Family-owned businesses are frequently a part of estate and succession planning. As a business owner, your business is often one of the largest assets in your estate. If you are gifting or transferring ownership, particularly for closely-held businesses, a business valuation is vital.
Valuing closely-held businesses can be challenging because family-owned small businesses have a unique set of issues to consider. As such, it is important to use an experienced appraiser to objectively assess the fair market value of the business. Doing so can protect yourself legally and help to ensure compliance with tax regulations. A valuation professional can also provide valuable assistance as a business advisor. Working with your accountant and attorney, together they can help plan equity transfers. This helps a business owner make more effective succession and ownership transfer decisions.
Below discusses the basics of gift and estate valuations for closely-held businesses. From explaining the role of the appraiser, business valuation report, valuation terms, common methodologies, to the financial information typically needed to perform the business appraisal. Please reach out with questions, we are always happy to answer!
THE APPRAISER’S ROLE
The valuation expert plays a critical role in estate planning. Valuations from an independent, professional appraiser should be obtained early in the estate planning process. Doing so increases the taxpayer’s chances that the Internal Revenue Service (IRS) will not challenge the valuation. If challenged, it increases the taxpayer’s chance of resolving the challenge quickly. A credible analysis also ensures that the valuation is correct, complete, and current.
THE VALUATION EXPERT’S ASSISTANCE
Why is a valuation expert needed? Valuation experts are independent, professional, and provide a formal opinion of value appropriate for the subject interest and the issues involved. The three factors that distinguish an expert are:
- Independent – An owner can have a particularly good notion of the value of his or her business, but the credibility of the analysis is compromised by the personal interest of the owner. An independent expert is objective with no actual or appearance of a conflict of interest.
- Professional – A layperson with no formal training in the valuation of a specific item may have a fairly accurate idea of the value of the property. But, if they cannot articulate the basis for their opinion in the language of the relevant technical community, then there is little credibility to the conclusion of value. Whereas, a valuation expert has the demonstrated knowledge and experience as well as the right credentials.
- Formal opinion of value – The valuation expert distinguishes him or herself by developing an opinion of value that considers all the required factors for the specific context of the appraisal. This opinion is disclosed and expressed in a format that allows the intended user and the IRS to follow and understand the logic of the valuation process. Ultimately, this opinion must and can be, reconciled to what results are in the marketplace, or even to subsequent unforeseen events.
IMPORTANCE OF A CREDIBLE VALUATION REPORT
Most IRS challenges to gift and estate transfers center around partnership interests of closely-held corporations. The IRS often audits transfers that are viewed as “undervalued assets” such as real estate and family business interests.
A credible valuation report from a qualified appraiser can often prevent a valuation challenge. Before challenging a case, the IRS must make a cost-benefit analysis to determine whether it has a strong case against the taxpayer. A good valuation report makes it less likely that the IRS will spend the resources to assert its case that the taxpayer’s position is somehow wrong.
If the IRS does challenge the valuation report, the burden falls on the IRS to then prove its case by retaining its own expert. During this process, the taxpayer generally has the burden of disclosing credible evidence to establish the taxpayer’s valuation position. An appraisal report provides the taxpayer with the basis to dispute what may be an unrealistic IRS valuation claim upon audit.
In the case that an estate attorney and taxpayer decide to try to save money by not hiring an appraiser, the taxpayer risks paying a great deal more in attorney’s fees, litigation expenses, penalties, etc. Hiring a valuation expert after the IRS has challenged the taxpayer also presents a difficult scenario for the appraiser. This is because the valuation may have to be performed years after the transfer took place.
QUESTIONS TO ASK PROSPECTIVE APPRAISER
Below is a list of several questions to ask a prospective business appraiser:
- How many valuations did you (or your firm) do over the last (three) years?
- Have you previously valued interests like that of the subject business and have competency in the subject industry?
- What valuation credentials (or designations) do you hold? Are your credentials up to date?
- What valuation methods do you typically use in a case like this one?
- What procedural reporting guidelines do you follow?
- What sets you (or your firm) apart from other valuation firms?
