Although 2020 is over, many unidentifiable risks remain as of today, which makes valuation of businesses and business interests ever more difficult this year.
Interestingly, in valuation as in life, in order to keep moving forward, we must be willing to look back. Valuation is oftentimes forward-looking, and many important areas remain in the hands of the valuation analyst's professional judgment.
It is therefore critical that the professional judgment is airtight and clearly laid out, well supported and reasonable for whatever context the valuation is used especially for gift and estate tax filings which may potentially end up in litigation or possibly challenged in an Internal Revenue Service audit.
As 2021 begins, I want to highlight the following areas in business valuation applicable in a gift and estate tax context.
Estimating a COVID-19 Discount for Lack of Marketability for Interests in Privately Held Businesses
For gifting fractional interests in privately held businesses, layering the discount for lack of marketability with a COVID-19 marketability discount is appropriate as this process helps to organize thinking and provide support for professional judgment.
A suggested methodology for determining an appropriate COVID-19 marketability discount is based on weighing factors such as those used in the 1995 U.S. Tax Court case Mandelbaum v. Commissioner of Internal Revenue and the IRS discount for lack of marketability job aid.
However, the categories would be modified to fit the current situation such as the effect of the shutdown and stay-at-home orders, employee issues, supply chain issues, paycheck protection program loans or other support.
Because the process gathers far more qualitative information than quantitative data, significant professional judgment is required and findings will always fall in a wide range. A caveat to this method, as with any discount, is double counting a risk that has already been accounted for in the discount rate, the cash flow multiplier or other discounts.
Businesses Impacted by COVID-19 and Scenario-Based Valuation Analyses
For businesses impacted by COVID-19, a scenario-based analysis is reasonable and appropriate. Typically, this involves a slightly complicated detour from the plain vanilla discounted cash flow method and developing a multi-scenario DCF and a weighting for each DCF scenario.
For instance, a best case scenario will be a short recessionary period and a slightly adverse impact on financial performance. A base case or middle case scenario will be a one-year recessionary period and a modestly adverse financial impact. And a worst case scenario will be a two-year recessionary period and a severely adverse financial impact.
Depending on the distribution of projected net cash flows and percentages used for the probabilities of each scenario, you will have either a symmetrical or skewed result. If symmetrical, the probability-weighted value will be the same.
There are various opinions regarding the application of multi-scenario DCF, and it is more important to factor the impacts into the benefit streams rather than in the risk factor. Also, the time frame is not limited to a five-year DCF — the time frame can be two years, three years or whatever is reasonably appropriate.
In a multi-scenario DCF, a valuation analyst can examine whether the subject firm can even survive over a certain time frame; determine whether the firm can improve and to what extent; and estimate some level of normalized operations post-pandemic. It is also helpful to determine or consider using different risk rates for different discrete time periods.
A caveat to this method is that even with adjustments to cash flows for the extra risks of COVID-19, projections will still have less reliability than before. Therefore, the discount rate will have to reflect some of the extra risks. In addition, it may also be appropriate to consider the use of ranges for an opinion of value, as opposed to one single number.
Is the Market Approach Still Relevant?
Many valuation experts point out that guideline merger and acquisition transactions during COVID-19 need special scrutiny.
The target firm may be particularly strong or there may be some powerful synergies in the deal. Also, the use of market-based multiples is problematic, as the values in the numerator and denominator may not reflect the impact of COVID-19.
Although there are various techniques for adjusting the guideline public-company multiples and guideline M&A transaction multiples to address the impact of COVID-19, some valuation experts offer alternative market-based methods for valuation dates occurring after the middle of February last year.
One method is considering the following for the guideline M&A method. If the purchase price of the target reflects the impact of COVID-19, affected purchase price, but the earnings used in the calculation of multiples do not unaffected earnings:
Calculate the multiples based on the affected purchase price and unaffected earnings of the target. This calculation will provide the affected M&A multiples.
If COVID-19 has affected the earnings of the subject company (affected earnings), adjust the affected earnings to quantify the unaffected earnings of the subject company.
Apply the affected M&A multiples to the unaffected earnings of the subject company to estimate the value of the subject company as affected by COVID-19.
Valuation Date — Timing the Gifting Date
2020 offered many opportunities for gifting at low valuations, especially for businesses impacted by COVID-19. A valuation done before COVID-19 may be obsolete but can be updated post COVID-19 and factor in the impacts of the pandemic.
