Why determine the current value of a business? Because if a major shareholder or partner dies, and you have not determined a value, the Internal Revenue Service, will do it for you. The IRS will select the method(s) of valuation as provided for in its regulations to create the highest value possible for tax purposes. This situation is rarely advantageous for the taxpayer.
Two major valuation considerations are market value and intrinsic value factors. Intrinsic value factors are broken down into the following two categories: earnings capacity and other considerations.
This is the preferred method. The greater the market activity in a company’s stock, the more weight can be placed on this method. This method is not applicable, however, to partnerships or corporations where there has been no trading activity. Even with traded companies, there can be serious limitations with this method, including:
If the stock is traded over-the-counter or through an exchange, these prices will prevail. The only exception is if the amount of stock, added to the purchaser’s other holdings, will constitute a controlling interest. That would increase the value of the shares. If both bid and ask prices are available, the mean price is used.
If the fair market value cannot be determined by reference to market transactions or to values set by arm’s length agreements, (buy-sell agreements, etc.) then intrinsic factors must be taken into account. The main categories under intrinsic value factors are earnings capacity, current financial statements and other considerations.
EARNINGS-CAPACITY INTRINSIC VALUE
Stock market analysts use price earnings ratios as one of their major indicators. A buyer is particularly concerned with the future earning power of the company. The past earning power is considered to estimate future earning power under these rules:
Once the average earning power is computed, the proper multiplier to capitalize that power must be determined and applied. The multiplier is directly proportional to the risk factor. The greater the risk, the smaller the multiplier. The best guide in determining a multiplier is to note comparable multipliers of publicly traded companies. If this is not possible, you might use comparable non-publicly traded companies.
After comparable companies have been located, the average price-earnings multiplier of their shares can be applied to the earnings of the stock to produce a valuation.
OTHER CONSIDERATIONS - INTRINSIC VALUE
In order to place the burden of proof concerning the actual value of a business in the hands of the owner, the IRS has intentionally left the regulations vague. According to the IRS, the following relevant factors will affect arrival at a fair market value:
There is no fail safe way to value a company for buying and selling purposes. The true value is the perceived value to a ready, willing and able buyer. However, there are a number of good approaches to estimate value; some of those discussed above. It is not unusual for a buyer – or the IRS – to ask for the logic behind a market valuation. Having a credible answer to that question will enhance your chances that the value will be accepted.
Business Valuation Information:
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