How to Calculate Business Valuation for Estate or Succession Planning
Business valuation is a critical step in estate and succession planning. For many owners, your business is your largest asset. If you are planning an estate or business transition, you need to know how to calculate business valuation accurately.
An incorrect valuation can be costly:
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Underestimating your business could make you miss tax-saving opportunities.
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Overestimating it may lead to unnecessary spending and planning efforts.
Why the IRS Cares About Business Value
The Internal Revenue Service (IRS) carefully monitors business sales, especially when prices fall below or exceed fair market value.
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Selling below fair market value may be treated as a partial gift, triggering gift tax on the difference.
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Selling above fair market value can also be treated as a gift to the buyer, which may have tax implications.
Knowing how to calculate business valuation properly ensures your transactions comply with IRS rules.
How Your Tax Liability Depends on Business Valuation
The value of your business directly impacts the taxes you owe:
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Capital gains tax on a sale
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Gift tax on shares you give away
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Estate tax on property at death
If the IRS calculates a different value than the one you reported, you or your estate could face additional taxes, interest, or penalties.Understanding how to calculate business valuation helps prevent costly mistakes and protects your financial future.
Why a Business Valuation Might Be Needed
No Active Market to Set Price
Large, publicly traded companies have active markets. Their stock price, set by buyers and sellers, usually represents fair market value.
Closely held businesses, however, don’t have this advantage. Without an active market, determining value becomes more challenging. Knowing how to calculate business valuation is essential for gift, estate, or sale purposes.
Determine Capital Gain
When you sell your business, your capital gain equals the sale price minus your basis in the business. This gain must be reported and is subject to capital gains tax.
A proper business valuation ensures the sale price reflects fair market value and that your tax liability is accurate.
Selling to a Family Member
If you sell your business to a family member, the IRS may carefully review the transaction for disguised gifts.
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If the IRS determines your business is worth more than your sale price, you could owe gift tax on the difference.
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Challenges can arise years later, and interest or penalties may apply.
Hiring a qualified appraiser to perform a valuation can help you avoid disputes and ensure compliance. Understanding how to calculate business valuation correctly protects both you and your family.
Sale of business to outsider
If you plan to sell your business to a nonfamily buyer, you likely want to maximize your sale price. An independent business valuation can help achieve this goal. It also reassures the buyer that the price is fair.
Without a valuation from a qualified appraiser, potential buyers may assume the business is overpriced, making it harder to sell.
Timing and circumstances affect the sale price. For example:
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A forced sale—when you need cash quickly—usually results in a lower valuation.
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A planned sale allows time to present your business at its full value.
Learning how to calculate business valuation properly ensures you set a fair price and attract serious buyers.
Transfer of business under buy-sell agreement
If your business has a buy-sell agreement, you already have a buyer lined up for your ownership interest when certain events occur.
A properly drafted buy-sell agreement may also establish the taxable value of your business interest. Some agreements require a periodic valuation to ensure the price remains accurate over time.
When an ownership interest changes hands under the agreement:
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The valuation sets the price exchanged between the parties.
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It determines the tax basis for the buyer.
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It calculates the capital gain for the seller.
Periodic valuations help prevent disputes and ensure smooth ownership transitions.
Transfer of interest by gift
Part of your estate planning strategies may be to transfer your business interest by gift. Gifts of a certain size are not subject to gift tax. In order to determine if you must pay gift tax (and, if so, how much), you need to know the value of the gift. Any time a business interest is transferred by gift, a valuation should be conducted to document the gift tax value and reduce the risk of the IRS changing the value of the gift upon a later audit.
Tip: Do the valuation as closely as possible to the date of the gift.
Estate tax purposes
A business valuation may be required when an owner dies. A valuation at this point can ensure that all applicable discounts are reflected in the value. It is also of major importance in determining the estate tax liability. The last thing your estate needs is to be subjected to an IRS audit and have poor (or no) documentation of the business valuation used in the estate tax return. If the business has a buy-sell agreement, a valuation may be needed to calculate the price at which the interest will be sold to the buyer named in the agreement.
Valuation issues
Appraisal versus value
An appraisal is the process of determining value and represents an opinion. The result of the appraisal analysis is the assignment of a value based on a specific point in time. There is no one process and generally no one definitive value for a business. It is possible for a business to have different values, depending on the purpose of the evaluation and the interpretation of the criteria examined. Because there is no single method or definition, it is important that the appraisal report contain a specific definition of value and the assumptions used in the analysis.
Multiple approaches to determining value
There is more than one way to approach a business valuation. The nature of the business itself may indicate that one way is more appropriate than another, and while there are general rules, it is still more art than science. Furthermore, appraisers are at their own discretion in determining if intangibles, fair market values or liquidation values will be used. Appraisers using the same named approaches may use different techniques to determine the value. As a result, sometimes multiple, independent valuations are conducted, and an average result is used. The table below shows three common valuation methods:
| Method | Methodology |
|---|---|
| Income approach | Value is based on expected income generation |
| Asset approach
Market approach |
Value is determined on basis of business assets
Value is based on past sales of shares of this or a similar business |
Valuation may be discounted
The value of some ownership interests may be discounted under certain conditions. For example, a minority stock interest in a closely held corporation is often discounted for estate tax purposes.The discount applies because minority shareholders cannot influence corporate decisions or policy, which reduces the interest’s marketability to anyone except controlling shareholders.
