Business Valuations: Well Worth It!

Kurt Ohliger, CPA (Sep, 2009)

A common question we receive from closely-held business owners is "what is my business worth?" The answer to that question is simple: It depends on who you ask. Ask a potential buyer of the business and no doubt their initial answer will be lower than what the seller perceives it to be worth. If four equal shareholders agree the business is "worth" $1 million, each shareholder could conclude that their individual share is worth $250,000. Unfortunately, the actual "value" of their stock could be significantly less than that amount.

So how do the parties resolve these differences? The most common approach is to obtain a business valuation. Whether your business is an S Corporation, C Corporation, LLC, LLP or a sole proprietorship, businesses (or their assets) are valued for many purposes. Among our clients, the transfer of ownership from one generation to the next provides the business valuation requirement. Other purposes include, but are not limited to, mergers, acquisitions, divestitures, liquidation, estate, gift, income tax, litigation, allocation of purchase price, execution of buy/sell agreements, family limited partnerships, marital dissolution, shareholder disputes, employee stock ownership plans, financial reporting and the list goes on. In addition to the business as a whole, individual ownership interests (majority or minority) can also be valued.

The following is a brief discussion of the importance of a business valuation as it relates to common transactions involving close-held businesses.

Mergers, Acquisitions and Divestitures
Whether you are looking to buy, sell or merge businesses knowing the "value" is a vital step in the transaction process. There are five standards of value, the most common of which is "fair market value", defined by Treasury Regulations Section 20.2031-1 as "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." The "value" is also dependent on the type of interest you are buying/selling. The transaction may involve a one hundred percent controlling interest, a majority interest that either possesses control (e.g. 51%-49% ownership) or does not possess control (e.g. one shareholder owns 99 nonvoting shares and another shareholder owns 1 voting share) or a minority interest. The per share fair market value would be different in each scenario as a result of discounts for lack of control and/or lack of marketability.

Estate or Gift Tax
Minimization of estate and gift taxes is often a primary objective of generational transfers of ownership in or assets of closely-held family businesses. Current shareholders may wish to transfer ownership now to reduce potential estate taxes upon their death. The main advantage of gifting ownership in a closely-held business is that the business and future appreciation will be out of the donor's estate. The done would take over the donor's tax basis for the purpose of computing gain or loss on a future sale. In the event of a shareholder's death, the value of ownership interests must be determined for estate tax purposes as of the date of death (or an alternative date six months after the date of death if elected). In this case the beneficiary gets a "step up" in basis; i.e., the tax basis for computing future gain or loss would be the fair market value of the business at the decedent's date of death (or alternate valuation date.)

Transfers in the form of gifts will require a valuation to properly document the "value" of the gift on the date of transfer. Treasury Regulations issued in 1999 set forth a comprehensive list of disclosure requirements that must be satisfied to prevent the IRS from challenging the value of the gift beyond the normal three year statute of limitations.

Buy-Sell Agreements
A buy-sell agreement (sometimes referred to as a business continuity agreement) controls the transfer of ownership in a closely-held business when certain events occur. Typical events covered by a buy-sell agreement are the death, disability or retirement of a shareholder and transfers, sales or redemptions of corporate stock. The agreement can be specific as to how the company is to be valued, including the process for do so (formulary, third-party valuation, etc.) and the frequency at which the valuation should be updated. Internal Revenue Code (IRC) Section 2703 states that a shareholder agreement among family members will be ignored for estate and gift tax purposes unless it is a bona fide business arrangement, provides for the transfer of property for full and adequate consideration and the agreement is comparable to other agreements entered into in arm's-length transactions. A business valuation can provide the documentation to satisfy the full and adequate consideration requirement.

Family Limited Partnerships
A family limited partnership (FLP) is a complex financial and tax planning technique that enables a family to hold, manage and share its wealth, including family businesses, among several generations as "partners". The formation of an FLP is initiated by an earlier generation through gifting of assets, which may include ownership in family businesses, in exchange for the partnership interest. As with all gifts, the "value" on the date of transfer must be properly documented to avoid unintended gift or income tax consequences.

These are just a few of the scenarios in which a business valuation may be warranted. Many more exist. If you are contemplating a transfer of ownership as part of retirement, succession planning, estate planning or if you are just wondering "what is my business worth?", a business valuation can help provide an answer. We urge you to contact your Dermody, Burke & Brown advisor to begin the discussion.

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