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Valuation and tax considerations in selling the closely-held corporation.

The owners of a closely-held corporation may want to sell their businesses for a variety of reasons. A closely-held corporation is defined as one that does not sell its stock to the public and whose owners are officers and directors involved with the management of the business on an ongoing basis.

Owners may want to sell because they are nearing retirement and there are no family members who have the interest or capability to continue the operation. Other owners may simply become bored with the business and look for alternative earning opportunities. A number of other reasons may exist to explain why the owners of a closely-held corporation may want to sell.

The reason for the sale, how to find a qualified and interested buyer and the timing of the sale, although major factors, are not the topic of this article. This article focuses on estimating the value of a business and structuring the sale in a manner suitable to both the seller and the buyer. Valuation is concerned with the worth of an ongoing business. The structuring of the sale is concerned with the tax implications to both seller and buyer.

Estimating the Value of a Corporation

In negotiations between the seller and the buyer of a business to arrive at the fair market value, the parties normally will look to the sales prices of similar businesses, attempt to determine the value of the net tangible assets and, if appropriate, an amount for goodwill, estimate the future earnings of the business and project future cash flows. The different methods may be used to establish floor and ceiling prices and then to establish a negotiated value within that range.

Sales of Similar Businesses

One approach to estimating the value of a business is to determine what has been paid for similar businesses in the recent past. An objective is to compare similarities and differences so that adjustments can be made for special conditions. There are two major hurdles in applying this method: the knowledge that a sale took place and the details of the sale. Given that the transaction involved a closely-held company, the details likely will be confidential. If one becomes aware of the parties involved, a direct inquiry may provide information, assuming that neither the inquiring nor the responding parties will breach confidentiality restrictions.

Net Asset Approach

Table 1 shows comparative balance sheets for Local Carpets, Inc. as of December 31, 1995, and December 31, 1994. At December 31, 1995, the tangible net asset value per the balance sheet is $354,000 ($645,000 assets less $291,000 liabilities). The numbers shown on the balance sheet are developed by applying generally accepted accounting principles and may have little relationship to their value. If an independent appraisal of the individual assets indicated that they had a total fair market value of $725,000, the tangible net asset value - sometimes referred to as "book value" - would be $434,000. Any effort to value a business using the net asset approach should involve the separate appraisal of the individual assets. The seller of a business, however, must be aware of the fact that a potential buyer is generally interested in the business for its ability to generate earnings. Thus, the net asset value approach is not considered the most reliable method for estimating the value of a business. The net tangible asset value, however, may provide the seller with an estimate of the absolute minimum amount that he or she could accept in a sale. The seller normally would not sell the business for its tangible net asset value because that amount does not consider the possible intangible assets. These could include such things as goodwill, customer lists and going concern items such as reliable suppliers and trained employees.
Table 1:

Local Carpets, Inc. Balance Sheets
December 31, 1995 and 1994

 1995 1994

Assets:

Cash $78,000 $21,000
Accounts receivable 145,000 135,000
Inventory 190,000 180,000
Prepaid expenses 7,000 6,000
Land 30,000 30,000
Building 200,000 200,000
Equipment 65,000 60,000
- Accumulated depreciation (70,000) (55,000)

 645,000 577,000

Liabilities and equity:

Accounts payable 100,000 115,000
Other current liabilities 51,000 60,000
Mortgage note payable 140,000 150,000
Common stock 50,000 50,000
Retained earnings 304,000 202,000

 645,000 577,000


The net asset approach may also be useful to the potential buyer of a business. To continue with our example, if the net tangible asset value of Local Carpets, Inc. at December 31, 1995, is $434,00 and the intangible assets have an estimated value of $50,000, the total net asset value is $484,000. Assume that the potential buyer is considering the acquisition of the business for a price of $484,000. If the buyer requires a rate of return of 25%, the business would need to earn $121,000. Table 2, which shows comparative income statements for Local Carpets, Inc. for 1995 and 1994, indicated that the business earned only $102,000 in 1995. In this case, the potential buyer would have to assess the probability that future earnings would be sufficient to meet the required rate of return. If the potential buyer requires a rate of return of 20%, the business would have to earn $96,800 ($484,000 x 20%) to meet this objective. Under this scenario, the business is already earning a return that meets the buyer's investment objective.
Table 2

