Tax Issues in Business Valuation

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