What “Restricted Stock” Means in the Tax Valuation Context
Restricted stock is a deceptively simple term. For gift and estate tax purposes, it refers to shares subject to legal, contractual, or practical limits on sale or transfer that materially affect marketability. These may include securities law transfer restrictions, company-imposed rights of first refusal, vesting or forfeiture conditions, lockups after a public offering, buy-sell agreements, and internal shareholder agreements. Although many owners assume that “restricted” simply means shares cannot be sold for a period, each restriction must be dissected to determine whether it actually affects value for tax purposes, and if so, how.
Tax valuation does not mechanically apply a fixed discount whenever a certificate bears a restrictive legend. Rather, the valuation must identify the character, duration, and enforceability of the restriction; the likely time to liquidity; the presence of any permitted buyers; and the existence of paths to remove or satisfy the restriction. Two identical legends can have very different valuation effects depending on whether the shares are in a thinly traded private company or a highly liquid public issuer subject to a brief, customary lockup. A robust analysis explains the exact legal impediments to sale, how a hypothetical willing buyer would price those impediments, and the empirical support for the resulting adjustment to value.
Governing Tax Standards: Fair Market Value and What Restrictions Count
For both gift tax and estate tax, the legal standard is fair market value as of the valuation date, defined as the price at which the property would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. The starting point for equity interests is Revenue Ruling 59-60, which sets out factors such as the company’s nature and history, economic outlook, book value, earning capacity, dividend-paying capacity, and prior sales. The key is that valuation reflects the realities known or knowable on the valuation date, including restrictions that a hypothetical buyer cannot avoid.
However, not every restriction affects value. Certain statutory provisions require disregarding some restrictions in intrafamily or closely held contexts. Sections 2703 and 2704 of the Internal Revenue Code (and their regulations) direct appraisers to ignore certain rights and restrictions if they are not comparable to those in arm’s-length transactions or if they are more restrictive than state law defaults. Likewise, a forfeiture restriction that is personal to a specific service provider may be irrelevant to a hypothetical buyer who would not be subject to it. The valuation must carefully analyze which restrictions truly bind the hypothetical buyer and which are conditions unique to the current holder or the holder’s family.
Types of Restrictions and Their Valuation Impact
Restrictions relevant to valuation fall into several categories, and their effects are not uniform. Securities law restrictions (such as Rule 144 holding periods for affiliates or restricted securities) can limit immediate resale and may necessitate a discount for lack of marketability. Contractual restrictions include rights of first refusal, co-sale rights, drag-along or tag-along provisions, transfer consent rights, and buy-sell agreements with predefined pricing formulas. Company policy restrictions may include insider trading blackout periods or internal approval processes for transfers. Finally, corporate charter or operating agreement provisions can restrict classes of shares or limit transferability.
Each restriction must be evaluated for its duration, enforceability, and the scope of the buyer population it eliminates or impairs. For example, a right of first refusal that permits the company to match a bona fide third-party offer may have modest valuation impact if it does not practically deter third-party bids. By contrast, a buy-sell agreement that forces sales at book value, or a consent right allowing insiders to veto transfers for any reason, can significantly reduce fair market value. Furthermore, restrictions that will lapse at a known date may justify a time-based discount derived from the expected path to liquidity, whereas indefinite restrictions demand a deeper, probability-weighted analysis.
Choosing the Right Valuation Approach for Restricted Shares
Appraisers typically weigh three approaches: income, market, and asset-based. The income approach (for example, a discounted cash flow analysis) is often preferred where the company’s future cash flows can be forecast with reasonable reliability. The market approach uses guideline public companies or guideline transaction multiples to triangulate value from comparable businesses. The asset-based approach may be appropriate for asset-intensive holding companies or early-stage entities lacking meaningful cash flow. The presence of restrictions does not eliminate these approaches; instead, restrictions affect either the cash flow assumptions, the selection of multiples, or the application of specific discounts for lack of marketability and control.
