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Valuation of Business for Estate Planning

Valuation of Business for Estate Planning

Business Valuation  |  Forensics & Litigation Support

An interest in a closely-held business can often be one of the most significant assets in an individual’s estate. As such, there are many planning opportunities that exist when creating an estate plan for a business owner. A timely valuation prepared by a qualified business valuation professional may be necessary to make informed business and financial decisions.

Let’s take a look at the ins and outs of business valuation when there’s a business involved in an estate.

Fair Market Value

For estate and gift tax purposes, assets must be valued at fair market value. Section 20.2031-1(b) of the Estate Tax Regulations and Section 25.2512-1 of the Gift Tax Regulations define fair market value as follows:

“. . . the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

This definition of fair market value is the most widely used in valuation practice and implied in this definition is that the value is to be stated in cash and cash equivalents. Court decisions frequently state, in addition, that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property.

Fair market value must be determined by an appraisal which must take into consideration a number of factors set forth in Revenue Ruling 59-60, which outlines and reviews the general factors to be considered in the valuation of the capital stock of closely-held companies and thinly-traded public corporations. These factors include:

  1. The nature of the business and the history of the enterprise from inception.
  2. The economic outlook in general and the condition and outlook of the specific industry in particular.
  3. The book value of the company and the financial condition of the business.
  4. The earning capacity of the company.
  5. The dividend paying capacity.
  6. Whether or not the enterprise has goodwill or other intangible value.
  7. Sales of the stock and the size of the block of stock to be valued.
  8. The market prices of stocks of corporations engaged in the same or a similar line of business, having their stocks actively traded in a free and open market.

Valuation Methodology

It is important to understand that valuation is not an exact science. There is no set formula to be used that is applicable to all of the valuation issues that arise in determining the fair market value of an interest in a closely-held business. Revenue Ruling 59-60 states “a sound valuation will be based on all relevant facts but, the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”

The factors outlined in Revenue Ruling 59-60 can be categorized into three general approaches to valuing the common stock of closely-held companies. The three approaches are generally referred to as the asset approach, the market approach and the income approach. The objective of using more than one approach is to develop mutually supporting evidence to the conclusion of value. The choice of methods is determined by the characteristics of the business to be valued, the pattern of historical performance and earnings, the availability of reliable information requisite to the various valuation methods, the marketability of the equity ownership interest to be valued, and others. In some cases, all three approaches may be utilized while in others, only one or two may be appropriate.

Valuation Adjustments

A number of recognized adjustments or discounts may be appropriate in arriving at the fair market value of the subject interest. These may include a discount for a minority interest when the subject interest does not represent a controlling interest in the business. The value of shares representing a minority interest may need to be discounted as they usually have little control over the operations of a company.

In addition, a discount may be applied to the value of a closely-held company because its shares are not readily marketable. This discount for lack of marketability may be a substantial adjustment to fair market value.

If the decedent was a key person or the founding entrepreneur in the subject business, the effect of that loss on the value of the business must be considered. It may be appropriate to apply a key person discount.

There are other potential valuation adjustments that a qualified business valuation professional may consider in determining fair market value.

Planning Opportunities Due to COVID-19

With many businesses seeing decreases in value as a result of the COVID-19 pandemic, this has created a unique planning opportunity for business owners.

With a decrease in many businesses’ value, coupled with the high exemption of $11.58 million ($23.16 million for married couples), there are opportunities to transfer assets that might normally be subject to estate and gift tax. In addition, while these higher exemption amounts are due to sunset in 2026, with the 2020 election around the corner, there’s no guarantee that these opportunities will be available through the scheduled sunset date.

Need Help?

Our team of business valuation experts is here to help. Contact us online or by calling 800.899.4623.

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Published on September 01, 2020