Revenue Ruling 83-120

Revenue Ruling 83-120 (valuation of preferred stock)

Sec. 1. Purpose

The purpose of this Revenue Ruling is to amplify Rev. Rul. 59-60, 1959-1 C.B. 237, as modified by Rev. Rul. 65-193, 1965-2 C.B. 370, and to provide information and guidance to taxpayers, Internal Revenue Service personnel, and others concerned with the valuation, for Federal tax purposes, of securities that cannot be immediately resold because they are restricted from resale pursuant to Federal securities laws. This guidance is applicable only in cases where it is not inconsistent with valuation requirements of the Internal Revenue Code of 1954 or the regulations thereunder.  Further, this ruling does not establish the time at which property shall be valued.
Sec. 2. Nature of the Problem

It frequently becomes necessary to establish the fair market value of stock that has not been registered for public trading when the issuing company has stock of the same class that is actively traded in one or more securities markets. The problem is to determine the difference in fair market value between the registered shares that are actively traded and the unregistered shares. This problem is often encountered in estate arid gift tax cases. However; it is sometimes encountered when unregistered shares are issued in exchange for assets or the stock of an acquired company.
Sec. 3. Background and Definitions

1. The Service outlined and reviewed in general the approach, methods, and factors to be considered in valuing shares of closely-held corporate stock for estate and gift tax purposes in Rev. Rul. 59-60, as modified by Rev. Rul. 65-193. The provisions of Rev. Rul. 59-60, as modified, were extended to the valuation of corporate securities for income, and other tax purposes by Rev. Rul. 68-609, 1968-2 C.B. 327.

2. There are several terms currently in use in the securities industry that denote restrictions imposed on the resale and transfer of certain securities. The term frequently used to describe these securities is “restricted securities,” but they are sometimes referred to as “registered securities,” “investment letter stock,” “control stock,” or “private placement stock.”  Frequently these terms are used interchangeably. They all indicate that these particular securities cannot lawfully be distributed to the general public until a registration statement relating to the corporation underlying the securities has been filed, and has also become effective under the rules promulgated and enforced by the United States Securities & Exchange Commission (SEC) pursuant to the Federal securities laws. The following represents a more refined definition of each of the following terms along with two other terms “exempted securities” and “exempted transactions.”

1. The term “restricted securities” is defined in Rule 144 adopted by the SEC as securities acquired directly or indirectly from the issuer thereof, or from an affiliate of such issuer, in a transaction or chain of transactions not involving any public offering.

2. The term “unregistered securities” refers to those securities with respect to which a registration statement, providing full disclosure by the issuing corporation, has not been flied with the SEC pursuant to the Securities Act of 1933. The registration statement is a condition precedent to a public distribution of securities in interstate commerce and is aimed at providing the prospective investor with a factual basis for sound judgment in making investment decisions.

3. The terms “investment letter stock” and “letter stock” denote shares of stock that have been issued by a corporation without the benefit of filing a registration statement with the SEC. Such stock is subject to resale and transfer restrictions set forth in a letter agreement requested by the issuer and signed by the buyer of the stock when the stock is delivered. Such stock may be found in the hands of either individual investors or institutional investors.

4. The term “control stock” indicates that the shares of stock have been held or are being held by an officer, director, or other person close to the management of the corporation. These persons are subject to certain requirements pursuant to SEC rules upon resale of shares they own in such corporations.

5. The term “private placement stock” indicates that the stock has been placed with an institution or other investor who will presumably hold it for a long period and ultimately arrange to have the stock registered if it is to be offered to the general public. Such stock may or may not be subject to a letter agreement. Private placements of stock are exempted from the registration and prospectus provisions of the Securities Act of 1933.

6. The term “exempted securities” refers to those classes of securities that are expressly excluded from the registration provisions of the Securities Act of 1933 and the distribution provisions of the Securities Exchange Act of 1934.

7. The term “exempted transactions” refers to certain sales or distributions of securities that do not involve a public offering and are excluded from the registration and prospectus provisions of the Securities Act of 1933 and distribution provisions of the Securities Exchange Act of 1934. The exempted status makes it unnecessary for issuers of securities to go through the registration process.

