Mitigating Estate Planning Risk: Discount for Lack of Marketability (DLOM)

Key Takeaways

·       DLOM is applied to a non-controlling interest in a privately held business to adjust for the fact that it is not readily sellable on the open market.

·       If the value of an ownership interest is reduced due to DLOM, it can significantly impact the amount of estate tax owed.

·       DLOM remains one of the most carefully scrutinized assumptions in any valuation because of its simplicity, its complexity, and its magnitude.

·       DLOM can be very useful when gifting or transferring ownership interests to family members or to other individuals. Just don’t use it without proper supervision.

Almost 40 years after the release of Thriller and more than 10 years after his untimely death, the Estate of Michael Jackson notched an almost $400 million win over the IRS in Tax Court. Although there were numerous Bad assumptions from the Commissioner’s expert, the most significant was marketability.

Valuation is inherently adversarial. Tax Court has a long history of the IRS refuting valuations of privately held businesses for gift & estate tax and of fighting for much higher values and higher taxes. One of the most often attacked assumptions is the discount for lack of marketability (DLOM). A DLOM is applied to a non-controlling interest in a privately held business to adjust for the fact that it is not readily sellable on the open market.

Why the DLOM?

DLOM remains one of the most scrutinized assumptions in any valuation for three reasons: its simplicity, its complexity, and its magnitude. DLOM is a simple, single number discount that does not require years of data and numerous line items of financial projections and complex calculations to substantiate. At the same time, DLOM is complex. There is no perfect set of data for non-marketable interests. Further, the data we do have requires a refined professional eye to apply it to a subject company while opening the door for debate. Although it is typically the last step in a valuation, a DLOM can be more than half of the fair market value of an asset.

American taxpayers have been on a hot streak in Tax Court, but with a recent $80 billion of additional funding, expect more scrutiny from a beefed-up IRS enforcement division. Judges have developed a more nuanced and sophisticated understanding of DLOM which puts more responsibility on appraisers.  

Most appraisers use empirical studies (restricted stock and pre-IPO) and theoretical models (option pricing and discounted cash flow). Empirical studies have strength because they’re based on real, observed transactions. However, they also suffer some key weaknesses which have been demonstrated in the courtroom. Many of the studies referenced are stale (dating back to the 1960s). Data in the studies include companies of vastly different sizes with differing risk factors from a myriad of industries. This results in discounts ranging from very high discounts to premiums in some cases. While theoretical models are a nice demonstration of the phenomenon of DLOM, they are just theory and are sensitive to specific assumption inputs.

A fact that is missed in the coverage of Cecil v. Commissioner, another recent taxpayer win, is that the IRS expert prevailed in his DLOM. The taxpayer’s expert took a reasonable DLOM and relied on a qualitative analysis of the previously discussed empirical studies and theoretical models. However, the Tax Court found the lack of specificity in the use of this data to be weak and therefore sided with the IRS expert. Overall, the Tax Court ruled generally in taxpayer’s favor. But because they lost the DLOM portion they missed out on millions of dollars in tax savings.

New model for DLOM benchmarking

To help address the lack of comparables and over-reliance on historical data, I have developed a new quantitative DLOM model that’s just being put into practice. The model compiles 4,700 restricted stock transactions since 2001 and identifies certain factors so it can benchmark the data sets and extrapolate the average discount observed. The model helps diffuse common IRS challenges to the discount rate used by taxpayers. Armed with this data, for instance, it’s a lot harder for the IRS to say a taxpayer is benchmarking against non-related industries, or transactions that are too old, or transactions of companies of different size or risk factors. Think of the model as a very sturdy house that can’t be blown over by the big, bad IRS.

Contact me if you’d like to learn more about our firm’s DLOM quant model.

Real World Example

If an individual holds an ownership interest in a privately held company, that interest may account for a significant portion of their overall estate. If the value of that ownership interest is reduced due to DLOM, it can significantly impact the amount of estate tax owed. Additionally, DLOM can come into play when gifting or transferring ownership interests to family members or other individuals. If the value of the ownership interest is reduced due to DLOM, the gift or transfer may use less exemption or be subject to less gift tax, which can be beneficial for the transferor.

DLOM is a relatively exclusive concept to trust and estate planning and valuations. No other topic consumes more of my time during initial meetings with clients. DLOM is a very powerful and versatile tool in the T&E planning tool kit. Just don’t use it without proper supervision. Be sure to consult with a qualified appraiser who has a detailed understanding of DLOM. Your clients have too much at stake.  


Conclusion

DLOM can significantly impact the value of a privately held company. Understanding what the IRS and Tax Courts look for when calculating a DLOM is essential. By using quantitative methodologies, recent and industry-specific data, and well-supported conclusions, a DLOM calculation can provide strong support for estate and gift tax planning purposes. Sure, DLOM is complicated, but it can be as “simple as ABC” with the right appraiser and the right set of data set on your side.

This article was originally published in Trust & Estates on wealthmanagement.com.

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DeJoy.