Why business valuations are a key ingredient in business succession planning
by Steve Goodman
CPA, MBA – President & Chief Executive Officer
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Most business owners do not routinely concern themselves with the value of their business unless they have plans to sell. Many may be curious, but when they hear a price tag to obtain a formal business valuation, pragmatic thinking overrides curiosity. The cost of a formal business valuation can rival that of a financial audit.
Business valuations are a key ingredient in the business succession process. Attorneys and financial advisors need an understanding of the business owner’s estate status. Closely held businesses typically represent a large fraction of their owner’s total estate. The same people also need a valuation that will withstand IRS scrutiny. Certain succession strategies involve sales to children or others. These sales must be based on a business valuation to separate a gift from a legitimate sale.
Even in a friendly transaction between a business owner and his/her chosen buyers, there is a desire for all parties to know the value of the business. Almost all external accountants provide tax advice to their clients, but only a few are involved in strategic planning and valuation strategies. Valuation analysts are often the only external professionals to assess future market conditions and a company’s competitiveness in a formal document. Valuation analysts work closely with financial planners and attorneys to recommend financial engineering strategies that can yield desired valuations.
The following material was adapted from Business Succession Planning, written by Steve Goodman, CPA in 2014. Mr. Goodman is Long Island, NY based estate planning professional with over 25-years experience in business succession planning and related fields.
Business Succession Planning
Developing a Business Valuation
It is important to understand that business valuations are an art form, not a science. There really is no exact measure for valuing a closely held business. There are well-established methods, such as the capitalization of earnings method, discounted future earnings method, and book value plus goodwill, that appraisers use depending on which method most accurately reflects the value of that particular business. You can even estimate the value of a business using rules of thumb that tend to apply to businesses that are similar.
For example, a typical manufacturing business may have a value equal to two and a half to three times EBITDA. But these only provide a starting point, and the actual fair-market value will largely depend on the specifics of the business itself, the current economic environment, whether the interest being transferred is restricted, whether it contains voting rights, whether it is a minority or majority interest, etc.
The reason you are seeking a valuation will also play a role. If you are selling to an unrelated third party, you will want the appraiser to use a value that generates the highest value. If you intend to gift an ownership interest to family members, you will want the appraiser to use the method that generates the lowest justifiable value for gift tax purposes (justifiable to the IRS). And yes, reasonable valuations may vary quite a bit.
The Artist and Artistry of Business Valuation
To further my point about the wide disparity in value a particular business may have, consider the case of Estate of Thompson, T. C. Memo 2004-174 (July 26, 2004). This case involved a question over the value of the voting common stock of Thomas Publishing Co., Inc. for estate tax purposes.
On the estate tax return, the taxpayer claimed value for the stock of $1,750,000. To support its valuation, it provided a report prepared by a lawyer and an accountant from Alaska, which is interesting since the business was located in New York. The government disagreed with the value reported by the taxpayer and, based on its own experts’ analysis, claimed that the true value of the stock in question was $35,273,000. That was not a typo—two sets of “experts” disagreed on the value of the stock by $33.5 million.
The tax court didn’t agree with either valuation, stating, “We find both the estate’s and respondent’s valuations to be deficient and unpersuasive in calculating the fair market value of TPC as an entity and in calculating the fair market value of the estate’s 20 percent interest therein.” ]The court concluded that the estate’s experts weren’t even qualified to be making an appraisal of such a business, that the experts used by the IRS didn’t look closely enough at the business itself, and determined that the value of the stock at the date of death was actually $13,525,240.
The example above is not an anomaly in the world of business valuations. More often than not, it is the norm. In Estate of Kohler, T. C. Memo 2006–152 (July 25, 2006), the estate reported a value of $47 million for a business interest owned by Mr. Kohler upon his death. The IRS audited the estate tax return and claimed that the shares had a fair market value of $144.5 million—a difference of almost $100 million! The taxpayer was not only facing additional estate taxes on the difference in the valuation (at a rate of 50 percent), but the IRS also levied an $11 million accuracy-related penalty—so the stakes were pretty high.
As typically happens, it came down to a battle of the “experts.”In this case, the court stated, “We are impressed by the valuation methodologies and conclusions of (the estate’s experts). Both are certified appraisers who spent sufficient time with the company and management to understand the Kohler business.
They used the correct projection to value the business, the realistic and accurate management plan, as a result of their understanding of Kohler.” With regards to the valuation provided by the IRS experts, the court stated, “We give no weight to the respondent’s expert valuation of the estate’s stock. Respondent failed to introduce any evidence or present any arguments to persuade us that the value reported on the estate’s tax return was incorrect, and accordingly, respondent has failed to meet his burden of proof.”
The court concluded that the value of the stock was exactly what the taxpayer had initially claimed on its estate tax return—$47 million. The taxpayer passed away in March of 1998; the court filed its decision in July 2006—more than eight years later. Imagine the turmoil that the family had to endure during these eight years, as some $60+ million that they expected to receive, much of which was tied up in the family business, may have been headed to the federal government.
The Cost of a ‘Bad’ Valuation
One of the greatest risks with an improper valuation of a business is the federal gift tax. While the past decade has brought numerous changes and much confusion over the gift tax, the American Taxpayer Relief Act of 2012 established a set of rules that were drafted to be permanent. The gift tax exclusion and estate tax exclusions changed with the passage of the Tax Cuts and Jobs Act of 2017.