BASIC GIFT AND ESTATE VALUATION TERMS
Fair Market Value – The standard for valuing assets as set forth in Section 20.2031(estate tax) and Section 25.2512 (gift tax) of the Regulations under the Internal Revenue Code. Fair market value is the price at which the subject property would change hands between a hypothetical willing buyer and a willing seller, with both having reasonable knowledge of all relevant facts and neither party being under any compulsion to buy or sell. Fair market value also assumes that the price is paid all in cash or its economic equivalent at closing and the buyer is a hypothetical buyer with no specially assumed characteristics. The factors surrounding the determination of fair market value are discussed more fully in Revenue Ruling 59-60.
Premise of Value – Relates to the highest and bestuse of a particular asset. The subject property is typically appraised under the premise of value in continued use. If the asset is a business interest, its continued use is as a going-concern entity. This premise of value incorporates the notion that the assets are an integral part of a going-concern business and that management’s policies are consistent with arm’s-length activities typical of the industry in which the entity operates. Otherwise, the premise of value may be an orderly liquidation, assuming the sale of all assets within a reasonable amount of time. An entity in financial distress may require a value under a forced liquidation assumption.
Basis of Value – Relates to the rightsassociated with the asset. For a private business interest, this can be categorized as a: (1) control interest, (2) 50 percent interest, (3) marketable minority interest, (4) nonmarketable minority interest, or (5) assignee interest.
Alternate Valuation Date – Section 2032 allows for a date other than the date of death to be used forthe valuation of assets in the gross estate. The following dates can apply:
- A date within six months of the date of death on which the property was distributed, sold, exchanged, or otherwise disposed of.
- The date six months after the date of death if the property is still held by the estate.
VALUATION APPROACHES FOR GIFT & ESTATE
The three generally accepted business valuation approaches are as follows:
- the income approach,
- the market approach, and
- the asset approach
Within each approach, there are several generally accepted business valuation methods.
THE INCOME APPROACH
The income-based approach is based on the premise that the value of the company is the present value of all the future expected economic income to be derived by the company’s creditors and shareholders.
The two primary methods used within the income approach are:
- The capitalization of earnings method
- The discounted cash flow method
The capitalization of earnings method measures the economic income for one period (i.e., one period before the valuation date or one period after the valuation date) divided by an appropriate investment rate of return or capitalization rate.
A discounted cash flow analysis measures the economic income for several discrete time periods into the future, typically five years. The projection of the prospective economic income is converted into a present value using a present value discount rate. This is the investor’s rate of return or yield rate over the expected term of the economic income projection.
THE MARKET APPROACH
There are two common methods in the market-based approach: (1) the guideline publicly traded company (GPTC) method, and (2) the guideline merged and acquired company (GMAC) method.
The GPTC method is based upon a comparison of a subject company to similar “guideline” publicly traded companies. Market derived pricing multiples are developed based upon the guideline companies’ financials and quoted trading prices. The selected pricing multiples are then applied to the subject company’s financials to arrive at indications of value.
The GMAC method is like the guideline publicly traded company method in that pricing multiples are calculated and applied to a subject company. The GMAC method, however, is based upon the analysis of similar companies (either publicly traded or privately traded), which have been recently acquired in a merger or acquisition transaction. In addition, transaction pricing multiples are based on the transaction price rather than the companies’ quoted trading price. This also includes any price premium for ownership control.
THE ASSET APPROACH
The asset-based approach is based on the economic assumption that the business is worth the fair market value of its assets, less the fair market value of its liabilities. See more information on valuation approaches here.
QUALIFIED AND CREDENTIALED APPRAISER
Besides extensive knowledge and experience, the estate planner should look for an appraiser who holds the right credentials. There are three professional associations in the U.S. offering education and professional credentials in the appraisal of private business interests.
- American Society of Appraisers (ASA), which offers the ASA
- National Association of Certified Valuation Analysts (NACVA), which offers the CBA and CVA
- American Institute of Certified Public Accountants (AICPA), which offers the ABV
Having one or several of these designations gives the analyst creditability before the eyes of the IRS. This makes it more difficult for the IRS to decide to challenge a valuation if a well-respected, independent analyst writes the report. And if the IRS does dispute the report, the analyst is prepared to defend it. Note that merely having a CPA or an advanced business degree is not evidence of valuation competence.
The most widely cited and recognized set of professional standards for appraisals is the Uniform Standards of Professional Appraisal Practice (USPAP), published by The Appraisal Foundation. USPAP covers appraisals for all disciplines, including real property, personal property, business interests, and intangible assets.
