John Wiley Accountants Handbook Volume 2_12 doc

EGTRRA has modified the income tax rules relating to the step-up in basis discussed above be-
ginning in 2010. To make up for the loss of revenue from the estate tax repeal, a new “carryover
basis” regime will become effective. Under this regime, property acquired from a decedent will have
a basis equal to the lesser of the decedent’s basis or the fair market value of the property on the date
of the decedent’s death. A total $4.3 million of property may, however, still qualify to use the current
step-up in basis rules. Up to $3 million of property passing to a surviving spouse, plus up to an ag-
gregate of $1,300,000 of property passing to any beneficiaries will qualify for a step-up in basis.
These new rules sunset after 2010, resulting in the modified carryover basis rules ending and the cur-
rent step-up in basis rules being reinstated in 2011. So just in case, we should all start keeping better
records in order to accurately reflect our tax basis in the assets we hold currently.
Estates must now make quarterly estimated tax payments in the same manner as individuals, ex-
cept that an estate is exempt from making such payments during its first two taxable years. Accord-
ingly, the penalties for underpayment of income tax are applicable to fiduciaries.
Some states also tax the income of estates, and the representative must see to it that such state
statutes are complied with.
41.2 ACCOUNTING FOR ESTATES
(a) GOVERNING CONCEPTS. The general concepts governing the accounting for decedent’s es-
tates are for the most part similar to those applicable to trusts, but there are some differences. The un-
derlying equation expressing the accounting relationship is assets ϭ accountability. However, the
representative is concerned not with the long-term management of property for beneficiaries, but rather
with the payment of debts and the orderly realization and distribution of the estate properties. The col-
lection and the distribution of income are incidental to the main function of the estate’s fiduciary.
Whenever an estate accounting is prepared, a reconciliation of the gross estate as finally deter-
mined for estate tax purposes should be made with the schedule of principal received at the date by
the representative. Every difference should be explainable.
(i) Accounting Period. The accounting period of the estate is determined by the dates set by the
fiduciary or by the court for intermediate and final accountings; nevertheless, the books must be
closed at least once a year for income tax purposes.
(ii) Principal and Income. Unless otherwise provided for, the rules outlined below for the
trustee should generally be followed by the representative in the allocation of receipts and dis-
bursements to principal and income. Such distinctions, although not called for under the will, are

frequently mandated by requirements of estate, inheritance, and income tax laws and regulations.
(iii) Treatment of Liabilities. The representative picks up only the inventory of assets of the
decedent at the inception of the estate. Claims against the estate, after presentation and review, are
paid by the representative and are recorded as “debts paid.” The payment of such debts reduces in
proportion the accountability of the representative.
(b) RECORD-KEEPING SYSTEM. No special type of bookkeeping system is prescribed by law,
but a complete record of all transactions must be kept with sufficient detail to meet the requirements
of the courts and of the estate, inheritance, and income tax returns. Much of the information may be
in memorandum form outside of the formal accounting system.
The federal estate tax law requires information regarding assets beyond those ordinarily under the
control of the representative (e.g., real estate). Such information must be assembled in appropriate
form by the representative, who has responsibility for the estate tax return.
(i) Journals. A single multicolumn journal is usually sufficient. It should incorporate cash re-
ceipts, cash disbursements, and asset inventory adjustments. Further, it is important to note and keep
track of the distinction between principal and income.
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ESTATES AND TRUSTS
(ii) Operation of a Going Business. If the decedent was the individual proprietor of a going
business and if the court or the will instructs the administrator or executor to continue the oper-
ation of the business, the bookkeeping procedure becomes somewhat complicated. The books of
the business may be continued as distinct from the general estate books, or the transactions of
the business may be combined with other estate transactions in one set of records. The best pro-
cedure, if the business is of at least moderate size, is to keep the operations of the business in a
separate set of books and to set up a controlling accounting in the general books of the executor
or administrator.
As soon as the representative takes charge of the business, the assets should be inventoried and
the books closed, normally as of the date of death. The liabilities should be transferred to the list of
debts to be paid by the representative, leaving the assets, the operating expenses and income, and the

subsequently incurred liabilities to be recorded in the books of the company. An account should be
opened in the books of the business for the representative that will show the same amount as the con-
trolling account for the business in the books of the representative.
(iii) Final Accounting. The “final” accounting is the report to the court of the handling of the es-
tate affairs by the representative, if required. It presents, among other things, a plan for the distribu-
tion of the remainder of the assets of the estate and a computation of the commission due the
representative for his services. If the court approves the report, it issues a decree putting the propos-
als into effect.
(c) REPORTS OF EXECUTOR OR ADMINISTRATOR. The form of the reports of the fiduciary
will vary according to the requirements of the court and to the character of the estate. In general,
however, the representative “charges” himself with all of the property received and subsequently dis-
covered plus gains on realizations, and “credits” (or discharges) himself with all disbursements for
debts paid, expenses paid, legacies distributed, and realization losses. Each major item in the charge
and discharge statement should be supported by a schedule showing detailed information. At any
time during the administration of the estate, the excess of “charges” over “credits” should be repre-
sented by property in the custody of the fiduciary. It may be necessary to show the market value of
property delivered to a legatee or trustee at the date of delivery, in which case the investment sched-
ule will show the increase or decrease on distribution of assets, as well as from sales. The income
schedule, when needed, should be organized to show the total income from each investment, the ex-
penses chargeable against income, and the distribution of the remainder.
Exhibit 41.2 is typical of the charge-and-discharge statement, each item being supported by
a schedule.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND
(a) NATURE AND TYPES OF TRUSTS. The trust relationship exists whenever one person holds
property for the benefit of another. The trustee holds legal title to the property for the benefit of the
beneficiary, or cestui que trust. The person from whom trust property is received is known as the
grantor, donor, settler, creator, or trustor.
An express trust is one in which the trustee, beneficiary, subject matter, and method of administra-
tion have been explicitly indicated. An implied trust may be created whether language of an instrument
indicates the desirability of a trust but does not specify the details or when the trust relationship is as-

sumed in order to prevent the results of fraud, breach of trust, or undue influence. The terms “con-
structive,” “resulting,” and “involuntary” trust are sometimes applied to such situations.
A testamentary trust is one created by a will. A living trust, or trust inter vivos, is created to take
effect during the grantor’s lifetime. Trusts are sometimes created by court order, as in the case of a
guardianship.
A private trust is created for the benefit of particular individuals, while a public or charitable trust
is for the benefit of an indefinite class of persons. Charitable trusts are discussed in Chapter 33.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
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19
A simple trust directs the trustee to distribute the entire net income of the trust to the named benefi-
ciary. A complex trust gives the trustee the discretionary authority to distribute or accumulate the trust
net income to or on behalf of the named beneficiary. In some instances, the trust may start off as com-
plex and then convert to a simple trust upon the happening of a specified event, that is, the beneficiary’s
attainment of age 21 or 25.
A grantor trust exists when both the grantor and beneficiary are the same individual. A grantor
trust may be implied if the grantor retains sufficient rights or controls over disposition of trust in-
come and/or principal.
When a grantor establishes an irrevocable trust inter vivos and transfers assets to it, the
grantor has made a completed gift of the property transferred for income, gift, and estate tax
purposes. Should the grantor retain any of the rights enumerated in IRC Sections 671 to 679,
however, the grantor will be continue to be treated as the grantor or owner of the trust property
for income tax purposes only. The grantor will be taxed on the income of the trust instead of the
trust or trust beneficiaries (even if they receive a distribution of this trust income). This is re-
ferred to as an intentionally defective grantor trust (IDGT) and can be used as an effective estate
and financial planning tool.
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ESTATES AND TRUSTS

ESTATE OF JOHN SMITH
Charge and Discharge Statement
A. L. White, Executor
From April 7, 20XX, to December 15, 20XX
First, as to Principal:
The Executor charges himself as follows:
With amount of inventory at the date of death, April 7, Schedule A $xxx
With amount of assets discovered subsequent to date of death,
Schedule B xxx
With gain on realization of assets, Schedule C xxx
$xxx
The Executor credits himself as follows:
With loss on realization of assets, Schedule C $xxx
With amount paid for funeral and administrative expenses,
Schedule D xxx
With amount paid on debts of the estate, Schedule F xxx
With distributions to legatees, Schedule G xxx
xxx
Leaving a balance of principal, Schedule C, of $xxx
Second, as to Income:
The Executor charges himself as follows:
With amount of income received, Schedule H $xxx
The Executor credits himself as follows:
With amount of administrative expenses chargeable to income,
Schedule D $xxx
With distribution of income to legatees, Schedule I xxx xxx
Leaving a balance of income, Schedule J xxx
Leaving a balance of principal and income of $xxx
Balance of principal and income to be distributed to those entitled
thereto, subject to the deduction of the Executor’s commissions,

