Valuing closely held businesses.

VALUING CLOSELY HELD BUSINESSES

When the owner of a closely held business dies, one of the most important estate tax considerations is the value of the business. Because the stock of such a corporation is held by a small number of shareholders (sometimes only one), this stock is not widely traded and a market value is not readily available.

VALUATION FACTORS

While acknowledging that this process is inexact, the Internal Revenue Service has set out eight factors that should be carefully considered in determining the value of any closely held corporate interest. These factors are not given equal weight; they must be evaluated within the context of each company's situation. In addition, they are somewhat general; even using the same factors, different overall values may be reached.

The nature and history of the business. This should include consideration of all aspects of a company's business, its products or services, operating assets and facilities, capital structure, sales records and management track record.

The economic outlook of the industry. This analysis involves evaluating a company's economic position with respect to its current competitors as well as future prospective competitors. After a company's position within its own industry has been considered, the economic conditions in related industries and conditions in the national economy may be part of the analysis.

The stock's book value and the company's financial condition. Since book value usually reflects historic or acquisition cost, it is not necessarily a good indication of the fair market value of assets underlying the stock. However, it can serve as a starting point in a value analysis.

A variation might be to use asset valuation, that is, the actual fair market value of the underlying corporate assets.

The company's earnings capacity. This involves potential future earnings as well as current earnings and should include consideration of the nature of the company's business and the risks involved. For businesses that sell products or services to the public, usually this factor is by far the most meaningful.

Critical to this determination is the key employee concept. The rate used to value a company's earnings capacity may be discounted if the owner was the company's key employee and if much of the business was due to his or her individual efforts. Many companies try to minimize the effects of this type of situation with insurance on the life of this key employee, payable to the company. However, even with these insurance proceeds, there may be times when a discount on a company's earnings capacity due to the owner's death is reasonable.

The company's dividend paying capacity. This factor centers on a company's ability to pay dividends, rather than the dividends it actually has paid.

Goodwill or other intangibles. Goodwill may be related to some of the other factors and may or may not be considered separately. If the goodwill is attributable to the personal characteristics of the decedent, it may not be transferable after his death.

The degree of control represented by the stock to be valued. The size of the specific portion of stock to be valued is also important. Obviously, shares that represent only a minority interest (especially in a closely held company) do not have the same degree of control as a majority interest; persons holding minority interests do not have the same degree of influence over corporate decisions.

The value of comparable listed stocks. The price at which the stock of a comparable publicly held corporation is traded will be evidence of the closely held corporation's value.

To be comparable, the two companies should be in the same line of business. While not identical, their capital structures should be similar. And the companies should have parallel records of sales volume and earnings growth.

USE OF BUY-SELL AGREEMENTS 

An instrument that may be helpful in this valuation process is a buy-sell agreement. Usually under such an agreement, either the remaining shareholders or the corporation itself agrees to purchase the stock at a specified predetermined price. While this price is not necessarily always accepted as the business's estate tax value, as long as it was determined in some reasonable manner and is based on a bona fide business arrangement, it may be accorded some weight and help determine the value of the owner's interests.

Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.