Discount for Lack of Marketability in Pass-Through Entity Valuations

Discount for Lack of Marketability, applied to a pass-through entity interest, measures the gap between what a public shareholder can do (sell in seconds, at a known price) and what an LLC member or limited partner cannot do at all without a buyer, a lawyer, and often months of waiting. The International Glossary of Business Valuation Terms defines marketability as "the ability to quickly convert property to cash at minimal cost." Public shares set the baseline against which DLOM gets measured; fair market value work usually starts with public market data, and DLOM exists to correct that data for the reality of a private, illiquid interest.

A pass-through entity looks, at first glance, like any private company that needs a haircut applied to it. Yet three things set PTEs apart from an ordinary private C-corp stake. Ownership transfer runs through operating agreements, partnership agreements, or buy-sell provisions, not an open market, so there's no bid-ask spread to observe anywhere. Comparable transaction data on PTE interests specifically is thin, which limits price discovery in a way that a minority stake in a private manufacturer taxed as a C-corp doesn't face. And the tax character of the entity travels with the interest: a buyer isn't just acquiring a claim on cash flow, they're taking on pass-through tax obligations a C-corp shareholder never sees. Put those three together and the marketability analysis for a PTE interest gets more fact-intensive than the comparable exercise for a C-corp minority stake. It isn't a lookup-table job, and the discount has to be earned, interest by interest.

How DLOM and DLOC interact, and why the sequencing matters for PTEs

DLOC and DLOM get mixed up constantly, and the mix-up does real damage in a valuation report. DLOC captures the inability to control decisions: distributions, sale of the company, hiring and firing management. DLOM captures the inability to turn the interest into cash on reasonable terms. Related ideas, but not the same idea, and treating them as interchangeable is where appraisals start to come apart at the seams.

Sequencing matters because the two discounts multiply rather than add. DLOM gets applied after DLOC, to a base that DLOC has already shrunk. Get the order backward, or apply both to the same starting number, and the combined discount comes out too large. Courts have grown wary of stacked discounts that look too convenient, and the burden sits with the appraiser to show, step by step, how each discount was pulled apart from the other.

Here's the discipline, easy to state and hard to actually do: separate the value effect of governance rights from the value effect of exit difficulty, and write that separation down so a reviewer can follow it. For PTEs this is harder than it sounds, because operating agreements often restrict control and transfer in the same clause. A provision limiting a member's voting rights while also blocking a third-party sale is doing two jobs at once, and the appraiser has to pull those jobs apart instead of lumping the whole clause into one discount or the other.

What empirical evidence actually underlies DLOM estimates

Two bodies of empirical work anchor most DLOM conclusions: restricted stock studies and pre-IPO studies.

Restricted stock studies compare what buyers paid for unregistered, restricted shares in a private placement against the market price of the same company's registered, freely tradable shares. The Stout Restricted Stock Study is the resource most appraisers reach for first, according to surveys run by Business Valuation Resources. As of March 2024, the Stout database held 779 transactions, with an overall average discount of 20.4% and a median of 15.6%. Patrick Polomsky of Stout, on a BVR webinar, named the obvious trap directly: averaging the whole database and calling the result a DLOM isn't defensible methodology. The data has to be filtered and tested against the specific characteristics of the subject interest, because it isn't one number that fits every engagement.

Pre-IPO studies work a different angle: they compare prices paid for shares before a company's initial public offering against the eventual offering price. Willamette Management Associates has documented a wide range of discounts here, generally running higher than what the restricted stock studies show, which tracks with the longer holding periods and thicker uncertainty built into pre-IPO deals.

Quantitative option-pricing models offer a third lens, treating illiquidity as the economic equivalent of losing a put option on the interest. The Longstaff model tends to produce a theoretical upper bound, useful for bracketing a range but not something an appraiser should hand over as a point estimate on its own. The Finnerty model lands toward the lower end of the defensible range and often gets weighted alongside the empirical studies to land on a balanced number. In both models, the inputs that move the output most are expected holding period and volatility: longer lock-ups and higher volatility both push the discount up.

None of these methods carries the analysis alone. Triangulating across studies and models is standard practice, and a PTE appraisal leaning on one database average will not survive IRS scrutiny.