It is a common misconception that one can simply take a recent 409A or financial reporting valuation and “apply a discount.” That shortcut rarely survives scrutiny. Section 409A valuations focus on options and compensation compliance, while financial reporting valuations target GAAP fair value realities for particular stakeholders. Gift and estate tax valuations must apply the tax fair market value standard, consider a hypothetical buyer and seller, and evaluate which restrictions travel with the shares. The correct approach documents the base enterprise value, allocates value to the subject class of equity, then layers in the incremental effect of the specific restrictions borne by the hypothetical buyer as of the valuation date.
Discounts for Lack of Marketability and Lack of Control
Discount for lack of marketability (DLOM) addresses the illiquidity and time required to convert shares into cash. Restricted stock studies, pre-IPO studies, option-pricing models, and regression analyses are commonly cited to quantify DLOM, but they must be matched to the facts. For instance, restricted stock studies may overstate DLOM where the subject company expects a near-term liquidity event, and may understate it where restrictions are protracted with uncertain exit. Empirical inputs need to be reconciled with the duration and type of restriction, dividend policy, volatility, expected growth, and the availability of information to outside investors.
Discount for lack of control (DLOC) applies when the interest lacks the ability to control corporate actions such as distributions, liquidity events, or transfers. If the restricted shares are a minority interest in a closely held company, DLOC and DLOM are distinct and both may apply. However, layering discounts requires caution to avoid double counting. A well-supported valuation will isolate the value effects attributable to control (for example, the power to initiate a sale) from those attributable to marketability (for example, the ability to sell shares readily), and will explain how the restrictions interact with governance rights embedded in the shares.
Special Situations: Public Company Lockups, Rule 144, and Blockage
Restricted stock in public companies often involves distinct considerations. A lockup agreement following an initial public offering can temporarily bar sales, but the underlying market is liquid, and the restriction has a finite, known end date. In such cases, DLOM is commonly grounded in a time-value-of-money framework that capitalizes the delay until sale, adjusted for volatility and risk of adverse price movement during the lockup. Where the seller is an affiliate, the additional limitations under securities rules may restrict volume or impose ongoing manner-of-sale constraints that also warrant analysis.
Large positions raise the specter of a blockage discount if attempting to sell the block would depress the market price or require a drawn-out disposal. The presence of trading windows, insider trading policies, and blackout periods can compound the illiquidity. The valuation should examine trading volume, historical volatility, and realistic execution strategies, including dribble-out plans or secondary transactions. The analysis must be anchored in what a hypothetical buyer would pay, knowing the volume constraints and the costs and risks associated with unwinding the position over time.
Documentary and Legal Restrictions to Disregard Under the Code
Not every restriction is recognized for tax valuation. Under Section 2703, restrictions in buy-sell agreements or options may be disregarded unless they meet stringent tests, including bona fide business purpose, not being a device to transfer property to family for less than full and adequate consideration, and terms comparable to those in arm’s-length deals. Section 2704 can disregard certain liquidation and voting restrictions in family-controlled entities that are more restrictive than state law defaults or that are removable by family members. These rules significantly alter the landscape for intrafamily transfers, where owners often assume that a tight operating agreement automatically depresses value. The tax law may say otherwise.
A careful appraisal will separate restrictions that would bind a hypothetical buyer from those that are ignored as a matter of law. For example, a right of first refusal exercisable by nonfamily investors with a track record of enforcement is very different from a family-only veto power removable after the transfer. The report should explicitly identify any restrictions disregarded under Sections 2703 and 2704, explain the legal basis, and adjust the valuation accordingly. Failing to make these distinctions invites IRS challenges and can unravel claimed discounts.
Selecting and Managing Your Appraiser
Appraiser selection is a core strategic decision. The IRS will scrutinize the appraiser’s credentials, methodology, and independence. A qualified appraiser should have demonstrable experience with restricted stock, DLOM quantification, and the specific industry of the issuer. The appraisal must be comprehensive, internally consistent, and tailored to the facts. Generic discount tables or rote citations to outdated studies are red flags. A strong report explains data sources, justifies comparable selections, reconciles disparate indications of value, and ties every adjustment to observable evidence or accepted theory.
