By Lance S. Hall, ASA1
Investors are still feeling the pain and panic of the dramatic stock market decline in the fall of 2008. In a mere 45 trading days from September 19 through November 20, 2008, the Dow Industrial Average plummeted 33.7 percent. Fear permeated investment decisions, resulting in a flight to liquidity and safety. On September 22, 2008, the three-month Treasury Bill Rate was 1.28 percent; by November 20, 2008, the three-month Treasury Bill Rate was 0.03 percent. This was the equivalent of stuffing cash in your mattress. Investors were willing to accept no return in order to avoid losing money in other investments.
From an estate planning perspective, it is axiomatic that wealthy individuals can take advantage of the lower asset values and lower interest rates (i.e., the Applicable Federal Rate) to remove assets from their taxable estates. Moreover, recently introduced H.R. 436 threatens to eliminate discounts for lack of control and lack of marketability for family-owned entities effective the date of enactment, if enacted. However, given the large stock market losses and uncertainty in the marketplace, is there a better reason to gift now? The simple answer is "yes." That better reason is "volatility." The current market's volatility may add another 15 to 30 percentage points to a "normal" discount for lack of marketability.
Restricted Stock
For individuals owning a family business or asset holding entity, the most common estate planning technique is to remove "control" over the assets in the estate by making gifts of minority interests. By so doing, the taxpayer is able to take advantage of what are often referred to as "discounts" for lack of control and lack of marketability. The IRS and the Courts recognize that the ability to control a business or asset has value. Likewise, the absence of control reduces the number of potential buyers who might be interested in investing in that business or asset. In other words, a minority interest is inherently less "marketable" than a controlling interest. Accordingly, the valuation of a minority interest almost always contains a discount for lack of marketability.
For over 30 years, the Tax Courts have accepted the use of restricted stock comparisons to determine a discount for lack of marketability. Restricted Stock generally refers to the stock of a publicly traded company that is unregistered and cannot be traded on any organized exchange except under Rule 144. The Securities and Exchange Commission's Rule 144 governs the sale of Restricted Stock. Generally, before Restricted Stock can be sold in the public marketplace, an investor must satisfy a "holding period."2 After the holding period is satisfied, Restricted Stock may be sold in the public marketplace subject to certain volume limitations.
Periodically, investors desire to sell their Restricted Stock prior to the satisfaction of the holding period. Rule 144 allows such sales as long as the sale is to a private "sophisticated" investor in a non-public transaction. Since the Restricted Stock is not as liquid (i.e., marketable) as its registered but otherwise identical sister securities, the private placement of Restricted Stock typically occurs at a discount to the public price of the registered securities. It is this discount that the Courts most often look to, to determine a private stock's discount for lack of marketability.3
Using Restricted Stock transaction data to determine a discount for lack of marketability requires a comparative analysis between the investment attributes of a subject private entity and those of the Restricted Stock companies. Such investment attributes often include size, as reflected in market value, total assets, net book value, revenue and undiscounted price per share; size of the block of stock in terms of the number of shares; market-to-tangible book value ratios; and volatility of the underlying stock price. In the table below, we have examined how these characteristics affect the discount for lack of marketability. Each column represents the average quantile discount from the lowest discount quintile to the highest discount quintile. Then, within each quintile, the average of each investment characteristic is recorded.
As is readily observable, in general, the larger the size, the lower the discount.4 On the other hand, the greater the volatility (and the related market-to-tangible book value), the greater the discount. In the table below, we have isolated volatility and divided it into quintiles, as well as the largest and smallest decile to show its affect on the discount for lack of marketability.
Again, the correlation between the underlying stock volatility and the discount appears very strong.
The VIX Index
Since 1990, the leading indicator of forward looking (30-day) market volatility has been the Chicago Board Options Exchange's VIX Index. VIX is generally interpreted as an indicator of investor sentiment and investing conditions. A reading of 20 or below is thought to be very favorable for stocks and indicates investor satisfaction. A reading of 30 or higher is associated with market declines and indicates investor fear and panic.5 Since 1990, the VIX has only topped a reading of 40 on three brief occasions: the collapse of Long-Term Capital Management (connected with the Russian debt crisis), the dot.com bubble burst, and 9/11. Despite these brief volatility shocks, the VIX has averaged a very agreeable 19.61 since 1990. This all stopped in September, 2008.
As indicated in the following graph, in August, 2008, the VIX was near its long-term average. However, from September 19 through December 29, 2008, the VIX has averaged an unprecedented 56.56 and has topped a reading of 80 twice.
If a reading of 30 is an indication of investor panic, a reading of over 50 can only be interpreted as investor Armageddon.
The Relationship between VIX and the Discount for Lack of Marketability
In determining a discount for lack of marketability for a privately held entity, a comparison with the characteristics of the Restricted Stock data is performed. However, the volatility of a private company cannot be directly ascertained. Accordingly, often the market price-to-tangible book value ratio is utilized. It is generally accepted that the greater a company's intangible book value relative to its tangible book value, the greater the volatility of a company's stock price.