legal fees, and the expenses of this accounting, Schedule K.
Exhibit 41.2 Sample charge and discharge statement.
A trust may include a spendthrift clause that prohibits the beneficiary from assigning his interest
before receiving it or prevents creditors from enforcing their claims against the income or principal
of a trust fund, or both.
Trusts are often used for business purposes, as when property is transferred by a deed
of trust instead of a mortgage, when trustees are appointed to hold title and perform other func
tions
under a bond issue, or when assets are assigned to a trustee for the benefit of creditors. Bankruptcy
and insolvency are discussed in Chapter 43.
(i) Limitations on Private Trusts. A public trust may be established for an indefinite period, but a
trust may not suspend indefinitely the power of anyone to transfer the trust property. The common
law rule, otherwise known as the Rule against Perpetuities, limits the duration of a private trust to 21
years after the death of some person who is living when the trust is created. Another common limita-
tion in certain states is “two lives in being” at the origin of the trust.
Accumulation of the income of a trust is also restricted by state law. A common provision, for ex-
ample, is that in the case of a trust created for the benefit of a minor, the income can be accumulated
only during the minority of the beneficiary. Even the income of a charitable trust cannot be accumu-
lated for an “unreasonable” period.
(ii) Revocation of Trusts. A completed trust cannot be revoked without the consent of all the ben-
eficiaries unless the right to revoke has been expressly reserved by the grantor. Trusts are therefore
sometimes classified as “revocable” or “irrevocable.”
(b)
APPOINTMENT AND REMOVAL OF TRUSTEES. In general, anyone competent to
make a will or a contract is competent to create a trust. The trustee must be one who is capable
of taking and holding property and who has the legal capacity and natural ability to execute
the trust.
(i) Choice of Trustee. The decedent’s will usually names the trustee for a testamentary trust. A
grantor who is establishing an inter vivos trust will usually appoint one or more of the following to
act as trustee: a relative; his professional adviser, that is, attorney, accountant, broker; a business as-

sociate; or an institutional entity, such as a bank or trust company. Each type of trustee has its pros
and cons; however, the most important concern is not to choose a trustee that will cause adverse in-
come tax consequences.
(ii) Methods of Appointment. Seven of the means by which trustees are appointed are:
1.
By deed or declaring of trust. The creator of the trust names the trustees in the instrument.
2. By will. The same person may be both executor and trustee under a will, but this dual capacity
should be clearly indicated.
3. By agreement.
4. By the court. The court will appoint a trustee when a trust may fail for lack of a trustee, when
a trustee refuses to serve or has died, or when a vacancy from any cause exists and no other
means have been provided for filing the vacancy.
5. By implication of law.
6. By self-perpetuating boards. When vacancies occur, they are filed by the remaining members
of the board.
7. B
y the exercise of a power of appointment. The instrument creating the trust may give the
remaining trustees, beneficiaries, or any other person the power to appoint a trustee to fill
a vacan
cy. Specific instructions should be included in the instrument as to the situation
establishing a vacancy, the persons who may be appointed, and the manner of making
the appointment.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
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21
(iii) Acceptance or Disclaimer. Acceptance of an appointment as trustee may be made by posi-
tive statement, by qualifying as executor if the appointment is by will, by the acceptance of property
of the trust, or by other acts from which acceptance may be presumed. An individual may refuse to
accept an appointment as a trustee and should execute and deliver a disclaimer expressing rejection
of the appointment.

(iv) Resignation of Trustee. According to the Restatement of the Law of Trusts 2d (1 Trusts
A.L.I. 234):
A trustee who has accepted the trust cannot resign except (a) with the permission of a proper court;
or (b) in accordance with the terms of the trust; or (c) with the consent of all the beneficiaries, if
they have capacity to give such consent.
(v) Removal of Trustee. The court has power to remove a trustee and appoint a successor under
certain circumstances. Scott cites, among others, the following six grounds upon which trustees have
been removed:
1. Failure to exercise discretion
2. Self-dealing
3. Failure to keep proper accounts, and mingling with trustee’s own funds
4. Incompetency and neglect of duty
5. Conversion of trust property
6. Refusal to obey orders of the court
5
(c) POWERS AND DUTIES OF TRUSTEES. The powers of trustees are obtained both from the
provisions and implications of the instrument creating the trust and from the general laws pertain-
ing to the trust relationship. The instrument may either expand or restrict the general powers, ex-
cept that it may not relieve the trustee from liability for gross negligence, bad faith, or dishonesty.
The powers of a trustee may be either (1) imperative or mandatory or (2) permissive or discre-
tionary. In other words, they must either be exercised definitely and positively within a given
length of time or upon the occurrence of some contingency, or they may be exercised at the dis-
cretion of the trustee.
(i) General Powers. The nine general powers of a trustee, which include all necessary incidental
powers, are:
1. To take and retain possession of the trust property
2. To invest trust funds so as to yield a fair income
3. To sell and reinvest when necessary
4. To sell and convey real estate when necessary to carry out the provisions of the trust
5. To release real estate so that it may earn income

6. To pay for repairs, taxes, and other such expenses in connection with trust property
7. To sue or defend suits when necessary
8. To make contracts that are necessary to carry out the purposes of the trust
9. To pay over and distribute the trust property to those entitled to it
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ESTATES AND TRUSTS
5
A. W. Scott, The Law of Trusts, 4th ed. (Little Brown, 1987), 1995 Supplement.
The trustee secures possession of the trust property and holds title in his own name. All debtors
should be notified of the change in ownership of claims against them in order to hold
them directly
liable to the trustee. All debts due the trust estate should be collected promptly. T
r
ust property must be
kept separate from the property of anyone else. The trustee will be liable for any loss occurring as a re-
sult of their mingling of funds or other property. An exception is usually made when a trust company is
acting as trustee; it may deposit cash in trust funds with itself or may mingle various trust funds and de-
posit same with designated depositories.
(ii) Duties. The 14 duties of the trustee are outlined by Scott as follows:
1. To administer the trust as long as he continues as trustee
2. To administer the trust solely in the interest of the beneficiary (the duty of loyalty as a
fiduciary)
3. Not to delegate to others the performance of acts which the trustee sought personally to
perform
4. To keep clear and accurate accounts
5. To give to beneficiaries upon their request complete and accurate information as to the admin-
istration of the trust
6. To exercise such care and skill as a man of ordinary prudence would exercise in dealing with

his own property; and if the trustee possesses greater skill than that of an ordinary prudent man,
he must exercise the skill he has
7. To take reasonable steps to secure control of trust property and to keep control of it
8. To use care and skill to preserve the trust property. The standard of care and skill is that of a
man of ordinary prudence
9. To take reasonable steps to realize on claims which he holds in trust and to defend claims of
third persons against the trust estate
10. To keep the trust property separate from his own property and separate from property held
upon other trusts; and to designate trust property as property of the trust
11. To refrain in ordinary circumstances from lending trust money without security
12. To invest trust funds so that they will be productive of income
13. To pay the net income of the trust to the beneficiary at reasonable intervals; and if there are two
or more beneficiaries he must deal with them impartially
14. Where there are several trustees, it is the duty of each of them, unless otherwise provided by
the trust instrument, to participate in the administration of the trust, and each trustee must use
reasonable care to prevent the others from committing a breach of trust
6
(d)
PROPER TRUST INVESTMENTS. The trustee is under a duty to invest funds in such a way as
to receive an income without improperly risking the loss of the principal. The only general rule as to
investment is that the trustee is under a duty to make such investments as a prudent man (the “pru-
dent man” rule or “Massachusetts” rule) would make of his own property, having primarily in view
the preservation of the estate and the amount and regularity of the income to be derived. In some
states (“legal-list” states), the legislatures tell trustees in what they must or may invest funds unless
the terms of the trust otherwise provide.
Eight kinds of investments that are almost universally condemned are summarized by Scott
as follows:
1. Purchase of securities on margin
2. Purchase of speculative shares of stock
3.

Purchase of bonds selling at large discount because of uncertainty of repayment at maturity
4. Purchase of securities in new and untried enterprises
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
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23
6
Id.
5. Use of trust property in the carrying on of a trade or business, even though it is not an untried
enterprise
6. Purchase of land or other things for the purpose of resale, unless authorized by the terms of the trust
7. Purchase of second and other junior mortgages
8. Making unsecured loans to individuals or firms or corporations
7
Three types of investments that are almost universally permitted include:
1. Bonds of the United States or of the state or of a municipality thereof
2. First mortgages on land
3. Corporate bonds of a high investment grade
In 1990, the American Law Institute adopted the Uniform Prudent Investor Act (the UPIA) and
published it in the Restatement of the Law of Trusts, 3rd ed. The UPIA incorporates a new Prudent
Investor Rule that has since been adopted by a significant majority of the states in a form that is sim-
ilar to, or somewhat comparable to, the scope of these new rules. The Restatement embodies three
main themes:
1.
Although it is thought that a trustee may not delegate any of his duties, other than certain
minis-
terial duties, this position is relaxed in that a trustee should, or even must, delegate investment
authority to skilled professionals should they lack the required expertise or experience to
properly manage the assets within the trust.
2. The costs incurred by the trustee in performing his duties must be reasonable.
3. A trustee is now charged with the responsibility for maintaining the trust portfolio so as to

keep pace with inflation. In other words, trustees should invest for the maximum total return
on investment without regard for distinctions between principal and income. This is referred
to as modern portfolio theory, permitting trustees to invest for capital appreciation as well as
current income in the form of interest, dividends, rents, and so forth.
(e) TRUSTEE’S PERSONAL LIABILITIES AND LIABILITY FOR ACTS OF CO-TRUSTEE. A
trustee is liable to the beneficiary for failure to fulfill his duties under the statutes, general rules of eq-
uity, or the provisions of the trust indenture.
A trustee must be particularly circumspect in all matters affecting his own property or benefit.
He is personally liable for torts committed by himself or his agents and, unless his agreement states
otherwise, is personally liable on all contracts made on behalf of the trust.
A trustee is not responsible for loss by theft, embezzlement, or accident if he has taken all the pre-
cautions that a careful businessman takes in guarding his own property, and if he is strictly following his
line of duty as a trustee. If a trustee is not insolvent and mixes trust property with his own, the beneficiary
may take the whole, leaving the trustee to prove his own part. If the trustee is insolvent, the beneficiary
shares with the other creditors unless definite property can be identified as belonging to the trust. Interest
will be charged against a trustee who has mingled trust funds with his own. If bank deposits are made in
the individual name of the trustee, he will be treated as a guarantor of the solvency of the bank, even
though he uses care in his choice of the bank and has not in any way misused the funds.
In general, a trustee is not liable for losses caused by the default or negligence of a co-trustee un-
less he has cooperated with the trustee who is at fault, or has known of the trustee’s misconduct and
has not taken any steps to prevent it. If, however, each trustee should have interested himself in the
matter in question, such as the proper investment of funds, each would be responsible even though he
took no part in or knew nothing of the misconduct. All trustees should act together in handling the
trust property and should apply to the court for instructions in case they cannot agree. Unanimity is
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ESTATES AND TRUSTS
7
Id.

