Partial Interests in Business

April 13, 2006

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Our discussion of business valuation methods assumes that you're attempting to put a value on the entire business in anticipation of sale. But what if you want to sell off just a part of the business? Or, what if you want to give away part, as part of your long-term succession plan?

Minority interest discounts. In family companies, it's fairly common to have a controlling interest in the company held by the founder, with smaller blocks of stock held by the children or key employees. If the entire company will be sold, state laws protect those holding minority interests and typically require that they will receive their pro rata share of the sales price. Thus, if the company was valued at $1,500,000, a 10 percent shareholder should receive $150,000 if the entire company were sold.

However, if only part of the company is currently being sold or given away, minority interests are valued at a discount from their pro rata price. The reason is simply that a minority owner is not likely to have much influence on the way the company is run. He can't control the board of directors, control the payment of dividends, or even prevent himself from being fired if he's an employee. Exceptions could occur if no one held a majority interest in the company, or if the company bylaws specified that a supermajority vote (e.g., two-thirds) were required to take certain actions. But, in most situations, the lack of control means that the value of a minority interest on the open market is considerably less than the value of the entire company would suggest.

The IRS recognizes this and will allow a "minority discount" on the price of the stock. Typical discounts range from 20 to 40 percent, although greater discounts might be possible depending on the facts of the situation. In the usual situation, the discount is good news because it allows the business owner to give away part of the company while minimizing gift taxes, or to sell part of the company while minimizing capital gains taxes and allowing the purchaser to buy into the business at a reasonable cost. Since tax consequences are so important whenever business interests are transferred, and since the IRS tends to examine minority interest values very closely because of the opportunity for abuse, we strongly suggest that you use the IRS's rules in deciding the discounted price.

Majority interest premiums. If a minority interest gets a discount, then you might logically think that a premium should apply to a majority interest because the interest effectively controls the corporation. If you thought that, you'd be right. Majority interests, when sold or given away, are typically valued at more than their pro rata share of the company's value. For example, a majority interest of 75 percent of the stock might actually be worth 90 percent of the total value of the company. A majority interest should never be worth more than the total company value, however, since those holding minority interests would always be entitled to something upon sale or liquidation of the company.

If you're planning to pass your business on to the next generation of your family, carving out minority interests and giving or selling them to your successors can be a good way to reduce your estate or capital gains taxes.