Defending Marketability Discounts With Mandelbaum Factors
If you or one of your clients gifts a closely held business interest, you will almost certainly need to obtain a business valuation for tax reporting purposes. In these types of valuations, appraisers often apply a discount for lack of marketability (DLOM) to account for the fact that closely held business interests are generally less liquid, and therefore less marketable, than publicly traded securities.
The DLOM can significantly reduce the fair market value of a closely held business interest, and thus the tax basis. Consequently, the IRS pays close attention to how appraisers determine marketability discounts. To avoid an IRS challenge, appraisers must provide a clear and thorough explanation of how they determined the DLOM, along with persuasive support for their conclusion. In this article, we review an important U.S. Tax Court case that sheds light on how the IRS evaluates the DLOM.
Common Approaches for Determining the DLOM
Traditionally, business appraisers have relied heavily on the benchmark approach to determine the DLOM. The benchmark approach refers to the use of the average or median discounts reported in restricted stock or pre-IPO benchmark studies to quantify the DLOM. The IRS has become increasingly critical of using the benchmark approach as the sole method for determining the DLOM due to flaws inherent in restricted stock and pre-IPO studies.
The main problem with restricted stock studies is that the reported discounts are influenced by data from samples that are not representative of the subject interest being valued. These studies generally don’t provide much detail, if any, about the sample transactions and companies involved, and many of them use old data that no longer reflects current market conditions. Further, restricted stock studies often involve small sample sizes, resulting in significant variance. In fact, the average DLOM reported in some of the most commonly cited restricted stock studies ranges from 13% to over 40%. In contrast, the average DLOM in pre-IPO studies are generally higher, ranging from around 30% to over 60%.1 The difference in the size of the DLOM can be attributed to unique characteristics of companies that have successful IPOs. Therefore, the results of pre-IPO studies won’t represent the subject interest being valued unless the company plans to go public.
Despite these flaws, appraisers rely heavily on these studies because they provide empirical data on comparable transactions. However, appraisers should no longer rely on blanket approaches that use averages or median values from benchmark studies to determine the DLOM. Rather, these studies should serve as a starting point for determining the DLOM, and be adjusted based on specific factors of the subject company being valued.
Mandelbaum v. Commissioner
In the 1995 U.S. Tax Court case, Mandelbaum v. Commissioner, the taxpayer’s valuation expert proposed a 70%-75% DLOM while the IRS’s valuation expert proposed a 30% DLOM. Both experts relied heavily on the benchmark averages of restricted stock and pre-IPO studies, and the court ultimately disagreed with the both parties’ experts’ opinions. Ultimately, Judge David Laro provided a set of nine company-specific factors that should be considered by the appraiser to adjust the averages found in benchmark studies. These factors, now commonly referred to as the “Mandelbaum factors”, are as follows:2
- Financial statement analysis
- Dividend policy
- Nature of the company (history, position in industry, economic outlook)
- Company’s management
- Amount of control in the transferred shares
- Restrictions on transferability of stock
- Holding period for stock
- Company’s redemption policy
- Costs associated with a public offering
Avoiding IRS Scrutiny
Since the Mandelbaum case, this approach has gained significant attention from the courts and valuation professionals. The IRS will likely consider these factors as they review your valuation report and evaluate the DLOM applied by your appraiser. Inadequate defense or support for the selected DLOM may result in a challenge from the IRS, potentially resulting in litigation costs and tax penalties.
A Mandelbaum study considers each of the Mandelbaum factors and determines the influence each factor has on the subject company’s marketability. The appraiser would then provide a thorough, clear explanation of his analysis, as well as persuasive support for his conclusions in the valuation report.
Determining the appropriate DLOM requires a certain level of subjectivity and professional judgment on the part of the appraiser. As a result, it’s important to select a qualified appraiser with extensive experience providing valuations for tax reporting purposes.
1 Internal Revenue Service. (2009). Discount for Lack of Marketability – Job Aid for IRS Valuation Professionals. Retrieved from https://www.irs.gov/pub/irs-utl/dlom.pdf.
2 Mandelbaum v. Commissioner, T.C. Memo 1995-255 (June 13, 1995).
This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.