The 2018 levels include a gift tax rate of 40 percent, a lifetime exemption of $11.2 million per person, annual gift tax exclusions of $15,000 per recipient, indexing of the lifetime exemption and annual exclusions, and portability between spouses, which means spouses have a total lifetime exemption of $22,400,000.As a result, the federal gift tax will not apply to the vast majority of business owners who wish to gift all or a portion of their business to family members.
For those who own a business valued at or above the exemption levels, it is important to note that the IRS is very aware of the fact that affluent taxpayers often undervalue gifts to family members—in fact, the IRS pretty much assumes they will, so red flags go up when they see a sizeable gift made to family members. As a result, be prepared to justify any gift of a business interest made to family members.
The IRS will be especially leery about any sale of a business interest to a family member as well. Should the IRS feel that the sales price was too low, it will deem the difference between the sales price and what it feels is the appropriate fair-market value to be a gift and attempt to levy gift taxes. As illustrated by the Kohler case above, even if the IRS is way off base on its valuation, you may end up in tax court having to argue your case. Your best protection is a well-documented business valuation completed by a qualified appraiser.
The IRS has stated that the valuation of property for transfer tax purposes (estate, gift, and generation-skipping taxes) is based upon the “price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” (Treas. Reg. § 20.2031–1(b); Treas. Reg. § 25.2512–1). If you want something more specific, we can look at Revenue Ruling 59-60, in which the IRS states the following:
SEC. 3. APPROACH TO VALUATION.
.01 A determination of fair-market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science.
A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter the process of weighing those facts and determining their aggregate significance.
SEC. 4—FACTORS TO CONSIDER
The following factors, although not all-inclusive, are fundamental and require careful analysis in each case:
- The nature of the business and the history of the enterprise from its inception
- The economic outlook in general and the condition and outlook of the specific industry in particular
- The book value of the stock and the financial condition of the business
- The earning capacity of the company
- The dividend-paying capacity
- Whether or not the enterprise has goodwill or other intangible value
- Sales of the stock and the size of the block of stock to be valued
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter
Oftentimes, I will hear from clients that they have a buy-sell agreement that includes a value (or formula to determine value), and they have been told that they can rely on this value as the value the IRS will agree to for estate and/or gift tax purposes. However, pursuant to IRC section 2703(b), the value of a business as stated in a buy-sell agreement entered into between the owners of the business may set the value of the business for estate and gift tax purposes only if
- It is a bona fide business arrangement.
- It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
- Its terms are comparable to similar arrangements entered into by persons in an arms-length transaction.
In other words, if you have a family business and decide to enter a buy-sell agreement with other family members in which the value of the business is set at a value lower than its true fair-market value, don’t expect that valuation to hold up against IRS scrutiny.
It’s All in the Details
As you consider your goals for transitioning your business and how the value of your business relates to your goals, keep in mind that there are myriad factors not on the balance sheet that may cause the value to be adjusted upward or downward. These include minority interest and lack of marketability discounts, tax affecting for S corporation earnings, the effect of unrealized capital gains, market absorption, control premiums, etc.
The value of your business based simply on your current balance sheet without any adjustments may not reflect an accurate value. It is always a good idea to seek advice from an advisor qualified to recognize where adjustments may be made to your advantage.
In some cases, the IRS has developed very specific rules relating to valuation. For example, substantial tax benefits may be achieved by donating a business interest to a charity or private foundation. In this case, the business owner is looking for a higher value, not a lower one. If the asset being donated is greater than $10,000 in value, in order to claim a deduction for your contribution, the IRS requires an appraisal of the asset to be completed by a qualified appraiser. A qualified appraiser is an individual who meets all the following requirements:
The individual either
- a. Has earned an appraisal designation from a recognized professional appraiser organization or demonstrated competency in valuing the type of property being appraised or
- Has met certain minimum education and experience requirements.
- The individual regularly prepares appraisals for which he or she is paid.
- The individual demonstrates verifiable education and experience in valuing the type of property being appraised. To do this, the appraiser can make a declaration that, because of his or her background, experience, education, and membership in professional associations, he or she is qualified to make appraisals of the type of property being valued. The declaration must be part of the appraisal. However, if the appraisal was already completed without this declaration, the declaration can be made separately and associated with the appraisal.
- The individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the three-year period ending on the date of the appraisal.
In addition, the rules list a host of individuals who may not be qualified appraisers including the donor, the donee, a party to the transaction, a person employed by the donor or donee, a person related to or married to the donor, and others.
An accurate business valuation will also be required if your plans include a transfer of ownership to key employees as compensation. Unless the ownership interest is transferred to the employee with restrictions (i.e., a restricted stock plan), the employee will recognize income tax based on the fair market value of the interest (IRC section 83) and the business will be able to deduct the fair market value of the interest transferred as long as it is “reasonable”(IRC section 162).
Not every business will require a formal valuation. There are times when a rule of thumb analysis may be appropriate, times when some basic calculations using established valuation formulas may be appropriate, and times when you will be best served by obtaining a formal business appraisal. A business valuation performed by a person competent to testify in tax court can be an expensive exercise.
If challenged by the IRS, a minority partner, a buyer, or someone else and their attorney, a professional valuation can sway the argument. The need for a formal valuation should be a matter for discussion between a business owner and the owner’s legal and financial advisors.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.