Small business value, as in other valuation contexts, is usually defined in terms of “market value” or “fair market value,” which means the amount a willing buyer would pay a willing seller for property (the individual business interests) or a business enterprise, assuming that each party to the transaction has reasonable knowledge of all material facts and that neither is under a compulsion to buy or sell. In the small business context, valuation is often problematic because, typically, there is no established secondary market in which the business interests are bought and sold, whereas a larger entity may be traded on an established market so that its fair market value is easily established by current trading prices.
Further, the business owners are typically very involved in the day-to-day operations and management of a small business—meaning that the current owners’ exit from the business can dramatically impact the business’ future operations and, thus, its current value.
Often, valuation issues in the small business context become important when the owner-managers seek to transfer their interests in the business to related parties—typically children or grandchildren. Even if these business succession plans are structured as bona fide sales, rather than outright gifts, the IRS is more likely to closely scrutinize the transaction in order to ensure that the interests were valued based on their market value, however limited, to avoid transitioning the business using artificially low values in order to disguise a gift transaction.
Similarly, estate tax valuation is often important in the small business context because of the lack of an established market to provide an objective valuation benchmark for determining the value that must be included in a deceased owner’s taxable estate.
Because of these factors, the IRS has recognized that there is no one exact formula that can be used in valuing a small business, and that the valuation process, by its nature, requires a fact intensive inquiry over which even independent expert appraisers might disagree.
1 Despite this, a series of general principles governing valuation of small business interests has emerged to provide guidance to the small business owner. At a high level, three methods of business valuation exist: asset valuation, income valuation and market valuation. The asset valuation approach (an asset sale) is often the default if no action is taken by the business owner and/or if the business owner dies while in business. Although the details can get complicated as it applies to specific fact situations, this method simply involves taking the sum of the assets and subtracting the liabilities to find the value of the business. This method is not appropriate for certain types of businesses. In the case of professional service organizations comprised of professionals such as attorneys, doctors, accountants and financial planners, the business’ tangible assets can be of negligible value, which could cause a vast undervaluation of the business.
Income valuation and market valuation are discussed at Q
9028 and Q
9029.
General valuation principles are discussed in Q
9025, while Q
9026 outlines the potential impact of a buy-sell agreement upon valuation. Q
9027 addresses some of the more specific issues that arise when the business interests are composed of corporate stock.
Special estate tax valuation rules are discussed in Q
9035.
See Q
8992 to Q
9023 for a discussion of business succession planning in general.
1. Rev. Rul. 59-60, 1959-1 CB 237.