Local Carpets, Inc.
Income Statements for the Years Ended December 31, 1995 and 1994

 1995 1994

Sales $1,800,000 $1,620,000
Cost of sales (1,152,000) (1,053,000)

Gross profit 648,000 567,000

Expenses other than taxes:

Operating, except depreciation 480,000 432,000
Depreciation 15,000 13,000
Interest 13,000 15,000

Total 508,000 460,000
Income before taxes 140,000 107,000
Income taxes (38,000) (25,000)

Net income 102,000 82,000


Although the net asset approach may not be the ideal way to estimate the value of a business, it may be particularly useful in the sale of smaller businesses whose future earnings are highly uncertain. This approach is also useful for arriving at a minimum value for the business and for comparing with the results obtained using other methods.

Earnings-Based Methods

Earnings-based methods generally are considered the most reliable for estimating the value of a business. This approach is based on the assumption that the value of a business is equal to the net present value of its future earnings.

Although earnings are widely considered the primary determinant of value, the use of this approach to value closely-held corporations has obvious limitations. One difficulty is estimating the future earnings, which are typically projected on the basis of past earnings. This method may be particularly unreliable for small closely-held corporations. For example, a business may be unusually dependent on a few customers, may be especially affected by the general economic climate, etc. Predicting changes in these types of situations is likely to be extremely difficult.

In estimating future earnings, the quality of prior earnings should be carefully evaluated. For example, salaries paid to the ownership group should be evaluated for their reasonableness (they may be unreasonably high or unreasonably low), and the accounting methods used for such items as inventory, depreciation and income taxes should be considered. Appropriate adjustments should be made to arrive at normal earnings based on reasonable compensation and accounting methods that best measure results of operations.

One approach to using earnings as a basis of valuation is to use a capitalization rate. Arriving at a capitalization rate is a somewhat subjective process, but it generally consists of a risk-free rate - usually the long-term Treasury Bond rate - plus premiums for risk and lack of marketability or liquidity. This approach is appropriate when future earnings are expected to be relatively stable. In our illustration, if Local Carpets, Inc. is expected to earn $110,000 per year in the future and 20% is deemed to be the appropriate capitalization rate, the value of the business would be estimated at $550,000 ($110,000/.20).

If earnings are expected to vary considerably in future years, an alternative is to discount those projected earnings back to their net present value to ascertain an estimate for the value of the business. The capitalization rate mentioned above could be used as the discount rate.

In some cases, particularly for service businesses, gross revenue may be used as a basis for estimating value. For example, if a business has a gross income of $300,000 per year and the appropriate multiplier is 1.5, the estimated value of the business would be $450,000. Although this is not a particularly logical approach, it may be useful in arriving at a general estimate of the value of a business. One must be familiar with multipliers used for different types of businesses and make adjustments for any special conditions that may exist.

The Internal Revenue Service has outlined a procedure for valuing a business based on earnings attributable to tangible assets plus earnings attributable to intangible assets. This procedure is used in Revenue Ruling 68-609.
Table 3

Local Carpets, Inc.
Statement of Cash Flows for the Year Ending December 31, 1995

Cash flows from operating activities:

Net income $102,000

Add (deduct) items not affecting cash:

Depreciation 15,000
Increase in accounts receivable (10,000)
Increase in inventory (10,000)
Decrease in accounts payable (15,000)
Other (10,000)

 72,000

Cash flows from investing activities:

Purchase of equipment (5,000)

Cash flows from financing activities:

Payment on mortgage note (10,000)

Increase in cash 57,000


Discounted Cash Flow

In the past few years, cash flows have become more widely used in evaluating business operations. A statement of cash flows is considered a basic financial statement under generally accepted accounting principles. The statement shows cash flows from operating, investing and financing activities.

