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Distributing Shares of Entities from IRA/Qualified Plans

Use of the Discount for Loss of Marketability for Valuation Purposes

By: Catherine Wynne

IRA Insights

Phil Jones' IRA was invested in Denver Rehab, LLC (DR), a privately held and profitable apartment building rehab company in Denver. DR had been in business for over 5 years and consisted of a group of 25 investors, some of which were IRAs. Phil was very satisfied with both the quality of the work and the earnings of DR, but was now contemplating the tax impact of distributing his IRA shares to himself and the consequent tax impact. The question loomed: what was the value of these shares for tax purposes?

Unlike the distribution of publicly traded stock with a daily market value, or real estate, which can rely on an appraisal, the value of stock in a privately held company is a completely different story. Why? Here are a few reasons:

• Unlike public stock, there is no effective way to market the shares.
• A less-than-majority ownership leaves the share owner with no substantial control over the company, and therefore the stock has less value to a prospective purchaser.
• Lastly, because there are likely no competing potential buyers due to lack of marketing for the shares (above), there may be only one "take it or leave it" offer on the shares.
  

CPAs and business valuation experts frequently are required to answer the question: What is the value of minority shareholder stock in a privately held company for tax purposes?

This is referred to as the "Discount for Loss of Marketability", DLOM for short, and would apply to Phil's IRA's share distribution in Denver Rehab LLC.

In general, valuation of this type of stock has only been extensively evaluated in the following two circumstances:

• Pre-public offering stock or IPO stock, which will eventually be offered to the public
• Restricted stocks, which may not, because of SEC rules, be offered to the public for a certain period of time
  

These are the two types of stock that require valuations and may be discounted. Historically, IPO stock has had a discount in value of 45% while restricted stock may vary between 30% to 35%1. Although private stock is not the same as restricted stock, the two are still somewhat analogous when looking at valuation discount scenarios.

Phil's IRA's stock would fall into the private stock category. It would be more prudent to use the DLOM evaluation for restricted stock (above) when evaluating the stock in DR. This means that if the value of DR is $5 million and the IRA owns 1/25 of the issued stock, the value of this stock, undiscounted, would be $200,000. Discounted, this value could actually be in the neighborhood of $130,000 to $140,000. Splitting the difference to $135,000 for the sake of illustration, Phil would be paying $41,850 in taxes as opposed to $56,000 on the distribution of the IRA shares based on a personal income tax rate of 31%. This is a substantial tax savings and it is tempting to stop at this point and go no further with the valuation.

What are the cautions in the application of DLOM? In some cases, because of lack of thorough analysis on the part of the taxpayer or his/her experts, the standard 30% to 35% has been challenged.

In McCord v. Commissioner, 120 T.C. 38 (203), a family limited partnership (FLP)2, the business valuation expert used the DLOM of 35%. The IRS expert thought differently and estimated the discount at 7.2%. Ultimately the court decided that the discount should be 20%. The argument, in this case, was the applicability of the restricted stock model to a FLP.

In other cases such as Peraccio v. Commissioner TC Memo 2003-280 and Lappo v. Commissioner TC Memo 2003-258, both FLP entities, similar valuations were at issue, both resolving in a lower DLOM than expected. The decisions resulted in a DLOM of 25% and 24% respectively.

What do these numbers mean to Phil or any other individual with regards to the valuation of stock being distributed from their IRA? The lesson is, although there are some "industry accepted" standards for valuing private stocks, it pays to do your homework when taking advantage of DLOM.

It is nearly certain that there is a discount in Phil's and maybe your IRA's stock valuation for taxable distribution purposes, but how do you make use of DLOM and still stay on the right side of the IRS? To take advantage of DLOM, you and your experts need to answer the questions, "What is the discount and how can I support this?" before jumping into the "industry standard" trap.

SUMMARY

An IRA can take advantage of the DLOM when valuing its shares for taxable distributions. Although the industry has historically used 30% to 35% as the discount, caution should be exercised when applying this discount randomly. Always seek the guidance of a qualified tax or legal expert in this area to avoid running into a dispute on applying the discount without supporting evidence of its validity.

References:

1 "Understanding the Valuation Discount for Lack of Marketability" by Russell T. Glazer CPA, ABV, MBA, The CPA Journal, August 2005 Issue

2 "The 35% "Standard" Marketability Discount: RIP" by Michael A Paschall, ASA, CFA, JD

Catherine Wynne is a principal in Entrust New Direction IRA, Inc., a licensee of The Entrust Group (TEG). TEG has been, since 1981, the leader in self-directed IRA, Roth, SEP and 401(k) administration. New Direction, in Lafayette Colorado, provides administration services as well as continuing education for tax and investment professionals and the general public. Website: NewDirectionIRA.com.

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