usually required for all important decisions in the case of private trusts, but a majority of a board of
trustees may act for a charitable trust.
In certain circumstances, a trustee may become personally liable for the unpaid estate taxes
of a decedent under the theory of transferee liability. Ordinarily, the beneficiary of an estate or
trust is ultimately liable for any unpaid estate or gift taxes due on the transfer. The liability is
equal to the value of the property received by the recipient as of the date of transfer. A review of
IRC Sections 6324 and 6901, primarily, is in order. For example, the trustee of an inter vivos
trust that is included in the gross estate for estate tax purposes could result in the trustee being
personally liable, as opposed to the beneficiaries, for payment of any attributable estate
taxes.
Certain trust distributions trigger the GSTT, discussed in Subsection 41.1(l), requiring the trustee
to pa
y this tax. As a result of this possibility, a trustee should consider maintaining a reserve
until he is satisfied that all such taxes are satisfied. Upon making distributions, the trustee
should also consider requesting that the beneficiaries indemnify him for any taxes that may be
assessed against him.
(f) GUARDIANS. If a person is incompetent to manage his own property because of a disability
such as infancy or mental incompetency, a guardian will be appointed by the probate or other appro-
priate court. The court must approve the appointment of a guardian by will. A guardian is a trustee in
the strictest sense of the term. He is directly under the supervision of the court. If possible, only the
income from the property should be used for the maintenance and education of the beneficiary; per-
mission must be granted by the court before the principal can be used for this purpose. Any sale of
real estate must be authorized by the court. A guardian should have the authorization of the court or
the direction of a will before paying money to a minor or to anyone for the minor; otherwise he may
be compelled to pay the amount again when the minor becomes of age.
(g) TESTAMENTARY TRUSTEE. The work of the trustee appointed by a will begins when the ex-
ecutor sets aside the trust fund out of the estate assets. One person may serve as both executor and
trustee under a will.
The testamentary trustee has slightly more freedom in handling the funds than does the
executor, and his responsibility may be made less rigorous by provisions of the will. He holds,

invests, and cares for the property, and disposes of it or its income as directed by the will. A
trustee should have specific authority of a will or the court, or the consent of everyone inter-
ested, before carrying on a business. If there are several executors, one can act alone, but
trustees must act jointly.
(h) COMPENSATION OF TRUSTEES. Trustees are usually allowed compensation for their
work, either by provision of the trust instrument or by statute. The statutory provision is usually a
graduated percentage of the funds handled.
A trustee is entitled to be repaid expenditures reasonably and properly incurred in the care of trust
property. The compensation is usually allocated to principal and income in accordance with the spe-
cific provision of the indenture or as provided by statute or rules of law.
(i) RIGHTS OF BENEFICIARY. The beneficiary has an equitable title to the trust property, that is,
he can bring suit in a court of equity to enforce his rights and to prevent misuse of the property by the
trustee. Unless the instrument by which the trust is created provides otherwise, the beneficiary, if of
age, can sell or otherwise dispose of his equitable estate in the property.
The beneficiary has the right to inspect and take copies of all papers, records, and data bearing on
the administration of the trust property and income that are in the hands of the trustee. The benefi-
ciary may have an accounting ordered whenever there is any reason for suspicion, or any failure to
allow inspection or to make satisfactory reports and statements. Whenever it seems advisable, a court
of equity will order an accounting.
The beneficiary may have an injunction issued to restrain the trustee from proceeding with any
unauthorized action, if such action will result in irremediable damage. The beneficiary may present a
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
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25
petition to the court for the removal of a trustee but must be able to prove bad faith, negligence, lack
of ability, or other such cause for the removal. The trustee is entitled to a formal trial.
The beneficiary can, if it is possible to do so, follow the trust property and have it subjected to
the trust, even if a substitution has been made for the original property, unless it comes into the
hands of an innocent holder for value. If the trust property cannot be traced or is in the hands of an
innocent holder for value, the beneficiary may bring action against the trustee in a court of equity

for breach of trust.
If the beneficiary is of age and mentally competent, he may approve or ratify acts of the trustee
that would otherwise be a violation of the trustee’s duties or responsibilities.
(j) DISTINCTION BETWEEN PRINCIPAL AND INCOME. Probably the most difficult problem
of the trustee is to differentiate between principal (corpus) and income. The intention of the creator
of the trust is binding if it can be ascertained, but in the absence of instructions to the contrary the
general legal rules must be followed.
The life tenant (the present beneficiary) is entitled to the net income and the remainderman (the fu-
ture beneficiary) to the principal, as legally determined. The principal is the property itself that consti-
tutes the trust fund, and the income is the accumulation of funds and other property arising from the
investment or other use of the trust principal. Increases or decreases in the value of the assets that con-
stitute the trust fund affect only the principal. The income determined under these rules is not always
the same as taxable income or income as determined by generally accepted accounting principles
(GAAP). The life tenant is entitled to receive only the net income from all sources for the entire term
of his tenancy. He is not allowed to select the income from only those investments that are lucrative.
The existing rules regarding principal and income are based on the Uniform Principal and In-
come Act of 1962 (UPAIA). These rules are, to a great extent, at odds with a trustee’s ability to
comply with the modern portfolio theory contained in the Uniform Prudent Investor Act described
earlier. As one commentator noted,
8
the incompatibility of the UPIA and UPAIA were reconciled
in 1997 by the National Conference of Commissioners on Uniform State Laws. The revised
UPAIA accomplishes:
this result by way of an adjustment power conferred upon trustees, pursuant to which the trustee is
empowered to allocate traditional trust accounting income (e.g., interest, dividends, rents) to prin-
cipal and perhaps more importantly, to allocate to income what is typically considered principal.
Thus, a trustee can increase the amount currently distributable to a beneficiary, for example, by al-
locating capital appreciation to income. Some states (New York, New Jersey, Delaware, and Mis-
souri) added an alternative approach to their respective adoptions of the new UPAIA: an optional
unitrust provision. Instead of being limited to the annual accounting income actually realized by

the trust in any year, the current beneficiary of a unitrust is entitled to an amount equal to a fixed
percentage of the value of the trust’s assets determined annually. As a result, the trustee is free to
invest for total return absent the need to produce sufficient income to satisfy the current benefi-
ciary. By adopting the unitrust alternative, the trustee is relieved of the obligation to determine
each year whether an equitable adjustment is warranted. In addition, the unitrust approach pro-
vides the current beneficiary with the certainty of knowing what he or she is entitled to each year
instead of having to await the trustee’s possible exercise of its discretionary adjustment power.
All of the statutes give testators and grantors the ability to opt out of the statutory language by
defining how they want principal and income to be recognized and charged. The UPAIA in effect
in a given state is operative only if the trust document or will is silent. The U.S. Treasury Depart-
ment and Internal Revenue Service have recognized this new trend in trust accounting and have is-
sued Proposed Treasury Regulation Section 1.643(a) through (d).
41
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ESTATES AND TRUSTS
8
The commentator is Linda B. Hirschon, Esq., of Greenberg Tauig LLP, New York, in an updated ver-
sion of her article “The Unitrust Alternative, A Framework for Total Return Investing,” Tax Manage-
ment Memorandum, Vol. 42, No. 23 (November 5, 2001). The updated version of the article appeared
in a NYS Bar Association CLE publication entitled, “New York’s New Principal and Income Act, the
Power of Adjustment Between Principal and Income and the New 4% Unitrust Option.”
The following describes the principal and income rules under the UPAIA of 1962. Trustees
are advised to seek to professional counseling to determine whether the 1962 or 1997 revised
rules are in effect in their respective state.
(i) Receipts of Principal. The following ten receipts of cash or other property have been held to
be part of the corpus of the trust and therefore to belong to the remainderman or persons entitled to
the corpus:
1. Interest accrued to the beginning of the trust. Bond coupons are not apportioned in the ab-
sence of a statute providing for such a division.

2. Rent accrued to the beginning of the trust. Under the common law, rent was not apportioned
according to the time expired.
3. Excess of selling price of trust assets over their value in the original inventory or over its pur-
chase price. Appreciation, in general, belongs to the trust corpus.
4. The value of assets existing at the time the original inventory was taken but not included in
the inventory.
5. Dividends (see discussion below).
6. Proceeds of the sale of stock rights.
7. Profit from the completion of executory contracts of a decedent.
8. Profits earned prior to the beginning of the trust on the operations of a partnership or sole
proprietorship.
9. Insurance money received for a fire that occurred prior to the date of the beginning of the
trust, or after that date if the property is in the hands of the trustee for the benefit of the trust
in general.
10. If trust property is mortgaged, the proceeds may be said to be principal assets, although there
is no increase in the equity of the remainderman.
(ii) Disbursements of Principal. The following 12 payments, distribution, and exhaustion of as-
sets have been held to be chargeable to the corpus:
1. Excess of the inventory value or purchase price of an asset over the amount realized from
its sale.
2. Payment of debts owed, including accruals, at the date of the beginning of the trust.
3.
Real estate taxes assessed on or before the date of the beginning of the trust. In the case of
special assessments made during the administration of the trust, the remainderman may
pay the assessment and the life tenant may be charged interest thereon annually during the
life of the trust, or else some other equitable adjustment will be made between them.
4. Any expenditures that result in improvements of the property, except those made voluntarily
by a life tenant for his own benefit, and all expenditures on newly acquired property that are
necessary to put it into condition to rent or use.
5. Wood on the property that the life tenant uses for fuel, fences, and other similar purposes.

