What general principles govern small business valuation?

The fair market value of any interest in an “unmarketable business,” whether it is structured as a partnership, corporation, limited liability company, or a proprietorship, is the amount that a willing buyer, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts. The net value is determined on the basis of all relevant factors, including the following:

(1)The value of all the assets of the business, tangible and intangible, including goodwill;

(2)The demonstrated earning capacity of the business; and

(3)The other factors set forth in the regulations relating to valuation of corporate stock, to the extent applicable.

Adequately determining the value of a small business’ “goodwill” requires special attention, as it is an especially fact intensive determination. Complete financial and other data upon which the valuation is based should be submitted with the relevant tax return, including copies of reports of examinations of the business made by accountants, engineers, or any technical experts as close to the applicable valuation date as possible.[2]

Professional appraisers, courts and the IRS generally follow the principles laid out in Revenue Ruling 59-60 when valuing the stock of a closely-held corporation or the stock of corporations where market quotations are not readily available. The factors outlined in Revenue Ruling 59-60 also apply in valuing interests of other business entities, such as closely-held partnerships or LLCs, for gift tax or estate tax purposes.

In the case of small business stock, where actual sale prices and bona fide bid and asked prices of the security of a closely held or other corporation are unavailable, fair market value (fmv) of the security is determined by taking into consideration the soundness of the security, the interest yield, the date of maturity and other relevant factors. In the case of shares of stock, fmv is determined by taking the company’s net worth, prospective earning power and dividend-paying capacity, and other relevant factors into consideration. In each case, “other relevant factors” include, but are not limited to: the goodwill of the business; the economic outlook of the particular industry; the company’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange.

Typically, in a valuation challenge today, the courts will adopt a “winner take all” approach, rather than seeking a compromise position between the two parties’ competing valuation proposals. This is because the Tax Court has found that the “compromise the difference” approach that was historically used by the courts merely encouraged the parties to assert extreme values, forcing the courts to determine a reasonable middle ground between those two extreme positions. The IRS has adopted the “winner take all” approach due to a 1980 case finding that the parties were fully capable of reaching an agreement themselves in order to avoid the judicial process (and the related expenses) altogether. Therefore, the court reasoned that the threat that the other party’s valuation approach would be adopted in its entirety would motivate more careful analysis by the parties before resulting to judicial intervention. This is the approach that the majority of courts now take with respect to valuation decisions.

How does the existence of a buy-sell agreement impact small business valuation?

A buy-sell agreement can function as an important business succession planning tool, as it allows the business owners to plan for the orderly withdrawal of one or more business owners and will specify a predetermined method for determining the price of the business interests. Despite this, IRC Section 2703 provides that the value of any interest must be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to the option, agreement, or other restrictions) or any restriction on the right to sell or use the property (i.e., buy-sell agreement), unless the agreement meets the following requirements:

(1)   It is a bona fide business arrangement;

(2)   It is not a device to transfer the property to members of the decedent’s family for less than full or adequate consideration; and

(3)   It has terms comparable to those entered into by persons in an arm’s length transaction.

Assuming these requirements are met, it is possible that the estate tax value of a business interest (including closely-held stock) may be controlled by the price or formula contained in a buy-sell agreement.

Though the facts of each case must be examined to determine whether the agreement price will be accepted for estate tax purposes, case law has established that if the following conditions are met, the agreement price will hold, even though the fair market value of the business interest may be substantially more at the valuation date than the agreement price:

(1)The estate must be obligated to sell at death (under either a mandatory purchase agreement or an option held by the designated purchaser;

(2)The agreement must prohibit the owner from disposing of his interest during his lifetime at a price higher than the contract or option price;

(3)The price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price; and

(4)The agreement must be an arm’s length business transaction and not a gift. Thus, the purchase price must be fair and adequate at the time the agreement is made, particularly if the parties are closely related.

Therefore, the price set in a buy-sell agreement was found to control valuation issues in a number of cases involving estate tax valuation where these requirements were satisfied. For gift tax purposes, however, an agreement restricting lifetime sale will be considered with all other pertinent factors, and may tend to lower the value of the business interest. If a business purchase agreement calls for shares to be purchased from an estate with installment purchase notes bearing a rate of interest lower than the market rate at the date of death, an executor may be allowed to discount the value of the shares by the difference between the interest rate called for in the buy-sell agreement and the prevailing rate at the date of death. The IRS has ruled privately that it was relevant that (1) the purchaser was to buy the stock by means of installment payments plus interest over a 30-year period, and (2) the market rate of interest increased substantially from the time of the buy-sell agreement to the time of the decedent’s death. The estate had no right to the payment of interest or principal on the promissory note until each installment came due.

A first-offer agreement, under which survivors have no enforceable right to purchase the business interest and can purchase the interest only if the executor wishes to sell, does not fix the value of the interest for estate tax purposes.

If an agreement is between closely related persons and is found to be merely a scheme for avoiding estate taxes, the price set in the agreement will not control. A buy-sell agreement is not binding unless it represents a bona fide business agreement and is not testamentary in nature. An agreement may be found to be a scheme for avoiding estate taxes, however, even if it also serves a bona-fide business purpose.

No effect will be given to an option or contract under which a decedent is free to dispose of the interest or shares at any price he or she chooses during life. On the other hand, an agreement that restricts sale during life, but not at death, also will fail to fix the estate tax value.

— Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017