As a practical matter, attorneys and CPAs should manage the appraisal process to ensure all relevant documents and facts are furnished before the valuation date analysis is finalized. This includes capitalization tables, governing documents, buy-sell agreements, historical financials, budgets and forecasts, board materials, recent financing transactions, and details of any transfer restrictions (including lockup letters and legal opinions). Surprises late in the process tend to impair credibility. Engaging early permits the appraiser to incorporate nuanced restrictions accurately rather than force-fitting a generic discount at the eleventh hour.
Critical Valuation Dates and Elections
For gift tax, the valuation date is typically the date of the gift. For estate tax, it is the date of death unless the executor elects the alternate valuation date under Section 2032, which generally is six months after death and comes with specific rules for property that is sold during the interim. The choice of date can materially alter value where restrictions are expected to lapse, new financing is imminent, or the company’s prospects are evolving. A short lockup that ends between date of death and the alternate valuation date, for example, may reduce DLOM if the election is made and if the statutory conditions are satisfied.
Documentation of the exact form and timing of restrictions on the valuation date is essential. Courts routinely reject attempts to import later events back into the valuation date unless those events were reasonably foreseeable. If a lockup is scheduled to expire in three months, that may be different from a lockup without a clear end date. Counsel should also confirm that transfer formalities were completed on the gift date; incomplete assignments or consents can shift the valuation date inadvertently, altering the applicable restriction profile at the moment ownership changed hands.
Coordination With Compensation, Section 83, and Company Agreements
Section 83 governs property transferred in connection with the performance of services. While Section 83 addresses income inclusion and compensatory vesting, it intersects with gift and estate issues when restricted shares are received by founders, executives, or family employees. For example, an unvested award subject to a substantial risk of forfeiture may be treated differently from fully vested restricted securities under state law and the governing agreements. The valuation for gift or estate purposes must consider whether a hypothetical buyer would be subject to forfeiture conditions or whether those conditions are personal and thus irrelevant to fair market value.
Company agreements often embed nuanced restrictions that change upon death or transfer to family trusts, including rights of first refusal, buybacks at formula prices, or compulsory conversions. Some founders assume a nominal formula price controls the valuation; in tax valuation, that assumption is frequently incorrect unless the agreement satisfies Section 2703’s comparability and bona fide purpose criteria. Counsel should reconcile all governing documents with the planned transfer mechanics to avoid triggering avoidable restrictions or overlooking waivers that could have mitigated DLOM or DLOC.
Common Mistakes and How the IRS Evaluates Restricted Stock
Several errors recur in examinations. The most frequent include: relying on book value or a simple recent financing price without reconciling differences in rights; importing a 409A conclusion for options to value common shares for tax transfer purposes; applying a generic 30 percent DLOM without empirical support; and ignoring Section 2703 or 2704 in family-controlled entities. Another common mistake is failing to analyze the actual enforceability of restrictions and their duration. IRS engineers and valuation specialists will ask how, precisely, the restriction impairs a sale and for how long, and whether comparable third-party investors accept similar limitations without demanding price concessions.
Expect the IRS to request the appraisal workpapers, the appraiser’s CV, and primary source documents including shareholder agreements and lockup letters. The agency will test whether the analysis ties to public or private transaction data, whether it is internally consistent, and whether later facts improperly influenced the valuation. In close cases, an examiner may apply their own DLOM model based on option-pricing or empirical studies and challenge unsupported discounts. A well-prepared taxpayer can withstand scrutiny by demonstrating a defensible linkage from the facts to the selected methodology and adjustments.
Practical Steps to Prepare for a Defensible Valuation
Preparation is often the differentiator between a smooth filing and a protracted exam. Prior to the valuation, assemble a comprehensive data room: corporate documents, shareholder agreements, board minutes, financial statements, projections, cap tables, recent term sheets, and all restriction documents. Provide a clear chronology of events around the valuation date, including any anticipated financings, product launches, or regulatory milestones. Identify whether any restrictions are expiring, waivable, or subject to consents, and collect written evidence of such features. If a buy-sell agreement exists, gather evidence of third-party comparability and historical enforcement to address Section 2703 concerns.
