The valuation of large, publicly traded companies such as those found on the New York Stock Exchange is usually set by the buyers and sellers in the market through active trading. This price is generally accepted as the fair market value. With a closely held business, however, there isn't an active market for the stock, so valuation becomes much more challenging. A determination of the value of your business should be conducted for gift or estate tax purposes or to engage in the sale of your business.
Determine capital gain
When you sell your business, the difference between your basis and the price you receive is your capital gain. Your gain must be reported and is subject to capital gain tax. A properly conducted business valuation can ensure that the price at which your interest is sold represents fair market value and that your tax liability is correct.
Sale of business to family member
You may be selling your business interest to a family member. You should be aware that the IRS tends to carefully examine this type of sale in search of disguised gifts. If the IRS determines a higher value for your business than the sale price you used, you might very well be liable for gift tax on the difference between the two values. Further, it usually takes a couple of years before the IRS challenges the value, and your additional tax liability may be compounded by accrued interest and penalties. A valuation by a qualified appraiser could avoid this potential problem.
Sale of business to outsider
If you are planning to sell your business to a nonfamily party, you may want to receive the highest amount possible. An independent evaluation may help you to achieve this objective while at the same time assuring the buyer that the price being paid is fair. Without a valuation from an independent, qualified appraiser, it might be harder to attract buyers due to the perception that the business is being overvalued by the seller. The timing and circumstances of the sale will also have an impact on the value. A forced liquidation or sale (one where the money is needed fast) will generally result in a lower valuation and price received.
Transfer of business under buy-sell agreement
If you have a buy-sell agreement for your business, you already have a buyer for your interest upon the occurrence of certain events. If correctly done, your buy-sell may have been specially drafted to establish taxable value. The terms of your buy-sell may require a periodic valuation of the business. When an interest changes hands under the agreement, a valuation is needed for the price exchanging hands, which sets the tax basis for the buyer and the capital gain of the seller.
Transfer of interest by gift
Part of your estate planning strategy may be to transfer your business interest by gift. Gifts of a certain size are not subject to gift tax. In order to determine if you must pay gift tax (and, if so, how much), you need to know the value of the gift. Any time a business interest is transferred by gift, a valuation should be conducted to document the gift tax value and reduce the risk of the IRS changing the value of the gift upon a later audit.
Tip: Do the valuation as closely as possible to the date of the gift.
Estate tax purposes
A business valuation may be required when an owner dies. A valuation at this point can ensure that all applicable discounts are reflected in the value. It is also of major importance in determining the estate tax liability. The last thing your estate needs is to be subjected to an IRS audit and have poor (or no) documentation of the business valuation used in the estate tax return. If the business has a buy-sell agreement, a valuation may be needed to calculate the price at which the interest will be sold to the buyer named in the agreement.
Determining the value of your business is not something you should attempt on your own, especially in light of the fact that the IRS could challenge your valuation. There are appraisers who specialize in determine the value of businesses. Your CPA may even be one of these specialist or can recommend someone who is.