Overview

Valuing a closely held business for gifting or estate tax purposes establishes the fair market value used on gift tax returns (Form 709) and estate tax returns (Form 706). Because these businesses are illiquid, owner-managed, and often have protections or restrictions, valuation can materially affect tax outcomes for donors, estates, and beneficiaries. The IRS and courts expect methodical appraisal work supported by contemporaneous records and a qualified appraiser’s report (see IRS guidance and Rev. Rul. 59-60). IRS Publication 561) explains general valuation principles; Form 706 instructions cover estate valuation rules.

Key valuation dates and tax rules

  • Gift valuation: The value for a gift is the fair market value on the date the gift is completed (date of gift). Gifts exceeding the annual exclusion require Form 709 and may use lifetime exemption amounts (check current figures with the IRS). The donor is responsible for reporting. (See Form 709 instructions.)
  • Estate valuation: For estate tax, assets are generally valued as of the decedent’s date of death. An alternate valuation date six months after death can be elected on Form 706 if it reduces both the gross estate and estate tax, but the alternate date applies to all assets. (See IRS Form 706 instructions.)

Because tax law and exemption amounts change, confirm current thresholds and filing rules on the IRS website before planning (IRS.gov).

Who should get a formal valuation?

  • Any owner planning a taxable gift of business interests or who expects the estate to approach the federal exemption.
  • Executors who must report business interests on Form 706.
  • Owners transferring interests to related parties, charities, or onto buy-sell arrangements where discounts or restrictions apply.

In my practice advising family business clients, I recommend a formal valuation whenever more than a de minimis portion of ownership moves or when discounts (minority, marketability) will materially change tax exposure. A robust appraisal reduces audit risk and supports settlement negotiations.

Recognized valuation approaches

The three classic approaches — income, market, and asset-based — remain central. A credible appraisal often blends methods and reconciles results.

  1. Income approach
  • Discounted cash flow (DCF) and capitalization-of-earnings models project future cash flows or earnings and discount them for risk.
  • Most appropriate for profitable, going-concern businesses with predictable cash flows.
  1. Market approach
  • Uses guideline public companies or comparable private transactions to derive valuation multiples (e.g., EBITDA multiple).
  • Challenging for truly unique, small private firms with few comparables; adjustments are necessary.
  1. Asset-based approach
  • Values underlying assets less liabilities — appropriate for holding companies, real-estate-intensive businesses, or firms not operating as going concerns.

Appraisers often reconcile these approaches, weighting them by relevance. The IRS and courts will examine the reasonableness of assumptions (growth rates, discount rates, comparables).

Common adjustments and discounts

Closely held interests frequently receive adjustments that reduce the reported value relative to a freely traded block of stock:

  • Minority interest discount (lack of control): A noncontrolling share often cannot direct distributions or strategy.
  • Lack of marketability discount (DLOM): Private-company shares are harder to sell.
  • Restrictions in shareholder agreements or buy-sell covenants: Transfer constraints reduce value.
  • Encumbrances and non-arm’s-length agreements: Below-market leases, loans, or family compensation arrangements require adjustment.

Use caution: aggressive or mechanical application of high discounts invites IRS challenge. Document the empirical basis for discount sizes — empirical studies, restricted stock studies, pre-IPO studies, and precedent transactions are typical evidence.

Documentation and the appraiser’s report

A defensible appraisal should include:

  • Engagement letter and scope of work.
  • Valuation date and standard of value (fair market value is typical for tax work).
  • Detailed company history and industry analysis.
  • Financial statements (five years if available), tax returns, budgets, and capital expenditure plans.
  • Adjusted normalized earnings and balance sheet (owner perks removed, related-party adjustments).
  • Description of legal documents: shareholder agreements, buy-sell agreements, voting agreements, debt instruments, and employment contracts.
  • Explanation of methods, assumptions, discount rates, comparables, and sensitivity analysis.
  • A conclusion of value and reconciliation of methods.

Qualified appraisers typically hold credentials such as Accredited in Business Valuation (ABV), Certified Valuation Analyst (CVA), Accredited Senior Appraiser (ASA — business valuation), or are Chartered Business Valuators (CBV) outside the U.S. Use an appraiser with tax-valuation experience and testimony experience if litigation is possible.

Special tax-related considerations

  • Section 2032A (special use valuation): Real property used in a trade or business or for farming may qualify for special-use valuation under limited circumstances. This can reduce estate tax for farms and closely held businesses with qualifying real property — consult a tax advisor.
  • Discounts under IRS scrutiny: The IRS often scrutinizes transfers that use Family Limited Partnerships (FLPs) or intentionally contrived restrictions solely to take discounts. Courts and the IRS may recharacterize transactions if they lack legitimate economic substance.
  • Charitable contributions of business interests: Gifts to charity of closely held interests require particular care (valuation, public charity’s ability to accept illiquid interests). See our article on gifting closely held business interests to charity for process and pitfalls.

Practical strategies and planning techniques

  • Early and phased gifting: Use annual exclusions and lifetime exemption strategically. Small, repeated gifts of minority interests (with proper valuation) can transfer family wealth over time.
  • Family Limited Partnerships and LLCs: These entities can centralize management and allocate tax benefits, but the IRS scrutinizes their formation and the legitimacy of valuation discounts.
  • Grantor Retained Annuity Trusts (GRATs) and installment sales to intentionally defective grantor trusts (IDGTs) can shift future appreciation out of the estate. These are advanced strategies requiring coordinated legal and tax work.
  • Buy-sell agreements and valuation formulas: Maintain clear, updateable valuation mechanisms in buy-sell agreements to reduce disputes and provide a defensible starting point for estate reporting.

Example (illustrative)

Assume a closely held service business reports normalized S-corp pre-tax earnings of $200,000. An appraiser uses a capitalization approach with a capitalization rate of 20% (reflecting required return and growth), indicating a going-concern equity value of $1,000,000. The interest being transferred is 25% and lacks control; the appraiser supports a 20% minority discount and a 25% marketability discount, applied sequentially, resulting in a transferrable value for that 25% interest materially lower than the pro rata portion of the whole. This example shows how discounts and methodology choices change reported values — explainable in the report and backed by data.

Audit risk and defending a valuation

  • Use a qualified, independent appraiser with tax experience.
  • Keep contemporaneous documentation for assumptions and adjustments.
  • Avoid overly aggressive discounting without empirical support.
  • Consider pre-filing strategies like obtaining a private letter ruling only in narrow circumstances — PLRs are rare and fact-specific.

When the IRS or heirs contest a valuation

If the IRS audits and contests valuation, the burden often lies with the taxpayer to substantiate the claimed value. Litigation or settlement may follow. Early use of qualified advisors and clear documentation improves the taxpayer’s negotiating and litigation position.

Practical checklist before gifting or reporting a business interest

  • Obtain a qualified appraisal or valuation memorandum.
  • Update or create buy-sell agreements and shareholder documents.
  • Normalize financial statements and prepare a clear capitalization and discount rationale.
  • Confirm gift or estate filing requirements and current exemption thresholds on IRS.gov.
  • Coordinate tax, legal, and estate planning teams to align structure and timing.

Further reading and related FinHelp resources

Professional disclaimer

This article is educational and not individualized tax or legal advice. Valuation and tax planning for closely held businesses are fact-specific and complex. Consult a qualified tax attorney, CPA with valuation experience, or accredited business appraiser before making gifting or estate decisions.

Authoritative sources

If you’d like, I can prepare a valuation document checklist tailored to your business type (service firm, manufacturer, real estate–holding company) to share with your appraiser or advisor.