The shortcoming of the Restricted Stock approach is that it contains data over many periods of time and, therefore, reflects the average volatility of the marketplace. This shortcoming can be overcome by making an adjustment to the discount for lack of marketability otherwise determined by adding or subtracting an increment to reflect the greater or lower volatility of the market as of the valuation date.
This is done by observing a monthly, six-month moving average VIX. From 1990 through 2005 (the period for which Restricted Stock transactions are available), the average VIX was 20.7. The fourth quintile VIX for the Restricted Stock period was 23.6, and the fifth quintile VIX was 26.7. As the table below indicates, when moving from a VIX of 20.7 to 23.6, the average discount for lack of marketability indicated by the restricted stock data is 1.2 percentage points or a 5 percent premium to the normal period discount. More significantly, moving from an average VIX of 20.7 to 26.7 indicates that the discount for lack of marketability should be 5.1 percentage points higher, or a premium to the normal discount of 20.5 percent.
Since the stock market today is significantly more volatile than the highest quintile volatility experienced during the Restricted Stock period, the adjustment to the normal discount for lack of marketability should be significantly larger than the 5.1 percentage points indicated when the VIX average is 26.7. From September 19 through December 29, 2008, the average VIX reading was 56.56. An appropriate adjustment for a VIX reading of 56.56, based on a linear relationship, ranges from 14.84 percentage points to 30.48 percentage points. In other words, if a normal discount for lack of marketability for your company is 30 percent, in the fall of 2008 the appropriate discount for lack of marketability for your company should have ranged from 45 percent to 60 percent. Clearly such discounts are extremely attractive for estate planning and will eventually go away as the VIX returns to normal.
Summary and Conclusion
There has never been a better time to gift. Asset values are down significantly from their peaks. The Applicable Federal Rate is at a historic low. H.R. 436, if passed, will eliminate discounts for family entities. And, by gifting now, as a result of unprecedented market volatility, discounts for lack of marketability are likely to be 15 to 30 percentage points higher. Now is the time to do effective estate planning.
Investors are still feeling the pain and panic of the dramatic stock market decline in the fall of 2008. In a mere 45 trading days from September 19 through November 20, 2008, the Dow Industrial Average plummeted 33.7 percent. Fear permeated investment decisions, resulting in a flight to liquidity and safety. On September 22, 2008, the three-month Treasury Bill Rate was 1.28 percent; by November 20, 2008, the three-month Treasury Bill Rate was 0.03 percent. This was the equivalent of stuffing cash in your mattress. Investors were willing to accept no return in order to avoid losing money in other investments.
From an estate planning perspective, it is axiomatic that wealthy individuals can take advantage of the lower asset values and lower interest rates (i.e., the Applicable Federal Rate) to remove assets from their taxable estates. Moreover, recently introduced H.R. 436 threatens to eliminate discounts for lack of control and lack of marketability for family-owned entities effective the date of enactment, if enacted. However, given the large stock market losses and uncertainty in the marketplace, is there a better reason to gift now? The simple answer is "yes." That better reason is "volatility." The current market's volatility may add another 15 to 30 percentage points to a "normal" discount for lack of marketability.
Restricted Stock
For individuals owning a family business or asset holding entity, the most common estate planning technique is to remove "control" over the assets in the estate by making gifts of minority interests. By so doing, the taxpayer is able to take advantage of what are often referred to as "discounts" for lack of control and lack of marketability. The IRS and the Courts recognize that the ability to control a business or asset has value. Likewise, the absence of control reduces the number of potential buyers who might be interested in investing in that business or asset. In other words, a minority interest is inherently less "marketable" than a controlling interest. Accordingly, the valuation of a minority interest almost always contains a discount for lack of marketability.
For over 30 years, the Tax Courts have accepted the use of restricted stock comparisons to determine a discount for lack of marketability. Restricted Stock generally refers to the stock of a publicly traded company that is unregistered and cannot be traded on any organized exchange except under Rule 144. The Securities and Exchange Commission's Rule 144 governs the sale of Restricted Stock. Generally, before Restricted Stock can be sold in the public marketplace, an investor must satisfy a "holding period."2 After the holding period is satisfied, Restricted Stock may be sold in the public marketplace subject to certain volume limitations.
Periodically, investors desire to sell their Restricted Stock prior to the satisfaction of the holding period. Rule 144 allows such sales as long as the sale is to a private "sophisticated" investor in a non-public transaction. Since the Restricted Stock is not as liquid (i.e., marketable) as its registered but otherwise identical sister securities, the private placement of Restricted Stock typically occurs at a discount to the public price of the registered securities. It is this discount that the Courts most often look to, to determine a private stock's discount for lack of marketability.3
Using Restricted Stock transaction data to determine a discount for lack of marketability requires a comparative analysis between the investment attributes of a subject private entity and those of the Restricted Stock companies. Such investment attributes often include size, as reflected in market value, total assets, net book value, revenue and undiscounted price per share; size of the block of stock in terms of the number of shares; market-to-tangible book value ratios; and volatility of the underlying stock price. In the table below, we have examined how these characteristics affect the discount for lack of marketability. Each column represents the average quantile discount from the lowest discount quintile to the highest discount quintile. Then, within each quintile, the average of each investment characteristic is recorded.
