Ownership of a business interest presents several estate planning issues and problems. Frequently, there is no ready market for closely held companies. This creates valuation and liquidity problems.
Even estimating the death taxes on the business interest is difficult because of this uncertainty. In addition, heirs are often unable to operate the business on the death of the principal. Thus, if the owner is a key person, the business’s existence after the owner’s death may be in jeopardy.
The business owner’s death can also create an “income gap” for his or her family. There may be a need to replace the owner’s business income to provide for his or her family’s support after the owner’s death.
Table of contents
Valuation of closely held business for estate tax purposes
To value a closely held business, the company’s net worth, earning power and dividend-paying capacity, and other relevant factors are considered. After that, the value determined on these factors is usually discounted if it is a minority share interest. In addition, a buy-sell agreement may fix the value of the business for estate tax purposes.
A business interest must be valued in any estate that will be subject to federal estate tax. This is necessary to:
- Estimate the federal estate tax due
- Determine the possible use of the marital deduction and other estate planning tools, and
- Determine the means of paying the estate tax (e.g., life insurance).
However, valuation is an inexact science presenting a frequently litigated issue. Moreover, there are many different ways in which a business interest can be valued. Federal estate tax makes a low value appealing.
However, when the estate is not subject to federal estate tax, a higher valuation may be desirable to give the business interest a high tax basis on the owner’s death. In addition, an older co-owner joining in a buy-sell agreement may want as high a value as possible to maximize the sales price his or her family will receive.
The IRS has established that the fair market value of an asset is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts .”
How to Value Business
Regulation §20.2031-3 and §20.2031-2(f) state that all relevant factors are used to determine the “net value” of a business, including:
- Appraisal of assets;
- Demonstrated earning capacity;
- Dividend-paying capacity;
- Economic outlook;
- Quality of management;
- Degree of control represented by the business interest; and
- Values of similar publicly traded businesses.
IRS Valuation Guidance
The IRS provides guidelines for the valuation of a closely held business for federal estate and gift tax purposes under Revenue Ruling 59-60. However, the ruling fails to give an exact formula. In addition, while all the guidelines cannot be given equal weight, no details are given as to the importance to be accorded the various factors.
While this IRS guidance deals with stock in a closely held corporation, it also applies to the valuation of partnerships and proprietorships (R.R. 65-192; R.R. 68-609; Reg. §20.2031-3(c)).
The valuation factors are as follows:
(1) Nature of the business and its history. Here, the primary consideration is the riskiness of the business. The greatest weight is given to recent events, with little importance given to past events that are unlikely to recur. This factor could be used in selecting a multiplier in a capitalization-of-earnings formula. Normally, a higher multiplier would be linked with a more stable business.
(2) Economic outlook. The economic outlook for the entire economy, this particular industry, and the particular company in general and in its specific industry are to be considered. If the loss of key personnel will significantly affect the value of the business, a subtraction from earnings to compensate for the loss of a key employee is suggested.
(3) Book value. When a business has large amounts of real or tangible personal property, book value is an important beginning in valuing the business based on the worth of underlying assets. However, in considering book value, remember that nonoperating assets may command a lower rate of return than operating assets, and depreciation deductions affecting book value can be greater than actual economic depreciation.
(4) Earning capacity. R.R. 59-60 holds that past income is useful in predicting future income, but averages will be unrealistic if they disregard trends.
(5) Dividends. Actual dividends paid may not be related to the dividend-paying capacity of the business. However, most closely held corporations try to avoid paying dividends. As a result, evaluating dividend-paying capacity is not likely to be significant in valuing such corporations.
(6) Goodwill. Goodwill is defined as the excess of net earnings over a fair return on net tangible assets. Thus, when a business earns more than a reasonable return on its assets, the additional return must be attributable to prestige, name, location, and other intangible value. In many service businesses, a large portion of the value is due to such intangible assets.
(7) Recent sales. Often, a recent arm’s length stock sale is the best evidence of value. Moreover, R.R. 59-60 does recognize that the percentage of the business sold affects valuation. Thus, a premium for a controlling interest or a discount for a minority interest may be appropriate.
However, sales between unrelated persons are rarely available. (8) The price of a similar traded stock. When a publicly-traded stock in a similar business can be found, the price-earnings ratio of that stock and other characteristics can be used to determine value. However, such comparisons are rarely available.
Many appraisers use an average of several different valuation methods; however, the IRS does not favor this approach. R.R. 59-60 specifically disapproves of averaging.
Note: When valuing a business for gift tax purposes, special valuation rules under §2701 – 2704 apply. The special rules apply if an older generation owner gives certain interests to younger family members while retaining rights.
In valuing tangible assets, the starting point is book value. However, each asset should be reviewed to determine whether its book value is a proper indication of value.
Normally, cash, accounts receivable, and inventories are accepted at book value. Machinery, equipment, patents, and real estate, unless recently purchased, will have values different from book value.
Special Real Estate Election – §2032A
In general, the value of real estate must be determined based upon its highest and best use. However, when certain requirements are met, an executor may elect to value, for estate tax purposes, real estate used as a farm or other closely held business based on its actual use rather than its highest and best use (§2032A).
The basic requirements of are:
- The property must pass to or be purchased from the estate by a qualified heir ;
- The decedent or a member of the decedent’s family must have owned the property and have materially participated in the operation of the farm or business for five out of the eight years preceding the earlier of: (a) The date of death, (b) The date on which the decedent became disabled, or (c) The date on which the decedent began receiving social security benefits (§2032A(b)); If a corporation, partnership, or trust owns the real property, the decedent (or a member of the decedent’s family) must have materially participated in the entity.
- The real property must have been used as a farm or in a trade or business on the decedent’s death and for five out of eight years immediately before the decedent’s death; and
- The value of real and personal property used in the business must be at least 50% of the adjusted value6 of the decedent’s gross estate, and the qualifying real property must be at least 25% of the adjusted value of the decedent’s estate. When the election is made, assets may be valued as follows:
A farm is valued by dividing the excess of the average annual gross cash rental for comparable farm purpose land over the average annual state and local real estate taxes for such comparable land by the average annual effective interest rate for all Federal Home Loan Bank loans (§2032A(e)(7)).
If cash rentals for comparable land in the same locality are not available, net-share rentals are allowed. The net-share rental is equal to the value of the produce received by the lessor of comparable land on which the produce is grown during a calendar year minus the cash operating expenses (other than real estate taxes) of growing the produce paid by the lessor.