However, a minority interest that cannot control policy but is large enough to sway decisions may have its discount challenged by the IRS.Understanding how to calculate business valuation correctly ensures that any discounts applied are accurate and defensible in case of an IRS review.
Valuation can be disputed
A lot of factors can affect the value of a business. Disputes between taxpayers and the IRS involving the valuation of property occur relatively frequently. To complicate things, even the IRS acknowledges that there is no one, true, fair market value for a closely held business, so the area is open to interpretation. Moreover, not only might the valuation be subject to dispute, but inaccurate valuations for tax purposes could be subject to civil and criminal penalties.
Timing is important
Transactions are valued by the IRS on the date of the transfer. To reduce the chance of the IRS calculating a value that differs greatly from the value you paid tax on, your valuation should be determined (and documented) as closely to the transaction date as possible.
| Event | Valuation Date | Type of Tax |
|---|---|---|
| Gift | Date of completion of gift transfer | Gift tax |
| Sale | Date of sale | Capital gains tax |
| Death | Date of death OR alternate valuation date six months after death | Estate tax |
Tip: It is important to get an accurate appraisal of the value of a business interest any time the business is transferred as a result of lifetime gift, sale, or bequest.
Different definitions of value
Fair market value
Fair market value (FMV) is the price at which property would change hands between a willing buyer and a willing seller (who are independent, nonfamily members), where both parties have reasonable knowledge of the relevant facts, and neither party is under any compulsion to buy or sell. This is the definition frequently used by the IRS.
Fair Value
Fair value is different from fair market value. In business valuation, fair value is a statutory standard used in specific legal or corporate situations.It is often applied when minority shareholders feel they are not receiving full consideration during a merger, sale, corporate dissolution, or auction.In these cases, the minority shareholders have their shares appraised. They then receive cash equal to the fair value of their shares.Knowing how to calculate business valuation properly ensures that fair value is accurately determined and legally defensible.
Investment value
Investment value is specific to an owner (or prospective owner) and includes consideration of factors such as the owner’s knowledge, abilities, related business interests, and expectation of earning potential and risk. A business will likely have different investment values to different people, depending on specific factors (i.e., the value is in the eyes of the beholder).
Intrinsic or fundamental value
Intrinsic value is a term that carries different meanings to different professionals. In some cases, it is used to refer to fair market value, fair value, investment value, or even some other type of value. Sometimes it is used to refer to the analysis of an investment banker, security analyst, or financial manager or analyst. The point is, this term has several meanings and interpretations, so it is very important that any valuation including this term have a very specific definition of its usage.
Going concern value
A going concern value considers factors specific to the business, both physical and intangible. Consideration is given to the existing infrastructure, goodwill, reputation, trained workforce, licensing, and/or plant capabilities of the business. The valuation is based on the assumption that the business will continue to be a viable operating entity and as such should bear a higher value than the sum of the values of its collective assets.
Liquidation or breakup value
Liquidation value is a determination of the proceeds (net of selling costs) realized if a company ceased operating and sold off the assets. There are two types of liquidation, and the specific situation will affect the valuation. An orderly liquidation involves the sale of assets over a period of time to maximize proceeds. A forced liquidation, on the other hand, means selling the assets as quickly as possible (often by auction) and often at a lower value than might otherwise be achieved if more time were available.
Book value
Book value is an accounting term that can apply to a specific asset or an entire company. An asset’s book value equals the historical cost minus any allowances for depreciation, amortization, or unrealized losses. The book value for a company is the shareholders’ equity, calculated from the balance sheet as the excess of total assets over total liabilities.
How do you determine the taxable value of your business?
Find a qualified appraiser
Determining the value of your business is not something you should attempt on your own, especially in light of the fact that the IRS could challenge your valuation. There are appraisers who specialize in determining the value of businesses. Your CPA may even be one of these specialists or know someone who is.
Don’t use an old appraisal
You may have had your business appraised in the past for another purpose. As tempting as it might be, don’t use an old appraisal now. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation.
FAQ
1. What is business valuation?
Business valuation is the process of determining the monetary value of a business. It is essential for estate planning, succession planning, sales, or gifting.
2.How do I calculate the value of my business?
There are several methods:
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Income approach: Based on expected income generation
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Asset approach: Based on business assets
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Market approach: Based on sales of similar businesses
Discounts may apply for minority shares or lack of marketability.
3. Do I need a professional appraiser?
Yes. A qualified appraiser ensures your valuation is accurate, defensible, and accepted by the IRS. Avoid using old appraisals, as market conditions and business factors change over time.
4. Can business valuation be discounted?
Yes. Minority interests in closely held businesses may receive a discount if the shareholder cannot influence company decisions, which reduces marketability.
5. Can business valuation help attract buyers?
Yes. An independent valuation reassures buyers that the price is fair and helps prevent disputes, especially when selling to outsiders.
