Closely held corporations are those in which a small group of shareholders control the operating and managerial policies of the firm. More than 90 percent of all businesses in the United States are closely held. These firms differ from most publicly held companies in which ownership is widely disbursed and the firm is administered by professional managers. Most—but not all—closely held firms are also family-owned businesses. Family businesses may be defined as those companies where the link between the family and the business has a mutual influence on company policy and on the interests and objectives of the family. Families control the operating policies at many large, publicly traded companies. In many of these firms, families remain dominant by holding senior management positions, seats on the board of directors, and preferential voting privileges even though their shareholdings are significantly less than 50 percent.
One of the major concerns associated with closely held firms is the determination of their value. This uncertainty is largely due to the fact that shares of a closely held business are owned by a small number of stockholders, and often by members of a family. Because there is no established market for the shares, it is difficult to establish the value of the shares in an estate or gift tax situation.
In preparing a valuation report, the major rules to be followed are contained in Internal Revenue Service (IRS) guidelines. According to the IRS, the proper estimate of value should be based on the price at which a property would change hands between a willing buyer and a willing seller, with neither party under any compulsion to buy or sell and with all relevant facts available to both parties (the fair market value standard). The IRS provides valuation criteria for closely held businesses that are generally accepted by appraisers and the courts. The criteria include the history of the business, economic outlook, book value, earning capacity, dividend-paying capacity, goodwill and other intangibles, past sales of company stock, and stock price of comparable businesses.
Without a marketplace that reflects the price arrived at by both buyer and seller, the security prices of a closely held firm must be set by calculation, comparison, and the use of financial ratios. Valuation techniques that have evolved fall into three principal categories: (1) market (price-earnings) methods, (2) cash flow methods, and (3) book value (balance sheet) methods. Another area of concern when addressing valuation issues is the notion of discounts for minority interests and lack of marketability.
It is important to have detailed plans and procedures for the sale or transfer of stock at the time of the death, disability, or retirement of a shareholder in a closely held firm. Without such procedures, the departure of one major shareholder could also signal the end of a business. Buy/sell agreements spell out the terms governing sale of company stock to an outsider and thus protect control of the company. In many instances, these agreements allow co-owners to buy out heirs or other shareholders in the event of death or disability. In order to be considered valid for estate-tax purposes, a stock buy-sell agreement must meet several conditions, including a "full and adequate consideration" provision. Life insurance is generally used to provide the funds to purchase the shares of a closely held company if one of the owners dies.
There are two basic types of buy-sell agreements: cross-purchase agreements and redemption agreements. With a cross-purchase agreement, the owner separately purchases a policy on the other owner (or owners). With a redemption agreement, the corporation is obligated to redeem the stock at a price set in the agreement if any of the business owners die. Typically, buy/sell agreements are funded with life insurance; the life insurance proceeds provide the necessary funds for the purchase of the business.
The prolonged disability of a principal can also present serious difficulties for closely held firms. A long-term disability buy-sell agreement can provide a cushion to protect the disabled principal's interests during recovery. The first step in implementing such an agreement is to determine how long the company should be without the disabled partner's services before a buyout is activated. It is recommended that an actual buyout of ownership interest be postponed at least 12 months but not more than 24 months after the infirmity occurs.
One of the most controversial tax issues facing closely held corporations involves the compensation paid to employees who are also major stockholders. The controversy arises because employee compensation is a tax-deductible business expense for corporations, while payments made to stockholders in the form of dividends are not tax deductible. When the individuals making the compensation decisions are also stockholders, they may be tempted to pay themselves higher salaries in order to avoid double taxation on profit distributions taken as dividends.
As Ted D. Englebrecht, Carla Mitchell, and Otto Martinson wrote in Management Accounting, "The mere nature of the closely held corporation, where typically a few individuals act as both the shareholders and the key employees of the corporation, often results in close scrutiny by taxing authorities with regard to the issue of reasonable compensation. As numerous court cases reveal, a reclassification of compensation from reasonable to unreasonable (dividends) can be quite costly in both additional tax liability and penalties for the corporation."
In determining whether the employee/owner of a closely held corporation received reasonable compensation, the IRS examines the following factors: (1) the employee's qualifications; (2) the nature and scope of the employee's work; (3) the size and complexity of the business; (4) the relation between salaries paid and gross income; (5) the relation between salaries paid and distributions to shareholders in the form of dividends; (6) rates of compensation for comparable positions in similar companies; (7) the company's compensation policies with regard to nonowner employees; (8) prevailing economic conditions; and (9) whether compensation for employee/owners is set through arm's-length bargaining.
In order to avoid having compensation reclassified as dividends by the IRS, Englebrecht, Mitchell, and Martinson suggest that the employee/owners of closely held corporations: (1) ensure that salaries are in line with industry standards; (2) base compensation on a contingency, such as a percentage of gross income; (3) make certain that total salaries are not so large that they eliminate taxable income; and (4) pay dividends. "Though there is no set formula for determining reasonable compensation," they wrote, "the best protection for a company is to substantiate the unique salary position of the shareholder."
[ Robert T. Kleiman ,
updated by Laurie Collier Hillstrom ]
Englebrecht, Ted D., Carla Mitchell, and Otto Martinson. 'What Is Reasonable Compensation in Closely Held Corporations'?" Management Accounting, March 1998.
Klaris, Raynor J. "Valuing the Family Business." Trust and Estates, February 1990.
Owens, Thomas. "Buy-Sell Agreements." Small Business Reports, January 1991.
Plesko, George A. "Gimme Shelter'? Closely Held Corporations since Tax Reform." National Tax Journal, September 1995.
Reilly, Robert F., and Robert P. Schweihs. "Buying and Selling Closely Held Corporations." National Pu1blic Accountant. October 1996.
Ward, John L., and Craig E. Aronoff. "Two Laws for Family Businesses." Nation's Business, February 1993.