One common reason business people get their businesses appraised is gift and estate taxes. Grants of business ownership interest by living owners to family members trigger gift tax liability. If the owners pass away, the business is inherited by the younger generation. One of the first tasks for the new owners is how to handle the very large estate taxes. With estate tax rates approaching 50%, the tax bite may be very painful.
Business valuation results: high or low?
Usually, business owners are interested in the highest business valuation possible. This is certainly the case if the business is to be sold to a third party. The same desire for high valuations applies if you consider partner buy-ins, and outside investment, whether venture capital or debt financing.
Gift and estate tax situations are very different. Since the tax is assessed on the current business enterprise value, business owners are interested in the lowest possible figure for their business value.
The tax authorities, for obvious reasons, are skeptical about low business valuations. Experienced tax agents expect that business people want to reduce their taxes – and often retain skilled tax lawyers and accountants to help them do so. Since gift and estate taxes are among the highest, it is natural that business owners would seek the most conservative estimate of their business value.
Tax authorities may develop their own business appraisal. Not surprisingly, the tax man’s business valuation may be quite a bit higher than the owners’ value estimate.
Business valuation: points of contention
Business owners and tax agents typically disagree on what a business is worth on the following points:
Since any business valuation result depends upon the set of assumptions, tax authorities may challenge your business appraisal by questioning your financial forecasts, risk estimates, as well as definition and premise of business value.
Business valuation is always forward-looking. Will the business earnings continue growing at their historic pace of 10% per year? Or will the growth rate stay within 5%, as claimed by the business owners? Will the industry become more risky in the next 5 years? Will the business continue operating or have to exit certain markets and sell some of its assets? Depending on which position is taken, the business valuation results you get will differ considerably.
Whether the assumptions of business owners or tax agent are more accurate, only time will tell. The business valuation result needed today may become a matter of dispute between the owners and tax authorities. And if the two sides cannot develop a reasonable compromise, these situations often end up in court. To avoid the costs of litigation, it is best to work out a solution acceptable to both sides.
Marketability discount and private business sale comps
Tax authorities generally understand that private business ownership interest is less marketable than public company securities. The question often is the amount of marketability discount that applies. Again, the owners tend to argue for higher marketability discount percentages.
This is where private business sale comparable data comes in very handy – if you can show the selling prices of similar closely held businesses, the fair market value of your business is much easier to defend.
Control premiums and minority discounts
If the value of partial business ownership interest is disputed, you can work up a reasonable minority discount by citing the control premiums paid for business acquisitions in your industry. Most sales of public company stock are minority ownership transactions. On occasion, a controlling ownership interest is acquired. The offer terms are publicly disclosed and typically state the price per share – which often includes a premium over the current share market price.
Alternatively, you can value the business ownership stake directly by using the Discounted Cash Flow method – and calculating the present value of the expected returns to the minority shareholder.