Why tax-affecting is inseparable from the DLOM question in PTE valuations

Tax-affecting means applying a hypothetical corporate income tax rate to a pass-through entity's earnings, so those earnings can be measured against the C-corporation benchmarks used in income and market approaches. It connects straight to DLOM because DLOM gets applied to a value conclusion, and if that conclusion rests on earnings tax-affected incorrectly, or not tax-affected at all, the DLOM percentage is sitting on a foundation that can't hold the weight.

The history is contested and worth knowing. Tax courts disallowed tax-affecting for roughly two decades following Gross v. Commissioner. That changed in 2019, when a U.S. District Court in Kress v. Commissioner accepted tax-affecting for an S corporation valuation; both the taxpayer's expert and the IRS's expert had tax-affected their analyses, and the court sided with the taxpayer's overall conclusion. Kress also delivered a concrete number on DLOM sizing: the court trimmed the original appraiser's DLOMs by roughly 3 percentage points, landing on discounts of 25% to 27% depending on the year.

The landscape didn't settle into agreement after Kress, though. In Jones v. Commissioner, the Tax Court found tax-affecting appropriate under the income method, using a combined federal and state C-corporation rate. Then in Jackson (2021), the Tax Court rejected tax-affecting outright, proof that the post-Kress environment still has real disagreement baked into it. The fight today centers mostly on the rate to use, whether an S-corporation premium belongs in the calculation, and what DLOC and DLOM levels fit the facts. Narrower fights, but no less technical for it. An examiner may still reason from the Gross framework, so documenting the tax-affecting rationale clearly is the first line of defense against that.

Transfer restrictions in governing documents and what IRC §2703 does to them

Operating agreements and buy-sell agreements routinely block transfer of a PTE interest to outside parties, a feature that rarely shows up in C-corporation share structures of similar size. These restrictions support an elevated DLOM for a plain reason: they shrink the pool of potential buyers and stretch out the expected holding period.

There's a trap buried in here, and it catches appraisers who don't watch for it. Under IRC §2703(a), family transfer restrictions have to be backed by evidence of comparable arm's-length transactions to survive an IRS challenge. Absent that evidence, the statute requires the restriction to be disregarded entirely for valuation purposes. An appraiser who cites a family transfer restriction to justify an elevated DLOM, without lining up arm's-length comparables to back it, loses the very support the restriction was supposed to provide.

The fix is to document the arm's-length comparables explicitly whenever the governing documents are doing the heavy lifting on DLOM. The restriction doesn't speak for itself, not to the IRS. It's also worth a second look for how it interacts with DLOC: if the same clause blocks a member from forcing distributions or triggering a buyout, part of its value effect belongs in the DLOC analysis, not the DLOM.

How distribution policy shapes DLOM for pass-through interests specifically

A minority shareholder in a C-corporation who receives no dividend bears no current tax cost from that, because the corporation pays entity-level tax itself. PTE structures carry a different exposure entirely. Partners and S-corporation shareholders get allocated taxable income whether or not cash actually reaches them, and that creates a phantom income problem for anyone holding an illiquid interest. A buyer stepping into that position, with no guarantee that distributions will cover the tax bill on income allocated but never received, is taking on real economic risk beyond plain illiquidity.

That risk shows up directly in the DLOM. An inconsistent or absent distribution history tells a buyer they may end up funding tax obligations out of pocket, and an operating agreement silent on distribution policy makes it worse. A documented distribution history, especially one tied explicitly to covering estimated tax obligations, pulls this piece of the discount back down.

The IRS Job Aid for DLOM lists dividend history and policy as one of nine factors in its framework. For a PTE, this factor carries more weight than the generic framework suggests, given the phantom income exposure that C-corp shareholders never face. A working checklist: review the operating agreement for mandatory tax distribution language, pull three to five years of actual distribution history, and check whether those distributions have consistently matched partners' estimated tax obligations.

Size, financial health, and management quality as DLOM calibrators

Size cuts in a predictable direction. Larger enterprises draw more potential buyers, which shortens search costs and expected holding period, both of which push DLOM down. Smaller PTEs face the opposite: a thinner buyer pool, higher transaction costs relative to deal size, and heavier due diligence for anyone considering a purchase, all pushing DLOM up. The size of the interest matters too, apart from the size of the enterprise itself. A larger minority stake can be more marketable than a small fractional interest, simply because it carries more practical influence even without control.