The AICPA has its own set of standards titled Statement on Standards for Valuation Services (SSVS-1). All CPA-members must follow SSVS-1 when representing that they are performing a formal appraisal.
INFORMATION REQUESTED FOR A GIFT AND ESTATE VALUATION
- Name of the client engaging the appraiser
- Legal name of the entity and identification of the interest in the entity to be valued
- Valuation Date(s)
- Name, email, address, and telephone number of key parties: the client, the lawyer, the accountant, etc.
Financial Statements and Accounting
- Company’s financial statements for the three to five most recent fiscal years ending prior to the valuation date(s)
- Federal/State income tax returns for the three to five most recent fiscal years prior to the valuation date(s)
- Current interim financial information for the latest period since the last fiscal year-end
- Interim financial information for the same period of the last fiscal year-end prior to the valuation date
- IRS audit correspondence or other advisory communications for the three to five most recent fiscal years prior to the valuation date(s), if any
Other Financial Data
- List of equipment and depreciation schedule as of the latest fiscal year prior to the valuation date(s)
- Aged accounts receivable list as of latest fiscal year prior to the valuation date
- Aged accounts payable list as of same date
- List of all periodic internal reports prepared for management
- List of shareholders’ (and any employee-family members’) and officers’ annual total compensation from the firm for the previous three to five fiscal years prior to the valuation date and the interim period prior to the valuation date
- Details of repayment terms of any due from officers or accounts receivable employees
- Copy of or summary of any significant equipment leases or rental agreements
- List of any employee benefit plans and contributions made to such plans by the firm include specific contributions for each owner for the previous three to five fiscal years prior to the valuation date
- Schedule or summary of insurance:
- Life and disability
- Property and casualty
- Copy of any budgets prepared for the firm for the three most previous fiscal years prior to the valuation date. Copy of current budget
- Copies of any other projections or strategic plans or other documents prepared for internal use or for lenders or other parties within the past five years
Legal and Corporate Organization Data
- List all current officers, key employees, and directors, with biographical information
- Copies of any existing written contracts of the firm:
- With employees
- With customers
- With suppliers
- With others, particularly affiliated firms.
- List of lawsuits or pending regulatory actions or litigation instituted by or against firm
- Current list of owners (including units/shares owned and total units/shares outstanding)
- List of other enterprises related to the firm by common ownership or common board members, if any. List any transactions between the subject firm and these affiliated firms, officers, directors, or shareholders
- Provide a copy of the articles of incorporation, by-laws, and any amendments thereto
Marketing and Operational Data
- Brief history of the firm, including how long in business and any changes in majority ownership
- Brief description of business’ activities or lines of business
- Information regarding competitors and market conditions as of the valuation date
Real Estate and Other
- Provide a list of real estate locations owned by the firm with:
- Copy of any appraisals prepared for property within three years of the valuation date
- Copy of or summary of the lease if the property is rented
HOW TO READ AND REVIEW A VALUATION REPORT
The following checklist is taken from Valuing a Business (Fifth Edition), Chapter 22 and sets forth the key areas to look for in any appraisal of a business interest.
The question to keep in mind while reading a valuation report is — “Why?”
The appraiser’s report should lead the reader through a logical path of analysis to a conclusion of value. The reasoning in the report should be supported by and based on accepted theoretical viewpoints and by empirical data. The report should explain in enough detail why the appraiser is relying on or selecting certain facts, assumptions, or theories as the basis for the valuation analysis.
- Identification of the subject property
- Identification of the client
- Relevant dates
- Definition of value
- Purpose of the valuation
- Ownership characteristics of the subject interest
- Degree of control
- Degree of marketability
- Economic outlook
- Industry outlook
- Company history and outlook
- Sources of information
- Financial statement analysis
- Valuation methodologies
- Asset-based approach
- Income-based approach
- Market-based approach
- Is the data used appropriate to the valuation date?
- Valuation synthesis and conclusions
- Analyst’s qualifications and potential conflicts
- Appraisal certification
- Statement of contingent and limiting conditions
Keep in mind that no business valuation is the same. Each one presents a different set of challenges that can have an immense impact on the value of the family business. That is why it is important to protect your interests and have an experienced and objective appraiser.
Peak Business Valuation would love to help in valuing your family business interest. We have extensive experience in gift and estate valuations. Please reach out with any questions via email or through a phone call.