Know What Your Business is Worth

Many business owners don’t think it’s necessary to know the value of their business unless they are planning to sell it. But there are many other instances when you want to know your company’s worth. These include making gifts of interests in the business, planning for your estate tax consequences and planning for business succession needs.

A buy-sell agreement, for example, typically spells out how the value of a business will be calculated in the event of ownership transfer due to a co-owner’s death, disability or retirement. Another example is if the business wants to take out insurance on the life of the owner. By knowing the value of your company, you can more easily determine what kind of policy you need and the extent of coverage.

Knowing the value of your business can also help you plan ahead for the inevitable tax bite you’ll face upon the transfer of your business – whether to your children or to outsiders – during your lifetime or at death. If you don’t establish a fair market value for your business interest that meets Internal Revenue Service criteria, and prepare for transfer taxes, your business might not survive.

Not surprisingly, the IRS often argues that the value of closely held shares subject to gift or estate taxes is higher than that established by the business owner or the estate. In fact, company valuation is at the heart of most disputes that the IRS has with an estate that contains a substantial closely held business interest. If the IRS determines that fair market value is higher than the value set under a buy-sell agreement, an estate could be required to pay taxes on an amount never received, leaving much less than anticipated to heirs.

The fair market value of a business interest is usually defined as the amount a willing buyer would pay to a willing seller, each under no compulsion to buy or sell. Among the key criteria used by the IRS in arriving at the value of a closely held business are: the nature and history of the business, the general economic outlook and outlook of the specific industry, the book value of the stock, the company’s earning capacity, its dividend-paying capacity, its goodwill or other intangible value, other sales of company stock and the size of the block of shares being valued, and the market price of stocks of comparable companies.

While there are many ways to value a business interest, reaching a determination can be tricky. That’s why it is beneficial to get an independent appraisal of your business. From a practical point of view, estate or gift tax returns filed without well documented, independent appraisals of business assets may be at greater risk of audit and tax adjustments, including interest and penalties.

When transferring a business, gift and estate taxes must be considered. Since these taxes start at 37 percent and run as high as 55 percent, it’s important to know the value of your company and to transfer the business interests in a way that reduces transfer tax obligations. Many business owners make gifts of stock in a family business to their children with the intention of eventually turning over control to them. These transfers also have the effect of shrinking the owner’s estate, which may reduce future estate tax liability.

You are entitled to gift up to $10,000 annually – in cash, shares of the business, or other property – to any donee without paying gift taxes. Together with your spouse, you can make yearly gifts of up to $20,000 transfer tax-free. The value of those assets, and any subsequent tax liability, is based on the fair market value of the property at the time of transfer.

Gifting is usually advantageous for businesses which are not yet highly appreciated but are expected to grow significantly over time. If you make a gift of your entire $1 million business interest today, you’ll owe gift tax on $400,000, the amount over your $600,000 unified credit exemption equivalent – assuming you have not already used it. If, instead, you wait ten years when the company’s value has grown to $2 million, you’ll face gift taxes on $1.4 million.

You may be eligible to take certain valuation discounts in determining the fair market value of the interests you transfer in your business. These discounts, in turn, may reduce your gift tax liability. For example, it may be possible to transfer a share of your business worth more than $10,000 without paying gift taxes because a minority stake in the company can be valued at a discount. The minority discount is a recognition that a minority interest in a company – or any other asset, for that matter – may be worth less because of the lack of control inherent in minority ownership.

Suppose your company is worth $1 million and each of the 100 shares of stock are valued at $10,000. By applying a 30 percent minority discount, you and your spouse could give each of your four children 2.86 shares a year without triggering gift taxes, rather than 2 shares at full value. Over five years, you could jointly give 57.2 percent of the business to your children, free from transfer tax, compared to only 40 percent without the discount. The amount of discount available will range from 0 percent to 99 percent, depending on your circumstances.

If you determine that the value of your business is highly appreciated, you may be better off passing it on to your children in your will. Of course, this approach can make your assets subject to hefty estate taxes. Valuation discounting, however, may help in reducing the estate tax bite.

A life insurance policy can be taken out to pay the estate taxes and avoid a forced sale of the business by your heirs. If the policy is owned by an irrevocable trust which is properly structured, the proceeds may remain out of your estate which can lower your estate tax liability. Again, valuation becomes important because the amount of insurance you’ll need will be based on the value of your business.

Each business must be evaluated on its own terms. And as circumstances change, the value of your business can also change. With the help of qualified professionals, your determination of what your business is worth can help you plan for the future in a variety of ways.