Financial health works along the same lines. Strong profitability, a solid balance sheet, and steady revenue all lower a buyer's perceived risk of getting stuck holding the interest for years. A distressed PTE commands a higher DLOM almost by definition: fewer willing buyers, longer marketing periods, more uncertainty around what price the interest would actually fetch.

Management quality deserves its own look. A PTE that leans heavily on a single owner-operator carries key-person risk, and that risk stretches out the expected marketing time for the interest. Documented succession planning, or a professional management team already in place, cuts that risk and, with it, the DLOM.

None of this exempts controlling interests. A controlling stake in a PTE still warrants a DLOM, because the timing and ultimate price of a sale stay genuinely uncertain even when a holder can direct the company's affairs. No empirical dataset pins down the controlling-interest DLOM with precision, but appraisers generally agree it should sit meaningfully below the discount applied to a minority interest in the same entity. A recent Iowa appellate decision, In re Marriage of Baedke (August 2024), affirmed a marketability discount on a controlling interest in a garden center in a divorce proceeding, a fresh judicial nod to the concept.

How governance dysfunction and litigation independently support an elevated DLOM

A PTE's governing documents, or the gaps in them, tell a hypothetical buyer exactly how hard ownership is going to be. Harder ownership means a longer expected hold and fewer people willing to buy in.

A handful of red flags signal this kind of dysfunction: an operating agreement silent on buyout triggers, distribution waterfalls, or deadlock resolution; active litigation among owners; a history of disputed distributions or capital calls; unclear or contested management authority. Any one of these stretches out the time a buyer needs to plan for, and stacks extra risk onto the purchase.

Two recent cases mark the edges here. In Estate of Fields v. Commissioner (T.C. Memo. 2024-90), the estate claimed a 15% DLOC and a 25% DLOM on a family limited partnership's limited partner interest. The court denied both discounts entirely, because the arrangement lacked adequate economic substance to begin with, regardless of whether the discounts themselves were calculated correctly. That's worth sitting with: governance failures can wipe out discounts rather than support them, when the underlying arrangement can't survive scrutiny on its own terms.

Rosenblum v. Treitler, decided by the First Department on October 7, 2025, went the other way. The court affirmed a 15% DLOM on LLC interests in a real estate holding company, after a contested dispute over whether the analysis should run at the member level or the enterprise level. The affirmance gives practitioners a current precedent for how DLOM applies to LLC structures specifically. Read together, Fields and Rosenblum draw the same line from two directions: governance dysfunction has to be real and documented, not a story laid over an arrangement that doesn't hold up on its own.

What makes a DLOM conclusion defensible when the IRS or a court reviews it

The IRS Job Aid for DLOM, published by IRS Large Business and International, lays out the examiner's framework directly. Appraisers who skip past its nine factors leave gaps an examiner will find and use.

A defensible DLOM conclusion in a PTE engagement has to show its work across four areas. Method selection needs a stated reason for why the chosen studies and models fit this particular entity, not a default to whichever average gets cited most often. Factor analysis needs to address each Job Aid factor explicitly, with the PTE-specific issues, distribution policy, transfer restrictions, tax character, treated on their own terms instead of folded into generic language. Tax-affecting documentation needs a clear, reasoned position on whether earnings were tax-affected and at what rate, written with an eye toward both the post-Kress consensus and the chance of a Gross-style challenge. And discount sequencing needs to show DLOC applied before DLOM, with no overlap counted twice.

Kress offers a lesson on precision worth remembering: even after accepting the taxpayer's overall methodology, the court still trimmed the DLOMs by about 3 percentage points. Precision in support matters as much as the methodology itself. Fields offers the harder lesson: a technically sound discount analysis bolted onto a defective arrangement earns nothing, because economic substance in the entity itself has to exist before any discount even gets considered.

DLOM in a pass-through entity valuation is a conclusion built fact by fact. It's defensible only to the extent the appraiser can show exactly how each piece of it was reached, and it should never be a plug figure or a range pulled from a database and left unexamined.