S-corporations are, by design, closely held entities, as federal tax law limits them to 100 shareholders. In an S-corporation, profits and losses are passed through directly to the shareholders’ personal tax returns, avoiding corporate-level tax.

Limited Liability Companies (LLCs) are also frequently structured as closely held businesses. An LLC’s ownership is determined by its operating agreement and can be held by a single individual or a small group of members. LLCs are pass-through entities for tax purposes, meaning income and losses are reported on the owners’ personal tax returns.

Governance and Ownership Agreements

Closely held businesses rely on internal legal documents to manage ownership and control. The most common of these is a shareholder agreement for a corporation or an operating agreement for an LLC, which contains a buy-sell agreement. This provision is a binding contract among the owners that dictates the terms of an ownership transfer.

A buy-sell agreement specifies what happens when a “triggering event” occurs, such as an owner’s death, disability, retirement, or divorce. By pre-defining the process for these situations, the agreement ensures an orderly transition of ownership, preventing potential disputes that could destabilize the business.

A component of a buy-sell agreement is the mechanism for valuing the departing owner’s interest. The agreement can establish a fixed price, a formula, or a process for obtaining an independent appraisal. The agreement also outlines the funding mechanism for the buyout, which could involve life insurance policies or installment payments.

These agreements also restrict the transfer of shares to outside parties. Most include a “right of first refusal,” which requires a shareholder who wishes to sell their interest to first offer it to the company or the other existing shareholders at the same price and terms.

Key Tax Considerations

The IRS applies specific tax rules to closely held C-corporations to prevent owners from using the corporate entity to gain unfair tax advantages. Two limitations are the at-risk rules under Internal Revenue Code Section 465 and the passive activity loss (PAL) rules under Section 469.

The at-risk rules limit a taxpayer’s deductible losses from a business activity to the amount they are personally “at risk” of losing. For a closely held C-corporation, this means the corporation can only deduct losses up to the amount of money and property it has contributed to an activity, plus any amounts borrowed for which it is personally liable. This prevents owners from using nonrecourse debt to create artificial losses.

The passive activity loss rules prevent taxpayers from using losses from passive activities to offset income from active sources. A passive activity is a trade or business in which the taxpayer does not materially participate. A special rule allows a closely held C-corporation to offset its passive losses against its “net active income,” but not against its portfolio income like interest or dividends.

Business Valuation Methods

Valuing a closely held business is challenging because there is no active market to establish a stock price. This lack of a ready market price necessitates the use of specialized valuation methods for purposes such as estate taxes, buy-sell agreements, or a potential sale. IRS Revenue Ruling 59-60 provides standard guidance on this topic.

There are three primary approaches to valuing a closely held business. The asset-based approach determines value by subtracting the fair market value of the company’s liabilities from the fair market value of its assets. This method calculates the net value of the company’s tangible and intangible assets and is often used for holding companies.

The income-based approach focuses on the company’s ability to generate future economic benefits. This method calculates the present value of anticipated future earnings or cash flows using techniques like the discounted cash flow method. This approach is favored for profitable, stable businesses.

The market-based approach derives value by comparing the subject company to similar businesses that have recently been sold or to public companies in the same industry. An appraiser analyzes financial metrics from these comparable companies, such as price-to-earnings ratios, and applies them to the subject company.