Small Business Resource

Determining The Value

Valuation of your business is likely to be performed by your CPA or a business appraiser using a methodology consistent with the approaches sanctioned by the IRS. This valuation will determine a range of fair market values for your business for purposes of gifting, estate taxation, and general planning. Note that this fair market value is not the same as the sales price for your business. To determine the sales price, the fair market value is used as a hypothetical starting point and adjusted to accommodate factors like timing of the sale and industry cycles, current condition of the merger and acquisition market, interest rates, and geographic location among others.

The technical details of business valuation are beyond the scope of this report. But one aspect worth noting is that estimating the value of your business will be critically dependent on who the business will be transferred to. If you are selling the business to an outside third party, you will seek the highest possible value for your ownership interest. If you are transferring ownership to your children, you must make every effort to develop the lowest defensible value for your ownership interest. This counter intuitive strategy is due to the huge role the IRS plays in the transfer of your business.

If you decide to sell to an outside third party, it will be for cash and you’ll want all you can get via a high value. But your children, your employees, your co-owner don’t have much of that green stuff. Their source of money, or cash flow, is the same as yours – the business. They will need to earn money on the business and pay income tax on it (tax #1) then pay the balance to you to buy the business – at which time you will pay a second tax on the gain (tax #2). The higher the business value, the greater the purchase price. The greater the purchase price, the greater the double tax bite.

For example, if company earnings are distributed to the purchaser (let’s say a key employee), it will be taxed to her as compensation – salary or bonus money. She will then pay the after tax money to you (say 65 cents of the original dollar of earnings). You in turn pay a capital gains tax on the 65 cents received (assume little or no basis on your ownership interest, therefore a tax of about 25 percent). The net is less than 50 cents on each dollar earned and paid out by the company.

In other words, all purchasers, other than outside third parties, need to look to the earnings of the company for money to pay to you because they have no money of their own. This results in a double tax paid on the money received by you (taxed once as the employee/purchaser earns it and once when you receive it for your stock). The higher the business value, the higher the tax, the more difficult it is to accomplish a successful transfer… the less likely you will leave your business in style. Methods for avoiding this double taxation are rather complex for our discussion here, but keep in mind that determining the value of your business will require you to decide early on how you wish to transfer it.