Are You Making the Most of Marketability Discounts in Your Estate Plan?

As an entrepreneur, your job is more than just a source of income. You invest effort and money into your business to build an organization that will live on after you. Your company can be part of your legacy and support your loved ones long after you’re gone. 

While that’s an invaluable gift for your beneficiaries, it presents complications during estate planning. You must be careful to value and protect your business, or your loved ones could face a serious, unexpected tax bill. That’s why you should understand how discounts for lack of marketability (DLOMs) work. Here’s what marketability discounts are, how they affect estate taxes, and how you can account for them in your estate plan. 

What Is a Discount for Lack of Marketability?

Businesses are assets like anything else you can own, buy, or sell. However, private businesses are particularly difficult to properly value compared to other assets. 

Most types of property are assigned a monetary value based on how much people are willing to pay for them. This is simple for consumer goods like electronics and furniture and only slightly more complicated for larger items like real estate. Appraisers make assumptions about how much a given asset is worth by finding similar recently purchased items and comparing their condition and selling price. 

Publicly-traded businesses are valued similarly. Determining the worth may be as simple as multiplying the company’s total stocks by their current selling price. The problem is that this isn’t possible for companies not traded on public financial exchanges. That makes it significantly harder to purchase these companies and theoretically lowers their value. 

As a result, private companies are subject to discounts for lack of marketability (DLOMs). This discount, which can range from 15% to 59%, applies to the taxable value of the company. 

For example, say a couple owns a manufacturing company with a book value of $50 million after its liabilities are subtracted from its assets. However, a professional appraiser determines that there is a lack of market demand for manufacturing functions and assets, so it would be particularly difficult to sell the company. The appraiser may recommend a DLOM of 40% due to market conditions. 

This discount would reduce the company’s taxable value to just $30 million, significantly reducing taxes upon transfer of ownership. It would reduce the value of the company subject to inheritances taxes from $25.88 million to just $5.88 million. At the current 40% inheritance tax rate, this would cut the total taxes the couple’s beneficiaries would face from $10.35 million to just $2.35 million. 

DLOMs and Estate Taxes

Many entrepreneurs and business owners want to pass on their companies to loved ones or trusted beneficiaries. However, successful privately-traded businesses often include millions in assets and potential future profits.

If the transfer is not managed carefully, the IRS may treat some or all of the company as subject to inheritance taxes. This could place a heavy financial burden on the recipients and the organization since the estate may not have the liquid assets necessary to cover the taxes. It may be required to sell part of the company or take out loans to cover the costs. But that is where DLOMs come in.

The IRS recognizes that a privately-traded company is not a liquid asset and cannot easily be converted into liquid funds. If owners wanted to sell the business quickly, they likely would not get its full book value. There is not a high demand for buying pre-existing companies outside financial exchanges. That’s why the IRS applies the discount for lack of marketability. 

Still, the IRS’ opinion of the appropriate DLOM may differ significantly from yours. It is crucial to prepare for DLOM disputes to protect your business from the 40% federal inheritance tax.

Incorporating DLOMs Into Your Estate Plan

You must consider how DLOMs could affect your beneficiaries if you want your company to continue after you’re gone. The best way to incorporate a DLOM into your estate plan is by estimating how large of a discount could be applied to your business’s value in advance. With that information, you can make informed decisions about passing on your assets with minimal tax penalties. 

An experienced estate planning attorney can help you accomplish this. You’ll work with your attorney and financial team to calculate the potential DLOM for your plan by:

  • Valuing your company according to industry standards. You’ll need to understand how the IRS will value your business to calculate the DLOM and potential taxes.
  • Collecting relevant quantitative data for your valuation. Your financial team will research similar businesses that went public through a restricted stock study or a pre-IPO study to find benchmarks for your DLOM.
  • Calculating your DLOM and supporting your conclusion with relevant documentation. With that data in hand, your team will calculate the appropriate marketability discount for your company. They should also document their calculations and assumptions to support the discount should the IRS challenge it.

These calculations and supporting documents should be updated regularly along with the rest of your estate plan. This information will make it significantly easier for your executor to protect your estate and beneficiaries from unnecessary inheritance taxes.

Experienced Estate Planning Lawyers in California

As an entrepreneur, marketability discounts are invaluable for reducing taxes on your estate. At the Law Offices of Denise Eaton May, P.C., we are dedicated to helping business owners protect their estates by providing personalized attention during the planning process. We can help you account for DLOMs in your estate plan and protect your beneficiaries and assets from unnecessary taxes. Schedule your free consultation to learn more about how our estate planning attorneys can help you.

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