Sec. 4. Securities Industry Practice in Valuing Restricted Securities

1. Investment Company Valuation Practices. The Investment Company Act of 1940 requires open-end investment companies to publish the valuation of their portfolio securities daily. Some of these companies have portfolios containing restricted securities, but also have unrestricted securities of the same class traded on a securities exchange. In recent years the number of restricted securities in such portfolios has increased. The following methods have been used by investment companies in the valuation of such restricted securities:

1. Current market price of the unrestricted stock less a constant percentage discount based on purchase discount;

2. Current market price of unrestricted stock less a constant percentage discount different from purchase discount;

3. Current market price of the unrestricted stock less a discount amortized over a fixed period;

4. Current market price of the unrestricted stock; and

5. Cost of the restricted stock until it is registered.

The SEC ruled in its Investment Company Act Release No.5847, dated October 21, 1969, that there can be no automatic formula by which an investment company can value the restricted securities in its portfolios. Rather, the SEC has determined that it is the responsibility of the board of directors of the particular investment company to deter- mine the “fair value” of each issue of restricted securities in good faith.

2. Institutional Investors Study. Pursuant to Congressional direction, the SEC undertook an analysis of the purchases, sales, and holding of securities by financial institutions, in order to determine the effect of institutional activity upon the securities market The study report was published in eight volumes in March 1971. The fifth volume provides an analysis of restricted securities and deals with such items as the characteristics of the restricted securities purchasers and issuers, the size of transactions (dollars and shares), the marketability discounts on different trading markets, and the resale provisions. This research project provides some guidance for measuring the discount in that it contains information, based on the actual experience of the marketplace, showing that, during the period surveyed (January 1,1966, through June 30,1969), the amount of discount allowed for restricted securities from the trading price of the unrestricted securities was generally related to the following four factors.

1. Earnings. Earnings and sales consistently have a significant influence on the size of restricted securities discounts according to the study. Earnings played the major part in establishing the ultimate discounts at which these stocks were sold from the current market price. Apparently earnings patterns, rather than sales patterns, determine the degree of risk of an investment

2. Sales. The dollar amount of sales of issuers’ securities also has a major influence on the amount of discount at which restricted securities sell from the current market price. The results of the study generally indicate that the companies with the lowest dollar amount of sales during the test period accounted for most of the transactions involving the highest discount rates, while they accounted for only a small portion of all transactions involving the lowest discount rates.

3. Trading Market. The market in which publicly held securities are traded also reflects variances in the amount of discount that is applied to restricted securities purchases. According to the study, discount rates were greatest on restricted stocks with unrestricted counterparts traded over-the-counter, followed by those with unrestricted counterparts listed on the American Stock Exchange, while the discount rates for those stocks with unrestricted counterparts listed on the New York Stock Exchange were the smallest.

4. Resale Agreement Provisions. Resale agreement provisions often affect the size of the discount. The discount from the market price provides the main incentive for a potential buyer to acquire restricted securities. In judging the opportunity cost of freezing funds, the purchaser is analyzing two separate factors. The first factor is the risk that underlying value of the stock will change in a way that, absent the restrictive provisions, would have prompted a decision to sell. The second factor is the risk that the contemplated means of legally disposing of the stock may not materialize. From the seller’s point of view, a discount is justified where the seller is relieved of the expenses of registration and public distribution, as well as of the risk that the market will adversely change before the offering is completed. The ultimate agreement between buyer and seller is a reflection of these and other considerations. Relative bargaining strengths of the parties to the agreement are major considerations that influence the resale terms and consequently the size of discounts in restricted securities transactions. Certain such provisions are often found in agreements between buyers and sellers that affect the size of discounts at which restricted stocks are sold. Several such provisions follow, all of which, other than number (3), would tend to reduce the size of the discount:

1. A provision giving the buyer an option to “piggyback,” that is, to register restricted stock with the next registration statement, if any, filed by the issuer with the SEC;

2. A provision giving the buyer an option to require registration at the seller’s expense;

3. A provision giving the buyer an option to require registration, but only at the buyer’s own expense;

4. A provision giving the buyer a right to receive continuous disclosure of information about the issuer from the seller;

5. A provision giving the buyer a right to select one or more directors of the issuer;

6. A provision giving the buyer an option to purchase additional shares of the issuer’s stock; and

7. A provision giving the buyer the right to have a greater voice in operations of the issuer, if the issuer does not meet previously agreed upon operating standards.

Institutional buyers can and often do obtain many of these rights and options from the sellers of restricted securities, and naturally, the more rights the buyer can acquire, the lower the buyer’s risk is going to be, thereby reducing the buyer’s discount as well. Smaller buyers may not be able to negotiate the large discounts or the rights and options that volume buyers are able to negotiate.

