Business valuation can be extremely complicated, and often an expert is employed take on this task. However, it is still important for a business owner to understand the framework and factors discussed in IRS Revenue Ruling 59-60.
IRS Revenue Ruling 59-60 provides the fundamental rules for business valuation of a closely held corporation. The stated purpose of the ruling is to “outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes.”
Somewhat surprisingly, even though the ruling is over fifty years old, it is still extremely relevant to how shares of closely held corporations are valued; it is the most insightful and widely cited source regarding business valuation.
While the stated purpose fails to mention that it should be used for family law matters, it is extremely relevant to this area of the law. When a business owner goes through a divorce, the business will need to be valued so that equitable distribution and property settlement can take place. Because this ruling essentially lays the framework for business valuation, it has obvious significance for divorcing business owners.
As the ruling explains, the eight factors listed below are not intended to be an all-inclusive list. Depending on the circumstances, other factors may be contemplated, but at a minimum these eight should examined.
Before discussing the eight factors set forth in IRS Revenue Ruling 59-60, we will discuss the concept of “fair market value,” as this is the value that the appraiser will be calculating.
The fair market value is an estimate of the value of what any given piece of property is worth. Fair market value is calculated as being the price at which a willing buyer would buy, and a willing seller would sell the item, both having reasonable knowledge of relevant facts. Additionally, this hypothetical transaction is one that occurs when the buyer is not under any compulsion to buy and the seller is not under any compulsion to sell.
Various court and appraisal opinions have added another element of fair market value, namely that it should represent an all-cash value. For instance, the value is not what someone may pay for any given item if he or she has to finance the purchase.
Determining the fair market value of some items is easy. The fair market value of your vehicle can easily be found by using an online value book. Having an appraisal done or looking at neighborhood comps can point to the fair market value of a piece of real estate. There are even reasonably straightforward methods to determine the fair market value of unique items such as an autographed baseball card, piece of artwork, or stamp collection.
But how do you find the fair market value of your business? It is hard to imagine a scenario where you willingly sell your business, to a willing and knowledgeable buyer, with neither party being under any pressure to buy or sell. And even if you could, what would the sale price be? But equitable distribution requires that a fair market value be given to a spouse’s business, so there has to be some way to attach a value to your business.
In understanding the difficult nature of placing a fair market value on a business, the IRS came up with eight factors that it promotes consideration of in order to achieve this difficult task. Each of those factors is laid out below.
(a) The nature of the business and the history of the enterprise from its inception.
By looking at both the nature and history of the business, it will give some indication as to the stability, or lack thereof, and the pattern of growth. This factor encompasses everything from where the business has been located, to who is running it, what the customer base is, the competitive strengths and weaknesses, and anything else that is relevant to the nature of the business and the history of the enterprise.
(b) The economic outlook in general and the condition and outlook of the specific industry in particular.
This factor indicates that any appraisal must contemplate economic conditions; both current and prospective amongst the backdrop of the national economy and the economy with regard to the particular industry the business is a part of. Whether your business is more successful than competitors is important in placing a value on the business. The risk associated with the business must also be considered, as the degree of risk plays a big factor affecting the future success of the business.
(c) The book value of the stock and the financial condition of the business.
To obtain the book value, the ruling explains that you should look at comparative annual statements for at least the two years preceding the appraisal, perhaps even longer. These annual statements should be viewed alongside the respective balance sheets. The book value in and of itself will provide little help in valuation, however it does provide a good starting point for conversion to fair market values.
(d) The earning capacity of the company.
The earning capacity can be found by viewing detailed profit-and-loss statements from the years leading up to the appraisal. The ruling suggests obtaining profit-and-loss statements from at least the previous 5 years, with each statement providing the following information:
(e) The dividend-paying capacity.
This basically is an inquiry into whether there are enough remaining funds, after paying expenses and accounting for future growth, to issue a dividend to shareholders. You will notice that the concern is given to potential dividends rather than actual dividends.
(f) Whether or not the enterprise has goodwill or other intangible value.
Goodwill refers to the concept of earnings in excess of a normal rate of return based on certain intangible factors. Relevant intangible aspects of the business are the prestige and renown, the ownership of a trade or brand name, and successful operation of in a particular location over a prolonged period of time. These intangibles are relevant to an appraisal of the business because they can help provide context for future earnings and growth.
(g) Sales of the stock and the size of the block of stock to be valued.
Careful investigation into this will prove if the transactions were at arm’s length or were isolated sales in small amounts. If sales of stock are made under distress or are otherwise forced, those sales are not reflective of the true fair market value of the stock.
(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
Essentially, the appraiser will need to consider “comps.” The value of your competitor’s stocks, traded and sold in a free market will shed light on the value of your company’s stocks. Per the ruling, in selecting corporations for comparative purposes, care should be taken to use only comparable companies.
Clearly walking through those eight factors is not something that can be done casually with an untrained eye. When it comes to valuing a business for purposes of equitable distribution, more often than not an expert is called upon, such as a Certified Public Accountant (CPA) with forensic experience, a Certified Business Appraiser (CBA) or an Accredited Senior Appraiser (ASA).
While you may have an expert come up with your business valuation, it is still important to understand this IRS Revenue Ruling. Knowledge of these factors will help you understand why the expert is asking for certain information from you, why the valuation process may take longer than you expected, and ultimately how the expert comes up with the fair market value of your business.
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