Picture this scenario: Your client, Mr. Enterprise, has asked for your help. His mother, Mrs. Enterprise, died two years ago. The IRS audited her Form 706 Estate Tax Return and raised a question on the valuation of her business, Signs of the Times, an outdoor advertising company with locations primarily in the Northeast and Midwest.
The estate had secured the services of an attorney and CPA to conduct the valuation. The gross sales, prior to her death were approximately $250 million. The net annual income for the 5 years preceding her death was $25 million. The estate tax return pegged the value of the business at $2 million. The IRS accessed a much higher value, $30 million, plus penalties and interest.
Mr. Enterprise’s question is, “Why is there such a disparity between the two values?”
A tool for the transition
Business valuations are used for a variety of purposes. An objective valuation provides the business owner with an important tool for planning an orderly transition. It is a benchmark against which to measure the owner’s personal, business and financial objectives. And it serves to identify viable transition options, including the timing of the liquidity event.
Business valuations are also important for banking, insurance, interfamily transfers, estate taxes and in instances of unexpected major events, such as the disability of an owner. In Mrs. Enterprise’s case, it was used to establish a value on the estate tax return.
In intra-family situations, a business valuation by a qualified appraiser can also help legitimize a transaction. If the value is considered to be less than fair market value, the transaction could thus be then considered a part gift and a part sale. This may cause unintended tax consequences and affect other planning.
Where there is a transfer among family members, for example, between parents and children or grandparents and grandchildren, the purchase price may come under close scrutiny by the IRS, even if an appraisal has been conducted that produced the valuation amount.
Thus, if a buyer and seller are related, the purchase price or valuation may not be viewed as indicative of fair market value. This is because the parties are not deemed to be “economically self-interested” to make a true arms-length transaction.
A lack of arm’s length dealing may have numerous other tax consequences that create unpleasant results. Many of these consequences result from the finding that the value of the property being questioned was different from the price actually paid due principally to the fact that the parties were related to each other. This includes, but is not limited to, increasing the value of the assets in the estate thus increasing the estate tax exposure, decreasing the amount of valuation discounts or changing the amount of marital and/or charitable deductions.
There are a number of key factors that impact the value of a business, such as the company’s strengths and weaknesses, profitability, competitive and geographic factors, unique aspects of its products or services, and “intangible” aspects of the enterprise. Past performance is reviewed and future potential is assessed. External factors such as the economy, industry trends, the mergers-and-acquisitions marketplace and current trends in the acquirer community are also examined.
A landmark case