3. Summary. A variety of methods have been used by the securities industry to value restricted securities. The SEC rejects all automatic or mechanical solutions to the valuation of restricted securities, and prefers, in the case of the valuation of investment company portfolio stocks, to rely upon good faith valuations by the board of directors of each company. The study made by the SEC found that restricted securities generally are issued at a discount from the market value of freely tradable securities.

Sec. 5. Facts and Circumstances Material to Valuation of Restricted Securities.

Guide to Valuation of Preferred Stock
Revenue Ruling 83-120

Valuation; stock; closely-held business. The significant factors in deriving the fair market value of preferred and common stock received in certain corporate reorganizations are discussed. Rev. Rul. 59-60 amplified.
Sec. 1. Purpose

The purpose of this Revenue Ruling is to amplify Rev. Rul. 59-60, 1959-1 C.B. 237, by specifying additional factors to be considered in valuing common and preferred stock of a closely-held corporation for gift tax and other purposes in a recapitalization of closely-held businesses. This type of valuation problem frequently arises with respect to estate planning transactions wherein an individual receives preferred stock with a stated par value equal to all or a large portion of the fair market value of the individual’s former stock interest in a corporation. The individual also receives common stock which is then transferred, usually as a gift, to a relative.
Sec. 2. Background

.01 One of the frequent objectives of the type of transaction mentioned above is the transfer of the potential appreciation of an individual’s stock interest in a corporation to relatives at a nominal or small gift tax cost. Achievement of this objective requires preferred stock having a fair market value equal to a large part of the fair market value of the individual’s former stock interest and common stock having a nominal or small fair market value. The approach and factors described in this Revenue Ruling are directed toward ascertaining the true fair market value of the common and preferred stock and will usually result in the determination of a substantial fair market value for the common stock and a fair market value for the preferred stock which is substantially less than its par value.

.02 The type of transaction referred to above can arise in many different contexts. Some examples are:

a. A owns 100% of the common stock (the only outstanding stock) of Z Corporation which has a fair market value of l.0,500x. In a recapitalization described in section 368(a)(1)(E), A receives preferred stock with a par value of 10,000x and new common stock, which A then transfers to A’s son B.

b. A owns some of the common stock of Z Corporation (or the stock of several corporations) the fair market value of which stock is 10,500x. A transfers this stock to a new corporation X in exchange for preferred stock of X corporation with a par value of 10,000x and common stock of corporation, which A then transfers to A’s son B.

c. A owns 80 shares and his son B owns 20 shares of the common stock (the only stock outstanding) of Z Corporation. In a recapitalization described in section 36S(a)(1)(E), A exchanges his 80 shares of common stock for 80 shares of new preferred stock of Z Corporation with a par value of 10,000x. A’s common stock had a fair market value of 10,000x.
Sec. 3. General Approach to Valuation

Under section 25.2512-2(f)(2) of the Gift Tax Regulations, the fair market value of stock in a closely-held corporation depends upon numerous factors, including the corpora- tion\’92s net worth, its prospective earning power, and its capacity to pay dividends. In addition, other relevant factors must be taken into account. See Rev. Rul. 59-60. The weight to be accorded any evidentiary factor depends on the circumstances of each case. See section 25.2512-2(f) of the Gift Tax Regulations.
Sec. 4. Approach to Valuation – Preferred Stock

.01 In general the most important factors to be considered in determining the value of preferred stock are its yield, dividend coverage and protection of its liquidation preference.

.02 Whether the yield of the preferred stock supports a valuation of the stock at par value depends in part on the adequacy of the dividend rate. The adequacy of the dividend rate should be determined by comparing its dividend rate with the dividend rate of high-grade publicly traded preferred stock. A lower yield than that of high-grade preferred stock indicates a preferred stock value of less than par. If the rate of interest charged by independent creditors to the corporation on loans is higher than the rate such independent creditors charge their most credit worthy borrowers, then the yield on the preferred stock should be correspondingly higher than the yield on high quality preferred stock. A yield which is not correspondingly higher reduces the value of the preferred stock. In addition, whether the preferred stock has a fixed dividend rate and is nonparticipating influences the value of the preferred stock. A publicly traded preferred stock for a company having a similar business and similar assets with similar liquidation preferences, voting rights and other similar terms would be the ideal comparable for determining \’92 \’92 g yield required in arm’s-length transactions for closely-held stock. Such ideal comparables will frequently not exist. In such circumstances, the most com- parable publicly-traded issues should be selected for comparison and appropriate adjustments made for differing factors.