During the appraisal, insist on explicit, document-cited references for each restriction and a tailored DLOM analysis. Where appropriate, request sensitivity tables demonstrating how value varies with different liquidity timelines or volatility assumptions. Keep contemporaneous correspondence that shows the appraiser’s independence and that management did not pressure the conclusion. After issuance, ensure the appraisal report is attached or incorporated as needed in gift tax returns and that affidavits or declarations support the factual representations made to the appraiser. These steps will position the file for audit and reduce the risk of valuation penalties.
When to Seek Rulings, Deficiency Risk, and Penalty Protection
Taxpayers sometimes face extraordinary uncertainty, such as novel restriction structures or rapidly changing liquidity prospects. In rare cases, seeking a ruling or pre-submission conference may be prudent, though such paths are time-consuming and often unnecessary when a qualified appraisal addresses the issues. More commonly, taxpayers mitigate risk through comprehensive appraisal documentation and careful return disclosure. Adequate disclosure on a gift tax return can start the statute of limitations and reduce the chance of open-ended challenges years later. Where appropriate, penalties may be avoided by demonstrating reasonable cause and good-faith reliance on a qualified appraisal.
Deficiency risk increases when discounts are large relative to peers, when restrictions appear self-imposed to depress value before intrafamily transfers, or when different filings within the same family group show inconsistent positions. Consistency in methodology and robust disclosure are critical. If a position is aggressive, consider supplemental support such as third-party legal opinions on restriction enforceability, or additional empirical analyses. The cost of such measures is typically modest compared to the expense and uncertainty of litigating discount disputes.
Illustrative Fact Patterns That Change the Outcome
Consider two founders with identical share counts. Founder A’s shares are subject to a 180-day IPO lockup with no additional restrictions. Founder B’s shares are subject to an indefinite company consent right, a right of first refusal at the lower of fair value or a formula price, and an information blackout that limits outside diligence. Although both are “restricted,” Founder B’s shares warrant a materially higher DLOM and possibly a DLOC if voting arrangements curb meaningful influence. A one-size-fits-all discount would be indefensible across these scenarios.
In a family-controlled manufacturing company, the operating agreement restricts transfers to nonfamily members and permits the company to repurchase at book value. If the book value clause is removable by family action or is more restrictive than state law defaults, Section 2704 may require disregarding it. A taxpayer who priced the gift at book value would likely face a substantial upward adjustment on audit. By contrast, if an independent third party negotiated and consistently enforced the same restriction for bona fide business reasons, and comparable companies in the industry use similar terms, Section 2703 analysis may support recognizing the restriction with appropriate adjustments.
State Death Taxes, Community Property, and Ancillary Considerations
Estate planners must also consider state estate or inheritance taxes that may apply different conformity rules for fair market value or discount recognition. While many states follow federal principles, some administrative practices differ, particularly around documentation and acceptance of large DLOMs. Similarly, in community property jurisdictions, characterizing the restricted shares and tracing any transmutation can influence what portion of the position is included in the estate or treated as the donor’s property for gift purposes, which in turn affects the specific restrictions binding the transferred interest.
Ancillary issues can complicate otherwise straightforward valuations. For example, shareholder agreements sometimes trigger price adjustments or consent requirements upon transfer to a trust versus an individual. Creditor rights, pledges, and negative covenants in credit agreements may restrict transfers or distributions indirectly. These features often escape lay attention but are central to a complete valuation. A meticulous professional will surface and address each ancillary constraint to avoid surprises on audit.
Final Thoughts: Complexity, Professional Judgment, and Audit Readiness
Valuing restricted stock for gift and estate tax purposes is not a formulaic exercise. It requires integrating corporate law, securities regulation, and federal tax valuation standards into a coherent analysis that a hypothetical buyer and seller would recognize as economically rational. Even seemingly simple restrictions can have multifaceted consequences depending on duration, enforceability, and the surrounding capital structure. The IRS expects a disciplined methodology, documented assumptions, and empirical support for all discounts. Cutting corners or borrowing values prepared for different purposes is an invitation to controversy.
The safest path is to engage an experienced attorney-CPA team and a qualified valuation professional early in the planning process. Together they can identify relevant restrictions, evaluate which are recognized under the Code, select appropriate valuation approaches, and quantify discounts with defensible data. This proactive, rigorous approach protects transactions, minimizes audit risk, and aligns reported values with the legal and economic realities of the restricted shares.