The life tenant may operate mines, wells, quarries, and so on, that have been opened and op-
erated on the property.
6. Losses due to casualty and theft of general trust assets.
7. Expenses of administration except those directly pertaining to the administration of income.
For example, legal expenses incurred in defending the trust estate are chargeable to princi-
pal; however, the expenses of litigation in an action to protest only the income are payable
out of income.
8. Trustee’s commissions in respect to the receipts or disbursements out of principal. Commis-
sions computed on income are ordinarily payable out of income.
9. Brokerage fees and other expenses for changing investments should generally be chargeable
to principal, since they are a part of the cost of purchase or sale.
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
•
27
10. Income taxes on gains made from disposition of principal assets.
11. Carrying charges on unproductive real estate, unless the terms of the trust direct the trustee
to retain the property even though it is unproductive.
12. Cost of improvements to property held as part of the principal.
(iii) Receipts of Income. The following six receipts have been held to be income and to belong to
the life tenants or persons entitled to the income:
1. Interest, rent, and so on, accruing after the date of the beginning of the trust. The proceeds of
a foreclosed mortgage may be apportionable between principal and income. Interest includes
the increment in securities issued at a discount.
2. Increase in value of investments made by the trustee from accumulated undistributed income.
3. Dividends (see discussion below).
4. Crops harvested during the trust.
5. Royalties or other income from operation of mines, quarries, or wells that were made pro-
ductive prior to the beginning of the trust, or were developed or leased in cooperating with
the remainderman.
6. Net profit from the operation of a business.

(iv) Disbursements of or Charges to Income. The following eight items have been held to be
chargeable against the income of the trust:
1. Interest payable, accruing during the life of the trust
2. Any expenses incurred in earning or collecting income, caring for trust property, or preserving
its value, and an appropriate share of administration fees and expenses
3. Income tax except those levied on gains from sale of principal assets
4. Premiums on trustee’s bond
5.
Provision for amortization of wasting property, including leasehold interests, royalties, oil and
gas wells, machinery, and farm implements (see discussion of depreciation below)
6. Provision for amortization of improvements to trust property when such improvements will
not outlive the duration of the trust
7. Losses of property due to the negligence of the life tenant
8. Losses due to casualty and theft of income assets
(k) PRINCIPAL AND INCOME—SPECIAL PROBLEMS. The distinction between principal and
income also involves a consideration of such problems as unproductive property, accruals, divi-
dends, bond premium and discount, and depreciation and depletion.
(i) Unproductive Property. When the trustee is required to sell unproductive property and
the sale is delayed, the net proceeds of the sale should be apportioned between principal and
income. The net proceeds are allocated by determining the sum that, with interest thereon at
the current rate of return on trust investments, would equal the net proceeds, and the sum so de-
termined is treated as principal and the balance as income (Restatement of Trusts 2d,
§ 241). Apportionment between principal and income is generally applicable to real estate, but
it has been applied in the case of personal property also. It does not matter whether the prop-
erty is sold at a gain or a loss.
(ii) Accruals. There are two dates at which the matter of accruals becomes significant. The first is
the date at which the trust begins. Income and expenses accrued at that date belong to the corpus of
the estate. The second date is the one when the life interest terminates. Income and expenses accrued
at that date belong to the life tenant or his estate.
41

•
28
ESTATES AND TRUSTS
Larsen and Mosich provide a summarization of the general rule of accrual as applied to certain
items, from which the following is taken:
1. Interest. Interest accrued on receivables and investments at the date the trust is established is
considered part of the trust corpus. Exceptions are interest on (a) savings accounts when the in-
terest is paid only if the deposit remains until the end of the interest period, and (b) coupon
bonds when the payment is contingent upon the owner presenting the coupon, in which case the
date of receipt is controlling. Similar rules apply to the accrual of interest expense.
2. Rent. The accrual of rent prior to the beginning of the trust is considered by many states as a
portion of a trust corpus. Any rent accruing between the date of the establishment of the trust
and the termination of the tenancy belongs to the income beneficiary. Rent expense is handled
similarly.
3. Dividends. Ordinary cash dividends are not divisible. If the dividend is declared and the date of
record has passed before the trust is created, the dividend is a part of the corpus. Otherwise it is
considered income to the trust. A stock dividend is treated in the same manner in many
states. . . . [For a discussion of special treatment of cash and stock dividends under the Massa-
chusetts and Pennsylvania rules, see below.]
4. Property taxes. Ta
xes which have been levied on trust property prior to the beginning of the trust
are charges against the principal. Any taxes assessed on the basis of trust property held for the
benefit of the income beneficiary are chargeable against income. Special assessments made during
the administration of the trust are usually paid by the remainderman, although in some cases
where the assessment is for improvements which benefit the life tenant, a part or all of the assess-
ment may be charged against income. When the assessment is paid from the corpus, interest on
the funds advance may be charged against income.
5. Profits. Income earned by a partnership or proprietorship does not accrue. The income which is
earned prior to the creation of the trust is considered a part of the principal of the trust. In many
cases a partnership is dissolved upon the death of a partner, and there may be no income earned

after the trust is established. In the event that the business continues by specific direction of the
grantor or provision of the partnership agreement, any income earned after the trust is created is
income of the trust.
6. Executory contracts. Any profits earned on the completion of an executory contract by the
trustee is an addition to the principal of the trust.
7. Livestock and crops. Any livestock born during the tenancy under the trust is considered in-
come, except to the extent that the herd must be maintained as directed by the grantor, in which
case the increase must be divided between principal and income in a manner which honors this
intention. If the principal includes land, any crops harvested during this tenancy are considered
income of the trust.
8. Premium returns. Any return of premium or dividend on insurance policies which was paid
prior to the creation of the trust is a part of the principal. This is considered realization of assets.
9. Royalties. Royalties or other income from the operation of mines or other natural resource de-
posits which were made operative before the trust was created or which were developed in co-
operation with the remainderman are income to the trust.
9
(iii) Dividends. The determination of whether a dividend is principal or income involves a con-
sideration of applicable state laws. Ordinary cash dividends declared during the period of the trust
belong to the income beneficiary. An ordinary stock dividend is usually regarded as income except in
states that follow the Massachusetts rule. This rule holds that all cash dividends are treated as income
and that stock dividends are entirely principal.
Some states follow the Pennsylvania rule, which holds that, in regard to extraordinary divi-
dends, it is not the form of the dividend but its source that determines whether and to what extent it
41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41
•
29
9
E. J. Larsen and A. N. Mosich, Modern Advanced Accounting, 6th ed. (Shephards McGraw-Hill, New York,
1994).
is income or principal. Generally, under this rule extraordinary dividends are income if declared out

of earnings accruing to the corporation during the period of the trust, but they are principal if de-
clared out of earnings accruing prior to the creation of the trust. Thus, if such dividends cause the
book value of the corporation’s stock to be reduced below the book value that existed at the creation
of the trust, that portion of the dividend equivalent to the impairment of book value is principal and
only the remainder is income. The present Pennsylvania law provides that stock dividends of 6% or
less “shall be deemed income” unless the instrument provides to the contrary.
Although there is still wide diversity among the courts and state statutes in the apportionment of
corporate distributions, Scott points out that the recent trend has been in favor of the Massachusetts
rule.
10
The Uniform Principal and Income Act (Uniform Laws Annotated, Vol. 7B, § 5) follows the
essence of the Massachusetts rule in treating cash and other property dividends as income and stock
dividends as principal.
(iv) Premium and Discount on Bonds. The necessity of accumulating bond discount or amor-
tizing bond premium in order to determine the correct interest income still gives rise to a great deal
of confusion in trust and estate administration. In general, it appears that most courts support the
amortization of premium on bonds purchased by the trustee, but there has been little or no support of
the accumulation of discount. Any difference between the inventory value and the face value of the
bonds taken over by the trustee is usually treated as an adjustment of principal.
In the event of redemption before maturity, it has been held that the proper procedure is to amor-
tize the premium to the date of redemption; the unamortized balance is a loss borne by principal. If a
bonus is received, it should be credited to principal.
Scott suggests:
It might well be held that the whole matter [of amortizing premium and discount] should be left to
the discretion of the trustee, and if he is not guilty of an abuse of discretion in unduly favoring some
of the beneficiaries at the expense of the others, the court should not interpose its authority. This, of
course, is the result reached where such discretion is expressly conferred upon the trustee by the
terms of the trust.
11
(v) Depreciation and Depletion. In determining whether provision must be made for deprecia-

tion and depletion, it is essential to consider carefully the intentions and wishes of the trustor. If the
trustor intended to give the full, undiminished income to the life tenant even though the principal
would thereby be partially or completely exhausted, no deduction from income for depletion or de-
preciation is allowed. If, however, there is an expressed or implied intention to preserve the principal
intact, the trustee is required to withhold from income an amount sufficient to maintain the original
property of the trust.
When the trustor’s intentions regarding the receipts from wasting property cannot be determined
from the trust instrument, then, according to Scott, the inference is that the trustor did not intend that
the life beneficiary should receive the whole income at the expense of the principal.
12
Thus, when the
trustee holds wasting property, including royalties, patents, mines, timberlands, machinery, and
equipment, he is under a duty to make a provision for amortization of such property. The general rule
has been applied to new buildings erected and improvements made by the trustee; however, the
courts have generally held that buildings that were part of the trust estate at the beginning of the trust
need not be depreciated. The courts have, in effect, refused to treat the buildings as wasting property.
The trend appears to be in the direction of adopting principles of depreciation followed in account-
ing practice. For example, the position taken in Section13 of the Revised Uniform Principal and In-
come Act is that, with respect to charges against income and principal, there shall be:
41
•
30
ESTATES AND TRUSTS
10
Scott, The Law of Trusts.
11
Id.
12
Id.
a