.03 The actual dividend rate on a preferred stock can be assumed to be its stated rate if the issuing corporation will be able to pay its stated dividends in a timely manner and will, in fact, pay such dividends. The risk that the corporation may be unable to timely pay the stated dividends on the preferred stock can be measured by the coverage of such stated dividends by the corporation\’92s earnings. Coverage of the dividend is measured by the ratio of the sum of pre-tax and pre-interest earnings to the sum of the total interest to be paid and the pre-tax earnings needed to pay the after-tax dividends. Standard & Poor’s Ratings Guide, 58 (1979). Inadequate coverage exists where a decline in corporate profits would be likely to jeopardize the corporation’s ability to pay dividends on the preferred stock. The ratio for the preferred stock in question should be compared with the ratios for high quality preferred stock to determine whether the preferred stock has adequate coverage. Prior earnings history is important in this determination. Inadequate coverage indicates that the value of preferred stock is lower than its par value. Moreover, the absence of a provision that preferred dividends are cumulative raises substantial questions concerning whether the stated dividend rate will, in fact, be paid. Accordingly, preferred stock with noncumulative dividend features will normally have a value substantially lower than a cumulative preferred stock with the same yield, liquidation preference and dividend coverage.

.04 Whether the issuing corporation will be able to pay the full liquidation preference at liquidation must be taken into account in determining fair market value. This risk can be measured by the protection afforded by the corporation’s net assets. Such protection can be measured by the ratio of the excess of the current market value of the corporation\’92s assets over its liabilities to the aggregate liquidation preference. The protection ratio should be compared with the ratios for high quality preferred stock to determine adequacy of coverage. Inadequate asset protection exists where any unforeseen business reverses would be likely to jeopardize the corporation\’92s ability to pay the full liquidation preference to the holders of the preferred stock.

.05 Another factor to be considered in valuing the preferred stock is whether it has voting rights and, if so, whether the preferred stock has voting control. See, however, Section 5.02 below.

.06 Peculiar covenants or provisions of the preferred stock of a type not ordinarily found in publicly traded preferred stock should be carefully evaluated to determine the effects of such covenants on the value of the preferred stock. In general, if covenants would inhibit the marketability of the stock or the power of the holder to enforce dividend or liquidation rights, such provisions will reduce the value of the preferred stock by comparison to the value of preferred stock not containing such covenants or provisions.

.07 Whether the preferred stock contains a redemption privilege is another factor to be considered in determining the value of the preferred stock The value of a redemption privilege triggered by death of the preferred shareholder will not exceed the pre- sent value of the redemption premium payable at the preferred shareholder’s death (i.e., the present value of the excess of the redemption price over the fair market value of the preferred stock upon its issuance). The value of the redemption privilege should be reduced to reflect any risk that the corporation may not possess sufficient assets to redeem its preferred stock at the stated redemption price. See. 03 above.
Sec. 5. Approach to Valuation Common Stock

.01 If the preferred stock has a fixed rate of dividend and is nonparticipating, the common stock has the exclusive right to the benefits of future appreciation of the value of the corporation. This right is valuable and usually warrants a determination that the common stock has substantial value. The actual value of this right depends upon the corporation’s past growth experience, the economic condition of the industry in which the corporation operates, and general economic conditions. The factor to be used in capitalizing the corporation’s prospective earnings must be determined after an analysis of numerous factors concerning the corporation and the economy as a whole. See Rev. Rul. 59-60, at page 243. In addition, after-tax earnings of the corporation at the time the preferred stock is issued in excess of the stated dividends on the preferred stock will increase the value of the common stock. Furthermore, a corporate policy of reinvesting earnings will also increase the value of the common stock. .02 A factor to be considered in determining the value of the common stock is whether the preferred stock also has voting rights. Voting rights of the preferred stock, especially if the preferred stock has voting control, could under certain circumstances increase the value of the preferred stock and reduce the value of the common stock. This factor may be reduced in significance where the rights of common stockholders as a class are protected under state law from actions by another class of shareholders, see Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977), particularly where the common share- holders, as a class, are given the power to disapprove a proposal to allow preferred stock to be converted into common stock. See ABA-ALI Model Bus. Corp. Act, Section 60 (1969).
Rev. Rul. 59-60, as modified by Rev. Rul. 65-193, is amplified.