Higher rates can cut closely held business valuations and open an estate-gift window

Higher required returns can cut the fair market value of a closely held business and open an estate-planning gift window. A lower, supportable fair market value lets an owner move a larger ownership interest out of the estate while using less of the lifetime gift and estate tax exemption. It can also reduce gift tax, according to WealthManagement.com's analysis.

Company-specific facts still dictate value, and a rate increase alone does not justify a lower appraisal. The move is the first rate increase in more than three years, and WealthManagement.com says advisors are acting for clients while the valuation effect draws little attention.

Under the income approach, expected future cash flows are converted to present value with a discount rate that reflects what a willing buyer would demand for time value and for risk. For an operating business that rate is often the weighted average cost of capital, which blends the required returns on equity and debt in proportion to the company's capital structure. When market rates rise, the risk-free rate and the borrowing costs folded into that blend can rise with them, and a higher WACC lowers the present value of the same cash flows.

Treasury Regulations Sections 25.2512-1 and 20.2031-1 define fair market value as the price a willing buyer and a willing seller would agree to, neither under compulsion and both reasonably informed of the relevant facts. Revenue Ruling 59-60 declines to supply a universal formula for closely held stock and instead lists what a valuation must weigh: earnings capacity, dividend-paying capacity, financial condition, industry outlook, goodwill and comparable-company evidence.

Value is fixed as of the valuation date, which for a lifetime transfer generally means the date of the gift. Attorneys, CPAs and advisors can revisit the assumptions under a client's planned gift and test whether the discount rate in an existing appraisal still reflects current borrowing costs and the risk-free rate.

A rate move is a reason to re-run the analysis; the appraisal still has to stand on the company's own facts. The likeliest candidates for a re-test are appraisals anchored to rate assumptions from before the increase.