A question asked by many business owners is: How do you do projections when you don't know how long COVID-19 will last? That's one of the million-dollar questions, but note that assumptions should be backed by reliable sources. Valuation experts point to sources such as the Congressional Budget Office and McKinsey & Co. that have done analyses about economic recovery periods.
The June 1, 2020, congressional report says that, as a result of the global pandemic, it will take 10 years before the country's real gross domestic product matches the office's projections from January 2020.
McKinsey predicts that in a muted recovery, it could take more than five years for the most affected industries such as restaurants and entertainment to get back to pre-pandemic levels
If a pre-COVID-19 valuation date is being prepared in a post-COVID-19 environment and the impact of the virus was not known or knowable as of the valuation date, the valuation should not take COVID-19 into account but a subsequent events section should be added to the valuation report.
The American Institute of Certified Public Accountants recently put out a subsequent events toolkit that includes frequently asked questions and sample disclosure language. It reminds valuation analysts who adhere to the institute's valuation standards that the disclosure of a subsequent event is not required, and it is up to the valuation analyst to decide whether it is appropriate to make the disclosure.
New Tax Law?
Many trust and estates attorneys have noted that 2020 was the golden age of estate planning, as there could be a new tax law under a new presidential administration — that would not be retroactive.
In contrast with the Trump administration and Republicans' general dislike of the estate tax, President-elect Joe Biden presumably would seek to reduce exemption amounts. This could be the first time ever that the estate tax exemption is reduced, they say.
Some recent cases and important rulings include the following 
- Nelson v. Commissioner, a 2020 U.S. Tax Court ruling in which the court ruled that a reduced minority discount is appropriate if the minority interest has elements of control.
- A 2019 IRS ruling concerning a donor who transferred stock to a grantor retained annuity trust. The agency ruled that a pending merger is to be considered in valuing the stock for gift tax purposes.
- The landmark 2019 case of Estate of Aaron Jones v. Commissioner, in which the U.S. Tax Court, ruling on an Oregon gift tax dispute, accepted the taxpayers' tax-affected valuations of pass-through entities without overturning gross.
The company-specific risk premium used in developing an appropriate discount rate has been a topic of interest especially in the wake of COVID-19. The Appraisal Foundation is seeking to develop guidance to promote more uniformity in practice in estimating corporate social responsibility for fair value for financial reporting.
At the moment, there are no empirical studies, magic formulas or computer algorithms that can determine with precision the CSR in a privately held company. Valuation is not a precise science and professional judgment is required. In the COVID-19 era, many experts recommend spending more time on the numerator — cash flows — of the valuation equation and less time on the denominator, which includes cost of capital.
Another area in developing the discount rate that has come to light recently is the size effect. Many financial veterans are concluding that the small-company effect does not, after all, exist.
The Russell indexes show that the factor is muted at best, and sophisticated statistical work confirms it. Several recent papers imply that taking a discount for marketability and a size premium may be double counting the illiquidity factor. Stay tuned.
There is no magic formula for doing business valuations for gift and estate tax purposes in the COVID-19 era. We take a fundamental approach nowadays with a much greater dose of professional judgment and dig deeper into the impact of COVID-19 in the operations, modifying the DCF, adjusting pre-COVID-19 market multiples, analyzing and layering in the extra risks, and more.
Although valuation in these unprecedented times is much more difficult and challenging than before, it can be made as reliable as ever.
Angela Sadang is a principal at Marks Paneth LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 Mandelbaum v. Commissioner , TC Memo 1995-255. In a landmark decision, Judge Laro provided a framework for evaluating discounts for lack of marketability in minority interest cases.
[2 ]See "Estimating a COVID-19 Marketability Discount for Small Businesses," Gregory Caruso, JD, CPA, CVA, Business Valuation Update, Vol. 26, No. 11, bvresources.com.
 See "Alternate Valuation Methods in the Era of COVID-19," Daniel R. Van Vleet, Business Valuation Update Vol. 26, No. 6, bvresources.com
 See "Recap of the VSCPA Business Valuation, Fraud, and Litigation Services Conference," Business Valuation Update, Vol. 26, No. 11, bvresources.com.
Nelson v. Commissioner, T.C. Memo 2020-81.
IRS ruling (CCA 201939002)
Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-1
 See Latest Paper in the Size-Effect Debate, BVWire, Issue#216-4, bvresources.com.
For a reprint of this article, please contact firstname.lastname@example.org.