Table 3 shows a statement of cash flows for Local Carpets, Inc. for the year ending December 31, 1995. The statement shows that operations generated a positive cash flow, whereas the investing and financing activities reduced the cash available.

Discounting future cash flows to estimate the value of the business is generally considered one of the more theoretically correct approaches. But how should cash flow be defined for this purpose? One approach would be to start with the cash flow from operations and adjust for capital expenditures and debt service requirements. Another approach would be to add noncash charges such as depreciation to net income and adjust for capital expenditures and debt service requirements, on the assumption that changes in receivables, payables and other operating items even out over time. The different approaches outlined in Table 3 provide significantly different cash flow amounts.

As is the case with projecting future earnings, estimating future cash flows is a difficult undertaking. Nevertheless, cash flow is an important aspect of valuing a business.

Combination Approaches

Although some valuation methods may be more theoretically correct than others, a less rigorous method may provide information that is more verifiable. For example, the use of projected earnings to value a business is widely regarded as more theoretically correct than is the use of the net asset method. However, it is easier to establish a fair value for existing assets than it is to accurately predict future earnings. Thus, it may be appropriate to use a combination of approaches to arrive at a reasonable estimate of the value of a business.

Tax Considerations in Structuring the Sale

A key element in closing a deal for the sale of a closely-held corporation is the recognition that the structuring of the sale has different tax implications to the buyer and seller. The basic decision is whether the assets or the stock will be sold. Whether the entity is a C or an S corporation, and whether it has always been that type of corporation, will have significant tax implications to the seller if assets are sold.

Sale of Stock

The advantages of a stock sale are its simplicity and favorable long-term capital gain treatment - assuming the stock has been held more than one year - to the seller. For federal income tax purposes, assuming long-term capital gain treatment applies, the excess of the amount received over the seller's stock basis is taxed at a maximum rate of 28%. Thus, they buyer gains control of the corporation in a simple transaction and the seller receives favorable tax treatment. Although control of publicly-held corporations frequently is obtained through the acquisition of stock, the buyers of closely-held corporations normally prefer to acquire the assets of the business. Since the seller generally would prefer to sell stock, the agreed-upon price for the sale is likely to be affected by whether the assets or the stock is being sold.

If stock is to be sold, an installment sale might be attractive to both the buyer and the seller. The buyer does not have to obtain outside financing, since the purchase is financed by the seller. Both parties should be aware of imputed interest rules if the interest rate on the debt is below IRS guidelines.

Section 453 of the Internal Revenue Code permits the recognition of income on the installment basis from the sale of stock that is not publicly traded. For example, if an owner sold stock to be paid for in equal installments over a five-year period, the taxable gain on the sale would be recognized as the seller collected the payments. Such an arrangement would not only spread the taxable income over a number of years but would, as previously noted, limit the amount of tax payable to the rate that applies to long-term capital gain income. The Revenue Reconciliation Act of 1993 raised ordinary income rates to a maximum of 39.6%, making long-term capital gain treatment even more attractive.

Sale of Assets

Generally, the sale of assets and subsequent liquidation of the business is unattractive to the seller of a closely-held business. This is particularly true if the business is a C corporation. Any gain on the sale of assets will be taxed to the corporation, and when the net assets are distributed in liquidation, the shareholder(s) will be taxed on the amount by which the proceeds received exceed the stock basis. The sale of assets followed by liquidation of the business thus results in gains being taxed at both the corporate and the shareholder levels, a disadvantage of operating as a C corporation. One of the advantages of a closely-held corporation electing S status upon formation is the elimination of the double taxation of earnings. It should be noted, however, that an S corporation which was formerly a C corporation will be subject to the built-in gains tax on any asset sales within 10 years after the S election is made.