reasonable allowance for depreciation under generally accepted accounting principles, but no al-
lowance shall be made for depreciation of that portion of any real property used by a beneficiary as a
residence or for depreciation of any property held by the trustee on the effective date of this Act for
which the trustee is not then making an allowance for depreciation.
(l) TAX STATUS OF TRUST. Unless the trust qualifies as an exempt organization (charitable, ed-
ucational, etc.), or unless the income of the trust is taxable to the grantor (revocable, or grantor re-
tains substantial dominion and control), the income of the trust is subject to the federal income tax in
a manner similar to the case of an individual. In general, the trust is treated as a conduit for tax pur-
poses and is allowed a deduction for its income that is distributed or distributable currently to the
beneficiaries. The trust may also be subject to state income taxes, personal property taxes, and so on.
A tax service should be consulted for the latest provisions and rulings as to deductions, credits, rates,
and filing requirements.
It is important to note that although trusts and estates are taxed similarly, there are two major dif-
ferences. Trusts must be operated on a calendar year basis, whereas estates may operate on a fiscal
year, usually tied to the decedent’s date of death. Secondly, trusts must pay estimated taxes in the
same fashion as individuals. Estates, on the other hand, are exempt from this requirement, but only
for their first two tax years.
The impact of RRA ’93 (the Revenue Reconciliation Act of 1993) substantially compressed the
income tax rates applicable to trusts and estates. Indexed from its original level effective for tax
years beginning in 1993, trusts reach the top 38.6% marginal bracket at $9,200 of taxable income in
2002. Compare this to married individuals filing jointly, for example, where the 38.6% top marginal
bracket is not reached until taxable income exceeds $307,050 in 2002. That is quite a disparity.
Trustees of existing trusts need to consider their responsibility to take this disparity into considera-
tion
when reviewing the mix of assets in the current trust portfolio and when exercising their discre
tion
to make discretionary distributions of income. In certain cases, where older trusts were established
with a different rate structure in mind, and where state law permits, a trustee may want to consider
bringing a court proceeding to reform the terms of the trust accordingly. If the settlor is still alive, all
of the beneficiaries are adults, and trust is irrevocable, it may be possible under state law, as it is in

New York, to revoke the trust and create a new one if the gift tax cost is not excessive.
(m) TERMINATION OF TRUST. A trust may be terminated by the fulfillment of its purpose or by
the expiration of the period for which the trust was created. A trust may also be terminated under a
power reserved by the grantor or by the consent of all beneficiaries unless continuance of the trust is
necessary to carry out a material purpose for which it was created.
When the trust is terminated, the trustee is discharged when he has transferred the property to
those entitled to it according to the terms of the trust instrument. The trustee, to protect himself, may
secure a formal release of all claims from all who receive any of the property and are competent to
consent, may require a bond of indemnity from the beneficiaries, or may refuse to act without a de-
cree of court.
41.4 ACCOUNTING FOR TRUSTS
(a) GENERAL FEATURES. Generally, accounting for a trust is the same as accounting for an es-
tate. The emphasis for a trust, however, is that principal or corpus versus income should be properly
distinguished. Two interests, that is, current or life versus future or remainder, usually serve different
parties. One party may have a current or income interest whereas another party holds a future or re-
mainder interest. Therefore, allocation between principal and income is important. See discussion at
Section 41.3(j) for an update on these issues.
(i) Accounting Period. The accounting period for a trust depends somewhat on the nature of the
trust and the provisions of the trust instrument. Reports may be required by the court or may be sub-
mitted to other interested parties at various intervals during the life of the trust.
41.4 ACCOUNTING FOR TRUSTS 41
•
31
(ii) Recording Principal and Income. A careful distinction must be made between principal
(corpus) and income in recording the transactions. The legal theory seems to be that the principal of
a trust is not a certain amount of monetary value but is a certain group of assets that must be capable
of isolation from the assets that compose the undistributed income. Actual separation of cash and in-
vestments is difficult because of such factors as accrued interest and amortization of bond premium
and discount. Ordinarily it is sufficient to keep one account for cash and one for each type of invest-
ment, and to indicate the claims of the principal and income in the total.

Accounts should be kept with the beneficiaries to show the amounts due and paid to each.
The trustee should keep records that will meet both the requirements of the income tax law and
regulations and the law relating to principal and income. There are apt to be conflicts at various
points in the determination of taxable income and of income belonging to the life tenant. The only
solution is to keep sufficiently detailed records so that all of the information is available for both pur-
poses. In some cases, it may be necessary to prepare reconciliation schedules in order to keep a
record of the differences between the income tax calculation of net income and the application of
trust accounting principles of accounting income.
See discussion at Section 41.3(j) for an update on these issues.
(iii) Accounting for Multiple Trusts. Several trusts may be created by a single instrument, such
as trusts originating through the provisions of a will, and a single trustee may have to keep his ac-
counts so as to be able to prepare a report of the administration of the estate as a whole and also a
separate report of each trust.
(iv) Treatment of Liabilities. In some cases, trust property will be encumbered with an unpaid
mortgage or other obligation of which the trustee must keep a record. It is also possible that in han-
dling the business of the trust some liabilities will be incurred. These are usually current in character,
and the entry made at the time of payment, charging the amount to an asset or expense account, is
usually sufficient.
(b) RECORD-KEEPING SYSTEM. The bookkeeping system requirements for the trust, like those
for any other enterprise, vary with the complexity of the situation. The trustee should keep a com-
plete record of all transactions relating to the trust in order to protect himself, to make reports to the
court, to prepare income tax returns, and to give the beneficiaries of the trust an adequate accounting.
No special type of bookkeeping system is prescribed by law, but a complete record of all transactions
must be kept in such a way that the reports required by the courts can be prepared. All records should
be kept in permanent form and should be carefully preserved and filed for possible future reference.
(i) Journals. In a comparatively simple situation, one multicolumn journal may be satisfactory,
but in most cases a set of various journals should be kept.
(ii) Principal and Income Accounts. It is necessary to distinguish carefully between principal
and income in the administration of trusts. The Trust Principal account and the Undistributed Trust
Income account record the net worth or capital of the trust. It will usually be necessary to analyze

those accounts for income tax purposes, just as equity is analyzed in corporation accounts to obtain
all of the information required for the income tax return. There may be some conflicts between in-
come as defined by the law relating to the administration of trusts and taxable income as defined by
the income tax law and regulations.
(iii) Opening Books of Account. If an inventory has been filed with the court, such as an execu-
tor’s or guardian’s inventory, the trustee must record the same values in his accounts. If no such in-
ventory was filed, the trustee should have one prepared that will serve as the basis of his property
accounting. Whenever possible, the inventory should contain the same values as those required for
income tax purposes in determining the gain or loss from the sale of property. In any case, a record
of such values must be available.
41
•
32
ESTATES AND TRUSTS
(iv) Amortization of Bond Premium or Discount. When bonds are taken over in the inv
entory
at more or less than their face value, the difference between the inventory value and the amount re-
ceived at maturity is ordinarily treated as a loss or gain on realization; but when bonds are pur-
chased at a premium or discount, the difference between the amount paid and the amount to be
received at maturity should be treated as an adjustment of the interest earned and should be written
off during the remaining life of the bond. If the amount is not large, the “straight-line” method may
be used, that is, the total premium or discount is divided by the number of remaining interest pay-
ments to obtain the amount to be written off at each interest date. If the amount is large, amortiza-
tion tables may be used in which the effective rate of interest is applied to the present value of the
bond to obtain the income due to the life tenant.
(v) Depreciation. Except for buildings forming part of the inventory at the date of origin of the
trust, or in trusts where contrary provisions were intended by the grantor, wasting assets, including
buildings and equipment, should be preserved by reflecting depreciation as a charge to income, if al-
lowed by the trust instrument or state law. Many states have no provision for depreciation.
If all of the trust income is distributed to beneficiaries without regard for depreciation, the entire

periodic deduction for depreciation is taken for income tax purposes by the beneficiaries, and the
trustee has no occasion to record depreciation in his records. In all instances, the trustee should be
guided by the provisions of the trust instrument or state law in his handling of depreciation.
(vi) Payments of Expenses. A distinction must be made between expenses chargeable to princi-
pal and income. In the absence of direction in the instrument, the fiduciary should rely on state law
as to allocation of trust expenses. Generally if an expense is recurring each year, it is usually charged
to income. It could also be allocable one-half to principal and one-half to income. If an expense is at-
tributable to corpus, it should be charged to principal. If the expense was to maintain and collect in-
come, then it should be charged to income. For example, capital gains are allocated to principal, and
the income tax paid by the trustee on capital gains should also be charged to principal; however,
when a bank assesses an annual fee for a custody account, the custody fee could be charged to in-
come or split 50/50 between income and principal.
(c) TRUSTEE’S REPORTS. Trustee’s reports vary in form and in frequency according to the na-
ture and provisions of the trust, and whether it is being administered under the jurisdiction of a court.
Moreover, the form of the report varies among jurisdictions. Before preparing the report, the ac-
countant should ascertain from the court whether a particular form is required. The valuations to be
used must always be the same as those appearing on the inventory unless specific permission has
been granted to change them. If assets have been written off as worthless, they must nevertheless ap-
pear in the new inventory without value.
If income and principal cash accounts have been properly maintained, the balance of the undis-
tributed income would be represented by an equal amount of cash in the bank. If specific investments
have been made with the intention that the funds used were still to be considered as undistributed in-
come, the assets acquired should be shown as assets belonging to the trust income account.
The reports consist primarily of an analysis of the principal and income accounts. In addition, a
statement showing the changes in the investments, an inventory of the property at the date of the re-
port, and supporting schedules of various items will be required. A reconciliation of cash receipts and
disbursements is also often prepared.
41.5 SOURCES AND SUGGESTED REFERENCES
Denhardt, J.G., Jr., and Denhardt, J.W., Complete Guide to Trust Accounting and Trust Income Taxation. Pren-
tice-Hall, Englewood Cliffs, NJ, 1977.

