In this article, the second in a series on business transition planning, we will discuss the value proposition for the closely held business. 

The fair market value of a closely held business is difficult to determine and has presented opportunities for disagreement with taxing authorities for generations.  Revenue Ruling 59-60 from 1959 states that fair market value is “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.”

There is no one formula that determines the value of a business and one must consider all relevant factors from the general economy to the specifics of the industry you are involved in.  The strength of the balance sheet and the consistency of earnings over time will color the determination of value.  The value of the business will be driven largely by prophecy – the hypothetical investor’s best guess at what the future brings.  This investor is looking at how the business will be paid for, how quickly it will be paid back and how much risk he wants to assume.

The benchmark risk free rate of return is typically the ten year Treasury, which is currently trading at 2.75%.  Stocks have more inherent risk than bonds and small publically traded stocks have more risk than the large cap stocks of the Dow Jones Industrial Average.  Small businesses that are not traded have an even higher risk as there is a very limited market and the transactional costs are generally much higher.  If there are only a few key customers or key employees that may not continue with the company then the risk grows larger still.  If you are valuing a minority interest then this will get discounted as that is not as valuable in the hands of the hypothetical investor as shares representing majority control.

The world we live in is not populated by hypothetical investors and it is important to have a strong viable business that can be sold to your employees, or an investor, or passed on to the next generation.  In the first article in the series we talked about having the right business structure.  Part of preparing the business for sale is having a good story to tell to the potential buyer.  This means treating the business like a business and not a personal bank account.  Limiting the amount of debt and focusing on a strong bottom line will make the company more attractive to a potential suitor and increase its value. 

The value of the business will depend also on who the buyer is.  A competitor or company in a related line of business will look at synergies that add value beyond the basic numbers.  Economies of scale and the elimination of competition are intangibles that are clearly part of the value equation, but may be difficult to measure.  Selling to key employees may help insure the legacy of the business, but you may end up helping to finance the transaction by holding a note. 

A transfer to family members is always problematic because the Internal Revenue Service will automatically assume that there is a gift involved.  It is essential that a full valuation by a competent business valuation expert be performed and a gift tax return be filed – even if the family members are paying full fair market value. Sumner Redstone, the billionaire media mogul, is currently fighting a million dollar plus tax bill due to transfers of stock to his children that occurred in 1972.  Unless a gift tax return is filed with all the proper documentation behind the transaction then the statute of limitations does not run and the IRS can assess additional tax, even 42 years later.  Without the proper documentation the presumption of correctness is with the IRS. 

There are a wide variety of factors that determine what your business is worth.  It is not as easy as doing quick calculations on the back of an envelope using some industry rule of thumb.  It will be based on what someone thinks the future will hold and how strong they view the performance of your company in that future.  Determining your business worth will take careful planning and thought and can not be completed overnight.  When the time comes to transition your business, your DB&B tax professionals are available to guide you through the process.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.