Even though no tax may be imposed, an S corporation that sells its assets will recognize gain or loss, the nature of which depends on the classification of the asset sold. Gains and losses pass through to the shareholders and are reported on their individual tax returns. Recognized gain increases the basis of the shareholder's stock, thus reducing the gain recognized on liquidation of the corporation. In this situation, the gain on the sale of assets is effectively taxed only once.

Although sellers generally prefer a stock sale, buyers typically opt to purchase assets. Buyers prefer the acquisition of assets and subsequent incorporation of a new business for a number of reasons: any accumulated earnings and profits are eliminated; the new business is free of any hidden liabilities; the assets acquired receive a step-up in basis (normally the cost will exceed the basis) with the attendant increased depreciation deductions; employee benefit plans may be restructured or eliminated; and the new owners are free to choose the state of incorporation. These buyer advantages for acquiring assets will generally outweigh any advantages relating to the acquisition of stock, such as the existence of a net operating loss carryover.

Sale of Stock to an ESOP

The use of an employee stock ownership plan (ESOP) is an attractive way for the owners of a C corporation to sell stock and, if desired, to still maintain an ownership interest. An ESOP is essentially a tax-qualified pension plan for the employees where the assets consist primarily of the sponsoring company's stock. It provides flexibility in that the plan can acquire stock directly from the corporation, enabling it to raise capital for any expansion needs, or directly from the owners of the business, enabling them to gradually cash out. These plans may be particularly attractive to employees, giving them an ownership interest in the company for which they work. Such equity interests may lead to a more productive employee group.

Typically, an ESOP borrows money to buy the sponsoring company's stock. Leveraged ESOPs offer many tax advantages. Principal payments on ESOP loans are tax deductible to the corporation, as is the interest on indebtedness. Future employer contributions to the ESOP are also deductible to the company in calculating taxable income. Banks and other commercial lenders may exclude 50% of the interest earned on ESOP loans in determining their taxable income if the ESOP owns 50% or more of the employer's stock. In addition, an individual that sells employer stock to an ESOP may be able to defer recognition of any gain for tax purposes if the sale proceeds are used to acquire qualified securities (stocks and bonds of U.S. operating companies) of another company and if the ESOP owns 30% or more of the stock.

The costs of services of an attorney, accountant and investment adviser to establish and maintain an ESOP can be substantial. The company's stock must be valued periodically. Because of the costs involved in establishing and maintaining ESOPs, they are feasible only for companies of sufficient size that have a minimum number of employees.

Nontaxable Reorganization

Section 368 of the Internal Revenue Code describes the various types of corporate reorganizations eligible for tax-free treatment. The corporate reorganization provisions are quite complex and beyond the scope of this article, but it is pertinent to note that if various requirements are met, owners of a closely-held corporation may be able to sell it in a tax-free transaction. Three types of corporate reorganizations permit the sale of a business tax free or partially tax free: a merger or consolidation (so-called Type A), stock-for-stock exchange (Type B) and the transfer of substantially all assets for stock (Type C). In all cases, the owners of the acquired closely-held corporation must have a substantial equity interest in the acquiring corporation to meet the requirements of a tax-free reorganization. The basis of the stock received in the acquiring corporation is a carryover from the stock of the acquired corporation. Gain would be recognized when the shares of the acquiring corporation are sold.

Summary

Two key factors in the sale of a closely-held corporation are: determining its value and structuring the sale in a manner suitable both for the buyer and for the seller. Valuation methods can be based on net assets, earnings, cash flow or some combination thereof.

The form of the transaction, through its tax effects, can have an impact on the agreed transaction price. Because of tax implications, buyers normally prefer to acquire assets, whereas sellers generally prefer to sell stock. Whether the selling entity is a C or an S corporation has important tax implications to the seller.

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Charles T. Hays, PhD, CPA, and Joel Philhours, PhD, CPA, are professors of accounting at Western Kentucky University in Bowling Green, Kentucky.
COPYRIGHT 1997 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997 Gale, Cengage Learning. All rights reserved.

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Author:Hays, Charles T.; Philhours, Joel
Publication:The National Public Accountant
Date:Jan 1, 1997
Words:3449
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