Denhardt, J.G., Jr., and Grider, John D., Complete Guide to Estate Accounting and Taxes, 4th ed. Prentice-Hall,
Englewood Cliffs, NJ, 1988.
41.5 SOURCES AND SUGGESTED REFERENCES 41
•
33
———, Complete Guide to Fiduciary Accounting. Prentice-Hall, Englewood Cliffs, NJ, 1981.
Executors and Administrators, 31 Am Jur 2d (rev.), Lawyer’s Cooperative Publishing. Rochester, NY, 1989, April
1995 Cum. Suppl.
Federal Taxes Weekly Alert, Effect of Death on an Individual’s Income Tax Attributes, November 16, 1995 Prac-
tice Alert, Research Institute of America.
Ferguson, M. Carr, Freeland, James J., and Ascher, Mark L., Federal Income Taxation of Estates, Trusts and Ben-
eficiaries, 2nd ed. Little, Brown, Boston, 1993.
Gillett, Mark R., and Stafford, Joel D., “Steps to Prepare and File Estate Tax Returns Effectively,” Estate Plan-
ning, May/June 1995. Warren Gorham & Lamont.
Harris, Ann C., “Proper Disposition if IRD Items Can Produce Tax Savings,” Estate Planning, September/
October 1994. Warren Gorham & Lamont.
Harris, Homer I., Estates Practice Guide, 4th ed. Lawyer’s Cooperative Publishing, Rochester, NY, 1984, No-
vember 1994 Suppl.
Harrison, Louis S., “Coordinating Buy-Outs and Installment Payment of Estate Tax,” Estate Planning, May/June
1995. Warren Gorham & Lamont.
Herr, Philip M., and Etkind, Steven M., “When and How an Interest in a Tax Shelter Should Be Disposed of Be-
fore Death,” Estate Planning, September/October 1990. Warren Gorham & Lamont.
Larsen, E. J., and Mosich, A. N., Modern Advanced Accounting, 6th ed. Shephards McGraw-Hill, New York,
1994.
Nossman, Walter L., Wyatt, Joseph L., Jr. and McDaniel, James R., Trust Administration and Taxation, rev. 2nd
ed. Matthew Bender, New York, 1988, August 1995 Cum. Suppl.
Peschel, John L. and Spurgeon, Edward D., Federal Taxation of Trusts, Grantors and Beneficiaries, 2nd ed. War-
ren, Gorham & Lamont, New York, 1989, 1995 Cum. Suppl.
Restatement 3rd Trusts (Prudent Investor Rule) §§ 227-229. American Law Institute, 1990.
Restatement, Second, Trusts. American Law Institute, 1959.

Sages, Ronald A., “The Prudent Investor Rule and the Duty Not to Delegate,” Trust & Estates, May 1995.
Schlesinger, Sanford J., and Weingast, Fran Tolins, “Income Taxation of Estates and Trust: New Planning Ideas,”
Estate Planning, May/June 1995. Warren Gorham & Lamont.
Scott, Austin Wakeman, The Law of Trusts, 4th ed. Little, Brown, Boston, 1987, 1995 Suppl.
Share, Leslie A., “Domicile Is Key in Determining Transfer Tax of Non-Citizens,” Estate Planning, January/
February 1995. Warren Gorham & Lamont.
Stephens, Richard B., Maxfield, Guy B., Lind, Stephen A., and Calfee, Dennis A., Federal Estate and Gift Taxa-
tion, 6th ed. Warren, Gorham & Lamont, New York, 1991, 1995 Cum. Suppl. No. 3.
Stephenson, G. T., and Wiggins, Norman, Estates and Trusts, 5th ed. Appleton-Century-Crofts, New York, 1973.
Tractenberg, Beth D., “Transferee Liability Can Reach Trustee as Well as a Beneficiary,” Estate Planning, Sep-
tember/October 1994. Warren Gorham & Lamont.
Trusts & Estates Staff, “Uniform Laws Provide a Road Map for Estate Planners,” Trust & Estates, May 1994.
Trusts, 76 Am Jur 2d (rev.). Lawyer’s Cooperative Publishing, Rochester, NY, 1992, April 1995 Cum. Suppl.
Turner, George M., Trust Administration and Fiduciary Responsibility, Shephards McGraw-Hill, New York,
1994.
Uniform Principal and Income Act. American Laws Annotated, Vol. 7.
Uniform Probate Code. American Laws Annotated, Vol. 8, 8A and 8B.
Waggoner, Lawrence W., “The Revised Uniform Probate Code,” Trust & Estates, May 1994.
41
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ESTATES AND TRUSTS
CHAPTER
42
VALUATION OF
NONPUBLIC COMPANIES
Allyn A. Joyce
Allyn A. Joyce & Co., Inc.
Jacob P. Roosma, CPA
Williamette Management Associates

42.1 DEFINITION OF VALUE 2
(a) Definition of Nonpublic 2
(b) Purposes for Valuations 2
(c) Fair Market Value 2
42.2 GENERAL PROCEDURE FOR
VALUATION 2
(a) Compile Background
Information about the Company 2
(b) Compile Financial Information
Regarding the Company 3
(c) Select Guideline Companies 3
(i) Compile Data on
Guideline Companies 4
(ii) Calculate Market Value
Ratios 4
(d) Estimate Dividend-Paying
Capacity 4
(e) Judgmental Modification of the
Valuation Ratios 5
(f) Application of the Market
Value Ratios 6
(i) Discount for Lack of
Marketability 7
(ii) Discount for Minority
Interest 7
(g) Discounted Future Benefits
Approaches 8
(h) Use of Formulas 9
(i) Net Asset Value Approach 10
42.3 SPECIAL SITUATIONS 10

(a) Wholesale and Retail
Companie
s
10
(b) Valuation of Service
Companies 10
(c) Companies with Low
Earnings 11
(d) Holding Companies 11
(e) Real Estate Companies 12
(f) Companies with Nonoperating
Assets 12
(g) Life Insurance Proceeds 12
(h) Companies with an
Extremely Strong Financial
Position 12
(i) Preferred Stock 13
(j) Employee Stock Ownership
Plans 15
(k) Valuations for Marital
Dissolutions 15
(l) Restrictive Agreements 16
(m) S Corporations 16
(n) Start-Up Companies 16
(o) Nonvoting Stock 16
(p) Valuation of a Controlling
Interest 16
(q) Fifty Percent Interest 18
42.4 COURT DECISIONS
ON VALUATION

ISSUES 18
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42.1 DEFINITION OF VALUE
(a) DEFINITION OF NONPUBLIC. A public company is one whose common stock has wide-
spread ownership and investment interest and such active trading that market quotations ordinarily
represent fair market value. In contrast, the common stock of a nonpublic company generally has
concentrated ownership and such few trades that the transactions do not provide reliable indications
of fair market value.
(b) PURPOSES FOR VALUATIONS. The need for valuing the common stock of a nonpublic or
closely held company arises on many occasions. Among the more important situations requiring
the valuation of nonpublic stock are filing estate and gift tax returns, transactions involving estate
planning, financial planning, employee stock ownership plan transactions and reports, granting
stock options, drawing stock purchase agreements, marital dissolutions, structuring recapitaliza-
tions, sales, mergers, and divestitures, and litigation.
(c) FAIR MARKET VALUE. Briefly stated, fair market value is that value at which a willing buyer
and a willing seller, both well informed and neither under any compulsion to act, would arrive in an
arm’s-length sale of the asset in question. Such value is always determined as of a specific date and
is based on all pertinent facts and conditions that are known or reasonably might be anticipated on
that date. The existence of a willing buyer and a willing seller is assumed in the very definition of fair
market value.
42.2 GENERAL PROCEDURE FOR VALUATION
(a) COMPILE BACKGROUND INFORMATION ABOUT THE COMPANY. In valuing the
common stock of a nonpublic company, it is necessary to become as informed as the well-informed
buyer and seller assumed in the definition of value.
The appraiser should review the history of the corporation, including date and state of incorpora-
tion, the products originally made, evolutionary developments to the present, and changes in control
over the years. A list of stockholders, directors, and a listing of officers’ names, salaries,
ages, and ex-

perience should be obtained.
The appraiser must understand the nature of the company’s products and/or services, raw materials
used, and the methods of manufacture. A facilities tour is helpful. He should inquire as to how techno-
logically advanced (or backward) the company is and review anticipated capital expenditures.
Information on the size of the labor force, the existence of collective bargaining agreements, and
background information on employee relations as well as the corporation’s strike experience should
be obtained. The risk of customer loss during a strike must be evaluated.
The analyst should carefully analyze the structure of the industry, including the identity of
existing competitors, barriers to entry and exit, and the bargaining position of customers and
suppliers.
Obtain information on the sales force, including its size, structure, methods of compensation,
and radius of distribution. Information on markets, including principal industries served and
42.5 SAMPLE CONDENSED
VALUATION ANALYSIS 18
(a) Company Background 18
(b) Selection of Guideline
Companies 19
(c) Qualitative Considerations 21
(d) Quantitative Considerations 22
(e) Application of the Valuation
Ratios 23
42.6 SOURCES AND SUGGESTED
REFERENCES 27
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VALUATION OF NONPUBLIC COMPANIES
principal customers served, is also important. Any material dependence on a single industry
(25% or more of sales) or on a single customer (10% or more of sales) should be carefully re-
viewed and the risk of a sudden loss evaluated. The nature of the markets served (e.g., replace-

