CAP Financial Analysis & Valuation 2 — Questions and Answers
Question 1: When valuing a closely held business interest for charitable gift planning, which factors does Revenue Ruling 59-60 require consideration of?
- Use of book value as the primary valuation method
- Eight factors including earnings capacity, dividend-paying capacity, goodwill, and prior arm's-length sales of the stock (Correct answer)
- Automatic application of a 40% minority discount
- Reliance exclusively on the comparable company method
Correct answer: Eight factors including earnings capacity, dividend-paying capacity, goodwill, and prior arm's-length sales of the stock
Revenue Ruling 59-60 identifies eight factors for valuing closely held business interests including the nature of the business, economic outlook, book value, earnings capacity, dividend-paying capacity, goodwill, prior sales, and market prices of comparable companies.
Rev. Rul. 59-60 requires a multi-factor analysis rather than any single mechanical formula. Appraisers may weight the income approach (capitalization of earnings), market approach (comparable companies), or asset approach (adjusted book value) differently depending on the business. For charitable gift purposes, the qualified appraisal must use this methodology, and undervaluation can result in accuracy-related penalties.
Question 2: A donor wishes to contribute a limited partnership interest to a charitable organization. Which concern is most important for the CAP advisor to address first?
- Whether the partnership distributes income monthly or quarterly
- Whether the partnership agreement permits transfer of the interest, and whether the charity can hold it without incurring UBTI (Correct answer)
- Whether the donor has held the interest for more than one year
- Whether the charity's investment policy permits alternative investments
Correct answer: Whether the partnership agreement permits transfer of the interest, and whether the charity can hold it without incurring UBTI
Limited partnership interests often have transfer restrictions and may generate UBIT for the charitable recipient—these structural issues must be resolved before the gift can proceed.
Partnership interests may be illiquid, have transfer restrictions requiring general partner consent, and generate UBTI from debt-financed income or operating income. If the charity receives UBTI, it may owe UBIT, reducing net benefit. Additionally, if the interest has associated liabilities, the charitable deduction may be reduced under the bargain sale rules.
Question 3: In the context of charitable gift annuities, the exclusion ratio determines:
- The percentage of the annuity payment that is a tax-free return of the donor's basis (Correct answer)
- The maximum percentage of gift value the charity retains for its mission
- The proportion of annuity payments subject to UBIT
- The ratio of charitable deduction to total gift value
Correct answer: The percentage of the annuity payment that is a tax-free return of the donor's basis
The exclusion ratio for a charitable gift annuity is the portion of each annuity payment that represents a tax-free return of the donor's investment, calculated by dividing the investment in the contract by the expected return.
For a CGA funded with cash, each payment has three components: tax-free return of basis using the exclusion ratio, ordinary income for the remaining amount until expected life, and after life expectancy all payments become ordinary income. For appreciated property gifts, there is also a capital gain element spread over the donor's expected life.
Question 4: A donor-advised fund sponsor must exercise which control over DAF assets after the donor's contribution?
- The sponsor must follow all donor grant recommendations without review
- The sponsor has exclusive legal control over DAF assets and must independently evaluate grant recommendations (Correct answer)
- The sponsor must distribute funds within 12 months of contribution
- The sponsor is prohibited from investing DAF assets in pooled investment funds
Correct answer: The sponsor has exclusive legal control over DAF assets and must independently evaluate grant recommendations
The DAF sponsor (public charity) has exclusive legal control over contributed assets; it evaluates donor grant recommendations and may reject those that do not satisfy charitable purposes—this control is what makes the donor's contribution irrevocable and immediately deductible.
Under IRC 4966, DAF sponsors must exercise expenditure responsibility when making grants to non-public charities. If the sponsor merely rubber-stamps donor recommendations without independent judgment, the IRS may challenge the deductibility of contributions. In practice, reputable sponsors reject a small percentage of recommendations, such as those to foreign organizations without equivalency determinations.
Question 5: Which financial metric is most relevant when assessing whether a nonprofit is overly dependent on a single funding source?
- Current ratio
- Revenue concentration ratio—the percentage of total revenue from the largest source (Correct answer)
- Net asset growth rate
- Program expense ratio
Correct answer: Revenue concentration ratio—the percentage of total revenue from the largest source
Revenue concentration measures what percentage of total revenue comes from any single source; high concentration signals financial vulnerability to that source's withdrawal.
Sophisticated donors and foundations assess revenue diversification when making grants. An organization with 70% of revenue from one government contract faces existential risk if that contract is not renewed. CAP advisors examining potential nonprofit partners review revenue diversity across individual gifts, foundation grants, government contracts, earned revenue, and investment income.
Question 6: The concept of program-related investments (PRIs) allows private foundations to:
- Invest endowment assets in impact-oriented public equities
- Make loans or equity investments in charitable projects that count toward the 5% minimum distribution requirement (Correct answer)
- Avoid UBIT on income from mission-aligned businesses
- Convert restricted grants into unrestricted operating support
Correct answer: Make loans or equity investments in charitable projects that count toward the 5% minimum distribution requirement
PRIs are investments whose primary purpose is to accomplish charitable objectives; they count toward the foundation's 5% minimum distribution requirement and are not treated as jeopardizing investments.
Under IRC 4944, a PRI must have a primary purpose of accomplishing one or more charitable purposes, with no significant purpose of producing income or appreciation. Examples include low-interest loans to affordable housing developers, equity investments in community development financial institutions, and loan guarantees to social enterprises. Once the charitable purpose is served, PRIs can be recycled for new charitable uses, making them an efficient tool for mission-aligned capital deployment.
CAP Financial Analysis & Valuation 2
When valuing a closely held business interest for charitable gift planning, which factors does Revenue Ruling 59-60 require consideration of?