As is readily observable, in general, the larger the size, the lower the discount.4 On the other hand, the greater the volatility (and the related market-to-tangible book value), the greater the discount. In the table below, we have isolated volatility and divided it into quintiles, as well as the largest and smallest decile to show its affect on the discount for lack of marketability.Again, the correlation between the underlying stock volatility and the discount appears very strong.The VIX Index
Since 1990, the leading indicator of forward looking (30-day) market volatility has been the Chicago Board Options Exchange's VIX Index. VIX is generally interpreted as an indicator of investor sentiment and investing conditions. A reading of 20 or below is thought to be very favorable for stocks and indicates investor satisfaction. A reading of 30 or higher is associated with market declines and indicates investor fear and panic.5 Since 1990, the VIX has only topped a reading of 40 on three brief occasions: the collapse of Long-Term Capital Management (connected with the Russian debt crisis), the dot.com bubble burst, and 9/11. Despite these brief volatility shocks, the VIX has averaged a very agreeable 19.61 since 1990. This all stopped in September, 2008.
As indicated in the following graph, in August, 2008, the VIX was near its long-term average. However, from September 19 through December 29, 2008, the VIX has averaged an unprecedented 56.56 and has topped a reading of 80 twice.
If a reading of 30 is an indication of investor panic, a reading of over 50 can only be interpreted as investor Armageddon.The Relationship between VIX and the Discount for Lack of Marketability
In determining a discount for lack of marketability for a privately held entity, a comparison with the characteristics of the Restricted Stock data is performed. However, the volatility of a private company cannot be directly ascertained. Accordingly, often the market price-to-tangible book value ratio is utilized. It is generally accepted that the greater a company's intangible book value relative to its tangible book value, the greater the volatility of a company's stock price.
The shortcoming of the Restricted Stock approach is that it contains data over many periods of time and, therefore, reflects the average volatility of the marketplace. This shortcoming can be overcome by making an adjustment to the discount for lack of marketability otherwise determined by adding or subtracting an increment to reflect the greater or lower volatility of the market as of the valuation date.
This is done by observing a monthly, six-month moving average VIX. From 1990 through 2005 (the period for which Restricted Stock transactions are available), the average VIX was 20.7. The fourth quintile VIX for the Restricted Stock period was 23.6, and the fifth quintile VIX was 26.7. As the table below indicates, when moving from a VIX of 20.7 to 23.6, the average discount for lack of marketability indicated by the restricted stock data is 1.2 percentage points or a 5 percent premium to the normal period discount. More significantly, moving from an average VIX of 20.7 to 26.7 indicates that the discount for lack of marketability should be 5.1 percentage points higher, or a premium to the normal discount of 20.5 percent.
Since the stock market today is significantly more volatile than the highest quintile volatility experienced during the Restricted Stock period, the adjustment to the normal discount for lack of marketability should be significantly larger than the 5.1 percentage points indicated when the VIX average is 26.7. From September 19 through December 29, 2008, the average VIX reading was 56.56. An appropriate adjustment for a VIX reading of 56.56, based on a linear relationship, ranges from 14.84 percentage points to 30.48 percentage points. In other words, if a normal discount for lack of marketability for your company is 30 percent, in the fall of 2008 the appropriate discount for lack of marketability for your company should have ranged from 45 percent to 60 percent. Clearly such discounts are extremely attractive for estate planning and will eventually go away as the VIX returns to normal.Summary and Conclusion
There has never been a better time to gift. Asset values are down significantly from their peaks. The Applicable Federal Rate is at a historic low. H.R. 436, if passed, will eliminate discounts for family entities. And, by gifting now, as a result of unprecedented market volatility, discounts for lack of marketability are likely to be 15 to 30 percentage points higher. Now is the time to do effective estate planning.
1Mr. Hall is a Managing Director of FMV Opinions, Inc., a national business valuation firm with offices in New York,, San Francisco, Los Angeles, Irvine, Chicago and Dallas, Mr. Hall heads up FMV's estate and gift tax valuation practice. Mr. Hall can be reached at lhall@fmv.com. Additional information regarding FMV Opinions, Inc. can be accessed at www.fmv.com.
2Through 1996, the holding period was two-years. From 1997 through 2006 the holding period was one year. Today, the holding period is only six-months.
3This data sort excludes transactions having registration rights and premiums.
4While the percentage block does not seem to be material, when isolated, it is a major determining factor in the discount for lack of marketability of Restricted Stock (not private stock).
5Antognelli, Ferreira, McArdle, and Traub, "Fear and Greed in Global Asset Allocation." The Journal of Investing. (Spring 2000), pp. 27--32.