ment versus original equipment market or job shop versus proprietary) should be examined. The
economic forces that give rise to demand for the company’s products or services should be un-
derstood. Market share data, when available, can be helpful. Price, quality, and service as com-
petitive factors should be assessed. The role of patents and proprietary or secret technology in the
competitive structure of the industry should be examined, and if these are important, the possible
effects of patent expirations should be reviewed. Research and development projects under way
should be reviewed with management.
Changes in the industry, particularly those of a technological or marketing nature, must be ana-
lyzed in terms of the company’s outlook. The analyst should obtain a “feel” for the industry. Back-
ground information can usually be obtained from trade sources. The analyst should understand the
growth and cyclical characteristics of the industry. He should review the performance of the com-
pany relative to its industry, and he should understand the reasons for any pronounced differences in
trends between the company and its industry.
(b)
COMPILE FINANCIAL INFORMATION REGARDING THE COMPANY. The appraiser
should obtain audit reports for the past five years. Some situations may require a complete audit of the
books or even the services of a forensic accountant. The appraiser should disclose the source of the fi-
nancial information upon which he has relied.
The appraiser should review the historical income accounts, including such areas as officers’
compensation, the company’s relationship with affiliated entities, and travel and entertainment.
It is helpful to restate the income account in ratios, as this may disclose trends in cost-price rela-
tionships that should be discussed with management. Margins by product lines should be reviewed
for a multiline company. The appraiser should obtain the latest interim statement and interview man-
agement with regard to the company’s outlook. It is useful to get the interim statement for the same
period of the previous year.
It is helpful to review a five-year comparison of the balance sheets, to analyze changes that may
be occurring in financial position, and to evaluate its capacity to finance future growth. The balance
sheet may indicate the existence of nonoperating assets, which, if material, should be segregated and
valued separately. The potential existence of hidden assets or hidden liabilities should be discussed
in interviews with management. The capital structure must be carefully reviewed, as well as the

terms of any stock purchase agreements or stock options.
The appraiser should get sales, income, and dividend data to review both the growth and cyclical
characteristics of the company, as well as its long-term dividend policy. It is important to review the
long-term outlook with management and to obtain financial projections if available.
(c) SELECT GUIDELINE COMPANIES. Having reviewed the quantitative and qualitative
factors discussed above, the appraiser must translate this complex array of facts into value. This
requires an analysis of the most relevant facts from the actual marketplace. This is ordinarily
done through the selection and analysis of guideline companies that can be used to formulate
objective guidelines for the evaluation of the subject company. Guideline companies are pub-
licly held companies that come as close as possible to the investment characteristics of the com-
pany being valued. Ideally, they are in the same industry. Frequently, however, there are no
public companies in the same industry, so it is necessary to select companies with an underlying
similarity of investment characteristics based on markets, products, growth, cyclical variability,
and other factors.
Such companies were traditionally called “comparative companies,” a term that seems to
connote companies “just like” the company being valued. It is seldom, if ever, possible to find
publicly held companies “just like” the company under consideration. Appraisers have come to
generally use the term “guideline companies” as a more appropriate term than “comparative
companies.”
42.2 GENERAL PROCEDURE FOR VALUATION 42
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The importance of a thorough, objective selection of guideline companies cannot be overesti-
mated. The credibility of any valuation analysis is dependent on the demonstrated objectivity of the
selection of guideline companies.
There are numerous sources for identifying public companies by industry. In recent years,
many appraisers have switched from printed sources of information on possible guideline com-
panies to computerized databases. It must be recognized that the breadth and depth of coverage
and the accuracy of the information contained in such services will affect the results. Although
they are far more efficient than the traditional printed sources, if such databases are not com-

prehensive in the number of companies they cover or in the way they classify businesses, some
actively traded companies that meet the criteria established for the selection of guideline com-
panies may be missed.
The appraiser must clearly state the criteria used in selecting guideline companies. A description
of each guideline company finally selected should be part of the report.
(i) Compile Data on Guideline Companies. It is necessary to compile financial and operating
data on the guideline companies. Annual reports should be obtained on the guideline companies, and
10-K reports often are helpful. As much information as possible must be gleaned from official re-
ports, trade sources, prospectuses, and so on, regarding products, markets, and customer depen-
dence, for each of the guideline companies. Balance sheet and income account comparisons are
recommended. Where possible, adjustments should be made to the income and balance sheets of the
guideline companies and/or the subject company to minimize differences in accounting when such
differences are material.
Generally, public companies compute depreciation on the straight-line basis for financial report-
ing purposes. If the company being valued uses accelerated depreciation, its income and net worth
should be adjusted to a straight-line basis when the difference is substantial (10% or more of average
income over the past five years).
Adjustments should be considered when there is a difference in inventory accounting method be-
tween the subject company and the guideline companies. The most common difference is that most or
all of the guideline companies are on last-in, first out (LIFO) and the subject company is on first-in,
first-out (FIFO).
The income accounts of the subject company should be carefully reviewed and the management
interviewed with regard to extraordinary factors affecting income, such as inventory write-downs,
uninsured losses, plant moving expenses, or anything of a substantial and nonrecurring nature. Ad-
justments should be made to eliminate the effects of these extraordinary, nonrecurring items.
(ii) Calculate Market Value Ratios. Next, the appraiser should calculate the market values
of the guideline companies by multiplying the number of shares outstanding by the price per
share on the valuation date. If the company has preferred stock outstanding, include it in this
computation.
It is necessary to compute the price-earnings ratio. The period selected must be the one that

best measures the earning power of the subject company relative to the earning power of the
guideline group. Generally, median ratios are used to avoid the distorting effect of extremes on
the arithmetic average.
Compute the average cash flow (net income plus noncash charges) for each of the guideline com-
panies using the same period. Compute the median price-cash flow ratio of the guideline group.
Compute the price-dividend ratio of each of the guideline companies. Generally, the dividend of
the latest year is suitable for this purpose. However, if there has been an abrupt change in the divi-
dend rate in a recent quarter, the new rate may be more indicative of dividend expectations. Compute
the median price-dividend ratio of the guideline group.
Compute market-value-to-book-value ratios and the median of these ratios.
(d) ESTIMATE DIVIDEND-PAYING CAPACITY.
The use of the price-dividend ratio raises
the question of the significance of the actual dividend payments of a nonpublic corporation. In
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VALUATION OF NONPUBLIC COMPANIES
many cases, even though the company has the capacity to pay dividends, it pays small ones
or none at all. This inevitably raises the question of whether actual dividend payments or
dividend-paying capacity should be capitalized. That dividend-paying capacity must be consid-
ered is quite clearly the position of the IRS (Rev. Rul. 59-60, ¶ 3e), but the courts have not al-
ways been as clear.
In estimating dividend-paying capacity, the guideline companies are useful. Compute the payout
ratio (dividends as a percentage of net income) of the guideline companies and derive the median
payout ratio of the group. Then examine the financial position of the company being valued relative
to that of the guideline companies. Consider also that the company being valued, as a closely held
company, does not have the same access to capital markets for equity capital as the guideline com-
panies and must, therefore, rely on the retention of earnings to a greater extent than publicly held
companies. When the financial position of the company being valued is weaker than that of the
guideline companies, the dividend-paying capacity is correspondingly less. If the financial position

of the company being valued is significantly stronger than that of the guideline companies, it may
have a dividend-paying capacity equal to or greater than that of the guideline companies, despite its
inferior access to capital markets.
A second part to this question is: If dividend-paying capacity should be capitalized, how?
Does a dollar of dividend that could be paid, but is not paid, have a value to the minority inter-
est investor equal to a dollar of dividend that is actually paid? One reasonable procedure is to
capitalize actual dividend payments at the same rate as the guideline companies and capitalize
unpaid dividend-paying capacity (the excess of the capacity to pay dividends over the actual
dividends paid) at half the multiplier derived from the guideline companies. This procedure rec-
ognizes that the minority interest investor does benefit from that unpaid dividend-paying capac-
ity because the company builds its equity base faster than it would if such dividends were paid.
However, it also recognizes that the benefit is not as direct nor as immediate as the actual pay-
ment of dividends.
(e) JUDGMENTAL MODIFICATION OF THE VALUATION RATIOS. These market value
ratios provide useful valuation guidelines. However, they are nothing more than guidelines and
must inevitably be combined with the appraiser’s judgment in arriving at a sound valuation con-
clusion. The appraiser must, after careful consideration of all relevant factors, come to one of three
possible conclusions:
1. Investors would find the subject company to be more attractive than the group of guideline
companies. (In this case, a premium must be added to the median valuation ratios.)
2. Investors would find the subject company to be less attractive than the guideline companies.
(In this case, a discount from the median valuation ratios is required.)
3.
Investors would regard the subject as being neither more nor less attractive than the group of
guideline companies. (In this case, the use of the median ratios would be appropriate.)
This decision requires a careful comparative analysis of the subject company and the guideline com-
panies in terms of both qualitative and quantitative differences.
In addition to the basic nature of the product, qualitative considerations may include such factors
as market position, geographic, product, and market diversification, patent protection, depth of man-
agement, research and development capabilities, and many others. Often, but by no means always,

public companies are larger and more diversified, and have more professional management. When
they are used as guideline companies for the valuation of a smaller, weaker, less diversified company,
a judgmental adjustment to the valuation ratios may be necessary. However, in making these judg-
mental adjustments, care must be taken to avoid “counting the same trick twice.” For instance, in
valuing a company with low earnings, one should not take a discount for poor management, if it is
the poor management that causes the low earnings. That would obviously be “doubling up.”
In terms of quantitative differences, the appraiser should first look to long-term trends and out-
look for sales and income. Place the sales and income of each of the guideline companies on an index
42.2 GENERAL PROCEDURE FOR VALUATION 42
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5
basis, selecting a base period that is not affected by abnormal factors. Determine the median sales
index of the group of guideline companies and compare it to the company being valued. Charts of
these comparisons are particularly helpful.
Differences in trends may be properly reflected in the valuation procedure through the use of a
weighted average. However, a pronounced long-term inferiority of sales trend, and particularly of in-
come trend, may require a further discount to the valuation ratios derived from the guideline compa-
nies. Conversely, a decided long-term superiority of trends may require an upward adjustment to
those valuation ratios.
The appraiser should also look to the factor of variability. A company with high variable earnings
is less attractive to investors than a company with a stable earnings trend. However, be careful in
comparing the trend of earnings of a single company to that of the group average or median. The av-
eraging process tends to have a stabilizing influence, and it may therefore be desirable to make a
comparison on an individual company basis.
A comparison of financial ratios is also recommended. This should include the current ratio
(current assets divided by current liabilities), liquidity ratio (current assets as a percentage of
total assets), and leverage ratios (total liabilities as a percentage of total assets and net worth
as a percentage of total assets). Differences in financial position can be appropriately reflected
in the estimation of dividend-paying capacity. In most cases, the use of dividend-paying ca-
pacity as a valuation factor makes a reasonable allowance for differences in financial position.

