What Is Closely Held Corporate Stock?

Closely held corporate stock represents ownership in a company that is not publicly traded and has a small number of shareholders. These entities are often family-owned businesses or private companies where the owners are deeply involved in day-to-day operations. Unlike shares of public corporations sold on stock exchanges, closely held stock has a limited ownership base and no ready market for its shares. The value of this investment is not determined by daily market fluctuations but by the underlying performance and assets of the business itself.

Defining Characteristics of Closely Held Stock

A primary feature of closely held stock is the concentration of ownership among a small group of individuals, who are often family members, the original founders, or key members of the management team. For tax purposes, the IRS may define a corporation as closely held if five or fewer individuals own more than 50% of the company’s stock value during the last half of the tax year.

This concentration of ownership leads to the lack of a ready market. There is no public exchange where these shares can be easily bought and sold, which means finding a buyer and determining a fair price can be a complex process.

Consequently, the transfer of closely held stock is nearly always subject to restrictions outlined in legal agreements. These restrictions are put in place to control who can become an owner, preserving the private nature of the company. These agreements are intended to maintain the stability and direction of the business.

A distinct operational aspect in closely held corporations is the frequent overlap between ownership and management. Shareholders are often the same people serving as directors, officers, and employees. This integration means that major business decisions are made by individuals with a direct and substantial personal financial stake in the outcome.

Valuing Closely Held Corporate Stock

Since there is no public market to set a price for closely held shares, a formal valuation is required in many situations. A valuation establishes a defensible estimate of the stock’s worth for transactions like a sale to a third party, a shareholder buyout, or for tax-related purposes such as estate planning or divorce settlements.

Valuation professionals use one of three main approaches to determine the stock’s value. The asset-based approach calculates the company’s net asset value, which is its total assets minus its total liabilities. This method is often used for holding companies or businesses where the value is tied directly to the tangible assets it owns.

The income-based approach focuses on the company’s ability to generate future profits. Methodologies like the Discounted Cash Flow (DCF) method project the company’s future cash flows and then discount them back to a present value. Another method, the Capitalization of Earnings, determines value by taking the company’s expected future earnings and dividing them by a capitalization rate.

A market-based approach involves comparing the business to similar private companies that have recently been sold or to publicly traded companies in the same industry. Adjustments are made to account for differences in size, profitability, and growth prospects between the subject company and the comparables. This method relies on finding sufficient data on comparable transactions.

Valuing closely held stock also involves applying specific discounts. The Discount for Lack of Marketability (DLOM) accounts for the fact that the stock is not publicly traded and cannot be converted to cash quickly. This discount reflects the financial risk of holding an illiquid asset, with studies suggesting it can range from 20% to 50%.

Another common adjustment is the Discount for Lack of Control (DLOC). A minority ownership stake is worth less on a per-share basis than a controlling stake. This is because a minority shareholder cannot direct company policy, declare dividends, or sell company assets, and the DLOC reflects this diminished power.

Transfer and Sale Restrictions

The transfer and sale of closely held stock are governed by shareholder agreements, with the buy-sell agreement being the most common document. This legally binding contract between the shareholders and the corporation dictates what happens when a shareholder wishes to sell their shares, dies, becomes disabled, or otherwise leaves the company. The purpose is to ensure an orderly transition of ownership.

A common provision is the Right of First Refusal (ROFR). If a shareholder receives an offer from a third party to buy their shares, the ROFR requires them to first offer the shares to the corporation or the other existing shareholders at the same price and on the same terms. The existing owners then have a specified period to decide whether to purchase the shares themselves before the sale to the outside party can proceed.

A similar but distinct mechanism is the Right of First Offer (ROFO). Under a ROFO, a shareholder who wants to sell must first offer their shares to the corporation or other shareholders before they begin to market them to outside buyers. The selling shareholder sets the initial price and terms, and if the existing owners decline, the seller is then free to find a third-party buyer, but typically cannot sell for a lower price than what was offered internally.

Shareholder agreements often define certain permitted transfers that do not trigger these rights. It is common for agreements to allow shareholders to transfer shares to immediate family members, such as a spouse or children, or to a trust established for estate planning purposes. These exceptions allow for personal wealth and succession planning.

Key Tax Implications

When a shareholder sells closely held stock, the profit from the sale, which is the sale price minus the shareholder’s original cost basis, is treated as a capital gain. The tax rate applied depends on how long the stock was held. Stock held for more than one year is subject to lower long-term capital gains tax rates, while stock held for one year or less is taxed at higher, ordinary income tax rates.

The valuation of closely held stock is important for gift and estate tax purposes. When shares are gifted to another person or transferred to heirs as part of an estate, a formal valuation is necessary to determine the fair market value. This value is used to calculate the potential gift or estate tax liability, and the IRS pays close attention to these valuations to ensure they are not understated to avoid taxes.

The corporate structure itself has tax implications for shareholders. A C corporation is subject to double taxation, meaning the corporation pays income tax on its profits, and then shareholders pay taxes again on the dividends they receive. In contrast, an S corporation is a pass-through entity, where the company’s profits and losses are passed directly to the shareholders’ personal tax returns, avoiding tax at the corporate level.