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Determining the Value of Your Business

Business valuation is a critical component to your estate or business succession planning. Your business may be your largest asset, and if you plan to engage in either one of these types of planning, at some point you will need to determine the taxable value of your business.

The basic concept of valuation is to determine a justifiable dollar value or price for a total or partial interest in your closely held business. It is the process of answering the question, "How much is your closely held business worth?" Business valuation plays a critical role in determining gift and estate tax liability and/or the appropriate selling price for an interest. Because valuing a business is so important, you should be very careful when selecting an appraiser.

What is the importance of determining taxable value?

The IRS is very interested in taxable value

Perhaps a key reason to be concerned about the taxable value of your business is the Internal Revenue Service (IRS), which is always on the lookout for sales at below and even above fair market value. If you sell something for less than fair market value, the IRS could deem the transaction a combination sale and gift and charge you gift tax on the difference between the value you received and the value the IRS calculated. Likewise, a sale at above fair market value could be deemed a gift (subject to gift tax) from the buyer to you.

Your tax liability depends on it

The value applied to your business bears an important and direct relationship to the amount of tax you will owe, whether it be capital gains tax resulting from a sale, gift tax on shares you have given away, or estate tax on property you own at your death. If the value determined by the IRS is different than the value your tax was calculated on, you (or your estate) could be liable for additional tax.

Why a valuation might be needed

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.

This material has been prepared solely for general  informational purposes, and it does not constitute tax, legal, or accounting advice. Nor does it represent, in any manner, a solicitation, offer, or endorsement of any banking or financial product, a guarantee of any future financial outcomes, or specific investment advice. Please consult with your own tax, legal and accounting advisor before engaging in any transaction.