When there are extreme differences, some further adjustment may be necessary. The financial
position of the company being valued may be so weak that the nonpayment of dividends does
not adequately reflect its poor financial position. In this case, an appraiser must make a judg-
mental negative adjustment to the valuation ratios. On the other hand, a strong financial posi-
tion is normally adequately reflected through either liberal dividend payments or a strong
dividend-paying capacity. A company with an extremely strong financial position relative to
the guideline companies represents an unusual situation, which is covered in Subsection
42.3(h).
Operating ratios, including sales times net worth, net income as a percentage of sales, and income
as a percentage of net worth, should be computed and charted. These ratios should be reviewed with
particular attention to the profit margin. A profit margin that is well below average may indicate a
high-cost operation and, when accompanied by highly variable earnings, may require some discount
to the valuation ratios. However, frequently a low profit margin is accompanied by a high ratio of
sales to net worth, and together these characteristics are symptomatic of integration lesser than that
of the guideline companies.
Finally, examine the fundamental assumption in the valuation procedure that the earnings out-
look of the subject company is roughly similar to that of the guideline companies. If there are strong
indications that such an assumption is not reasonable, make an appropriate adjustment to the valu-
ation ratios.
(f) APPLICATION OF THE MARKET VALUE RATIOS. At this point, the appraiser has de-
rived four valuation ratios that have been derived from the guideline companies: price-net worth
ratio, price-earnings ratio, price-cash flow ratio, and price-dividend ratio. The application of the
four ratios provides four indicators of value, and there may be considerable variation among
them. This inevitably raises the question of their relative importance. There is close to universal
acceptance of the notion that, except under unusual circumstances, earnings are the most impor-
tant valuation factor.
Some appraisers and some courts completely ignore the concept of cash flow. The use of cash
flow in valuation analysis is most appropriate when the company has large assets that do not neces-
sarily decline in value with time and are not “used up” in production. An obvious example is a real
estate holding company. The use of cash flow in the valuation of companies with very little invest-

ment in depreciable assets (service companies, for instance) is somewhat redundant in that cash
flow may be almost identical to earnings, and its use is simply a repetition of the price-earnings
ratio analysis.
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VALUATION OF NONPUBLIC COMPANIES
If the subject company is significantly more or less capital intensive than the guideline compa-
nies, the cash flow approach should be modified or eliminated.
Some appraisers completely ignore dividends and dividend-paying capacity. Some give no
weight to the book value factor.
The necessity of translating these indicators into a value presents a dilemma to the appraiser.
If he uses specific weights, he must defend these as reasonable and not constituting a formula. On
the other hand, deriving a value from only one of these factors also constitutes a weighting pro-
cedure because it assigns a weight of 100% to that one factor and zero to the others. Some ap-
praisers cope with this problem by simply stating that “all things considered, I think the value is
X,” but they must face the obvious question: What factors did you consider and how much
weight did you give to them?
For the most part, courts do not specify the weight they accord to these various valuation factors. In
the few cases where the courts have been specific, they have tended to ascribe primary importance to
earnings rather than do dividends, and they have demonstrated a tendency to give more weight to earn-
ings than to dividends. The factor of book value has generally received relatively little weight in court
decisions involving industrial companies. However, it is not totally ignored.
Whatever weights are used, the appraiser must thoughtfully analyze the resulting value for rea-
sonableness. If this stock were publicly traded at this price, would it be more attractive than the
shares of the guideline companies? Would it be significantly less attractive than shares of the guide-
line companies? If the appraiser can answer both of these questions in the negative, he has probably
arrived at a reasonable result.
(i) Discount for Lack of Marketability. The value derived from the guideline analysis is the
freely traded price, that is, the price at which the common stock of the subject company would trade

if it had an active public market.
Clearly, lack of ready marketability makes a stock considerably less attractive than it would be if
it were readily marketable. This was recognized by the IRS in its Rev. Rul. 77-287 when, in dis-
cussing the value of unregistered shares of public companies, it stated: “The discount from the mar-
ket price provides the main incentive for a potential buyer to acquire restricted securities.”
In recent years, appraisers have generally used transactions in the restricted shares of public com-
panies as the best guideline for determining the appropriate discount for lack of marketability. A
number of studies have been made of this market, and they indicate a rather wide dispersion of dis-
counts but most indicate a median discount of about 35%. The two seminal studies, those of Maher
and Moroney, indicated median discounts of 34.73% and 33% respectively.
1
More recent studies
have been made by Willamette Management Associates (median 31.2%) and Standard Research
Consultants (45%). The change in the required holding period of restricted stock has limited the
usefulness of this evidence in the valuation of nonpublic companies.
Willamette Associates has also analyzed the relationship of original public offering prices to
arm’s-length trades during the three years preceding the public offering, which suggests discounts in
the 40% to 60% range.
(ii) Discount for Minority Interest.
The discount for lack of marketability should not be confused
with a discount for minority interest. This chapter has explained the use of publicly held guideline
companies in making a judgment as to the value of stock in a nonpublic company. The prices at which
the common stocks of those guideline companies sell reflect minority interest values; therefore, the
comparative analysis enables the appraiser to express an opinion about the price at which the stock of
the subject closely held company would trade if it had an active public market (the freely traded value).
It is therefore a minority interest value to begin with, and a minority interest discount is inappropriate.
42.2 GENERAL PROCEDURE FOR VALUATION 42
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1

J. Michael Maher, “Discounts for Lack of Marketability for Closely-Held Business Interests,” Taxes—The Tax
Magazine, September 1976, pp. 562–571. Robert E. Moroney, “Most Courts Overvalue Closely Held Stocks,”
Taxes—The Tax Magazine, March 1973, pp. 144–154.
However, the stock of a closely held company is lacking in marketability, and a discount for lack of
marketability is appropriate.
(g) DISCOUNTED FUTURE BENEFITS APPROACHES. A discounted future benefits valuation
involves two fundamental, difficult, and very imprecise steps:
1. The long-term projection of the benefit
2. The determination of an appropriate discount rate, by which the future benefits may be re-
duced to present value
It is essential that the discount rate and the benefit be matched. That is, a dividend or net-free cash
flow discount rate must be applied to projected dividends or net-free cash flow. An earnings discount
rate must be applied to projected earnings. The use of a net cash flow discount rate to discount earn-
ings, for instance, is erroneous.
Data on past rates of return on publicly traded common stocks are readily available and can be
used as a reference point in estimating the appropriate rate of return (dividend or net-free cash
flow discount rate) of a subject company. As a result, discounted future benefits valuations are al-
most always done on the basis of cash flow. The term “net cash flow” is often used, usually in the
context of an enterprise valuation. Because net cash flow is the total cash flow of the business
minus its capital (fixed assets and working capital) needs, it is essentially the same as dividends or
dividend-paying capacity.
The projection of net-free cash flow or dividends is a three-step procedure:
1. Project total cash flow (total revenues less cash expenses)
2. Project the capital needs of the business
a. Project required capital expenditures
b. Project required net working capital changes
3. Compute dividend-paying capacity (total cash flow minus total capital needs)
The general theory used in estimating the expected rate of return is that investors’ return expecta-
tions are based on past returns. In establishing the required rate of return for a nonpublic company,
practitioners almost invariably use long-term stock return data compiled by Ibbotson Associates,

whose Annual Yearbook includes series of stock return data.
In deriving the required rate of return for a subject company, it is first necessary to estimate the
rate of return investors expect on the small companies themselves on the valuation date. Then, if the
appraiser believes that an investment in the subject company is riskier than in the small companies,
he must add an increment to their rate of return to reflect that greater risk. Conversely, if the appraiser
believes the risk is less, the rate of return must be reduced.
The value of stock is the present value of future returns in perpetuity. This axiom requires, at least
theoretically, that future dividends or net-free cash flows be projected and their present value be de-
termined in perpetuity or, as a practical matter, so far into the future that present value increments be-
come insignificant. There are three ways of doing this:
1. The arithmetic method
2. The algebraic method
3. The semialgebraic method
Under the arithmetic method, each year’s dividend is projected and its present value determined
using the expected rate of return. This is done for all future years until the annual present value in-
crements become insignificant. Then the present values are totaled to give value.
In the algebraic method, the appraiser used the Gordon Model, which is:
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VALUATION OF NONPUBLIC COMPANIES