How to Legally Reduce Tax Liability Through Valuation Logic

If you’ve ever looked at a business valuation and thought, “That number seems low,” you might have just stumbled upon one of the most powerful tools in estate tax planning.

In the world of gift and estate taxes, a lower valuation isn’t a bad thing—it’s a strategy. By applying specific “valuation discounts,” savvy business owners and their advisors can legally reduce a business value by anywhere from 10% to 45%. 

Here is how the logic of “Fair Market Value” translates into impressive tax savings. 

The “Willing Buyer” Logic

Business valuations for gift or estate purposes use fair market value as a standard of value.  Fair market value is a defined term in business valuation.  Fair market value stresses that the buyer and seller are both hypothetical and not necessarily the same parties.[i]

To understand discounts, you have to look through the eyes of the IRS’s favorite imaginary person: the Hypothetical Willing Buyer.

Imagine someone offers to sell you 10% of a family-owned landscaping business. You’ll have no say in how the company is run, you can’t force a dividend payment, if you work there you can still be fired, and you can’t easily sell your shares to someone else because there’s no public and a very limited private market.

Would you pay the full “sticker price” for those shares? Of course not. You’d demand a discount for the headache of having no control and no exit strategy. The IRS and courts recognize this economic reality. 

The Two Heavy Hitters: DLOC and DLOM

When we talk about reducing tax liability by approximately 35%, we are usually talking about stacking two specific types of discounts.

1. Discount for Lack of Control (DLOC)

This is often called a “minority discount.” If you own less than 50% of a typical partnership or corporation, you can’t fire the CEO, set your own salary, or sell the company’s assets.[ii] Because you lack “control,” the value of your specific shares is worth less than a proportional slice of the whole pie. 

• Typical Range: 5% to 25%

2. Discount for Lack of Marketability (DLOM)

If you own stock in Apple stock, you can sell it in seconds and receive the money in three days. If you own stock in “Bob’s Manufacturing, Inc.,” it might take you six to nine months to find a buyer and another three months to close the deal. That delay and uncertainty converting the business to cash create a “marketability risk.”

• Typical Range: 10% to 35% 

How the Math Works (The “Stacking” Effect)

Discounts aren’t added together; they are applied sequentially. This is where the big savings happen.

Let’s look at a quick example:

• Enterprise Equity Value:  The control, marketable value of the equity of a company is $10,000,000.  You own a 10% lack of control, unmarketable share of a business.
• Your pro-rata value: before discounts is $1,000,000.  But you have no control.  In addition, private companies are hard to sell and take time. 
• Apply DLOC (20%): The value drops to $800,000.
• Apply DLOM (25%): You take 25% off the new $800,000 figure, bringing it down to $600,000.

In this scenario, with properly performed work, you’ve legally reduced the taxable value of that business interest by 40%. If you are gifting that stock to your children, you just moved $1M worth of value while only using $600k of your lifetime gift tax exemption.  Now, any future value growth is in your children’s trust or accounts, not yours. 

The Legal “Guardrails”

While these discounts are powerful, you can’t just pick a number out of thin air. The IRS and the courts are highly skeptical of “round numbers” that aren’t backed by data. To make a discount stick, you need a professional valuation report from a qualified appraiser that properly cites and calculates one or more of the below methods[iii] to determine marketability:

• Restricted Stock Studies: Data showing what investors pay for non-tradable shares.
• Pre-IPO Studies: Comparing prices of stock before and after a company goes public.
• The Mandelbaum Factors: A specific set of legal criteria used by courts to judge marketability.
• Statistical Studies:  Modeling of various Put Option Contracts are used to justify marketability.
• QMDM, Stout DLOM Calculator, Stout and Aldering/Hitchner have developed methodologies using Stout data. 

With tax laws constantly under review many families are using these discounts to “freeze” the value of their estates today. By gifting discounted shares now, all the future growth of that business happens outside of your taxable estate.  Minimize taxes with thoughtful planning.