Valuation of the Stock of a Closely-Held Business
“Not an exact science,” nevertheless, valuation of the stock of a closely-held business must stand up to IRS scrutiny. This article looks at IRS guidance for determining value.
February 21, 2008
Sponsored by BNA Software
by Nancy Faussett, CPA
Determining the worth of most of our valuables is generally not all that difficult. However, although a family-owned business is often one’s principal source of income and may represent the majority of one’s total worth, placing an accurate value on it is never easy. Since, by definition, the stock of a closely-held business is held by only a few individuals and is rarely traded in the marketplace, there is no established market price for it. This is what makes it so difficult to determine its worth.
The reasons for needing to value a business are varied, from wanting to gift a portion of the business, wanting to buy or sell the business or even wanting to redeem a dissatisfied owner’s share. In addition, you may need to value a business for a property settlement in a divorce and, of course, you need to value the business when it is included as part of an estate.
Whatever method is used for valuing the stock of a closely-held business it must be able to stand up to the scrutiny of the IRS. It is logical, therefore, to look to the IRS for guidance on how the value of such stock should be determined.
The basis for how to determine the value of the stock of a closely-held business is found in IRS Revenue Ruling 59-60. Because each situation is somewhat unique, there is no general formula that can be used. In fact, the revenue ruling clearly states that the valuation of the stock of a closely-held corporation “is not an exact science.” All available financial data, as well as all other relevant factors, should be considered. When valuing it for estate purposes, estate tax planning software may be very useful.
Revenue Ruling 59-60 lists eight fundamental factors that should be considered (although this list, as the revenue ruling states, is not intended to be all-inclusive):
Note: In the case of the death or disability of a shareholder, a buy/sell agreement often contains the conditions for selling the stock to an outsider or buying the stock of a co-owner. A buy/sell agreement can sometimes be used in the valuation of a closely-held business if properly set up under IRS Code Section 2703. A key provision of Section 2703 is that for a buy-sell agreement to be used as a factor in valuation, its terms must be comparable to a similar agreement that is made in an arm’s length transaction.
Methods of Valuation
The above factors in Revenue Ruling 59-60 form the basis for several possible methods of valuation:
Remember that whichever method is chosen, the valuation must be done on each company’s own merits, taking into consideration all of the particular facts and circumstances. There is no single “correct” method that will work in all cases.
Estate Tax Planning and How Software Can Help
When an estate includes the stock of a closely-held business, a correct valuation affects not only the amount of the estate tax liability but also how such liability will be paid. The closer one can come to an objective versus a subjective valuation, the more likely it will be accepted by the IRS. Estate tax planning software can assist you in this endeavor.
Since a closely-held business rarely will ever actually go public and there is a lack of marketability for its stock, adjustments (referred to as “discounts”) need to be made. Estate tax planning software can assist you in accounting for these discounts. For example, there are discounts if the stock represents a minority interest in the business, if it is non-voting stock, if a deceased shareholder was a key person (although this may be compensated for by a key-man life insurance policy), and if the business has any built-in capital gains.
Estate tax planning software also can help with both Section 303 and Section 6166 planning. IRS Code Sections 303 and 6166 were created to assist the estate of a closely-held business owner meet its death-tax requirements when the decedent’s interest in the business exceeds 35 percent of the adjusted gross estate. Section 303 allows sale or exchange treatment, rather than dividend treatment, when redeeming closely-held business stock to help pay estate taxes, funeral costs, and administrative expenses. Section 6166 extends the period of time (up to 14 years) for paying the estate tax attributed to a closely-held business interest.
So, while valuing a closely-held business can be challenging, there are techniques and software that can be used. Determining its value is simply a lot more complicated than determining the worth of most other valuables because so many factors need to be considered.
Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.