The IRS will want to know, and you should know how they'll figure it out. Revenue Ruling 59-60 has the answers.
Sooner or later every closely held business must be valued for either sale or tax purposes. As we said last month (June, page 139), you can do it while you're alive, or the Internal Revenue Service will do it for you when you're dead. The process of valuation, however, is the hardest task in taxation. The primary reason is that the rules of the game aren't very well defined.
Valuation is an art, not a science, but there are disciplines to follow, lying mainly in approaches and techniques. The IRS outlines its approach in Revenue Ruling 59-60, a document that is must reading for any owner of a closely held company.
Ruling 59-60 lists eight factors to consider in a valuation:
* The nature of the business and its history from its inception
* The economic outlook in general and the condition and outlook of the specific industry in particular
* The book value of your stock and the financial condition of the business
* The company's earnings capacity
* The company's dividend-paying capacity
* Whether or not the business has established goodwill or other intangible values
* Past sales of stock and the amount of stock to be sold now
* The market price of publicly owned and traded companies in the same or a similar line of business
The ruling further states that "all available financial data" and other "relevant factors affecting the fair market value" must be considered.
To see how an approach to valuing a business might work, refer to the box on this page. Remember that the real value of the company -- the amount on which you must pay taxes -- will probably be determined by a combination of approaches. The IRS itself emphasizes that the eight factors listed above do not have equal weight, and that valuation is a matter of judgment and common sense. Two companies in the same business, with almost identical numbers, could have substantially different values because of a change in just one factor. No set of general rules or volume of regulations can account for the importance of unique facts.
However you solve the valuation puzzle for your business -- and it's a process to be left in the hands of professionals -- there will always be one important factor to consider. The courts call it "general lack of marketability." The problem is simple to explain. If, for argument's sake, you own 100,000 shares of a stock currently selling for $10 a share, you can call your broker and receive $1 million in about four days, less commissions and, in the long run, taxes. If your company, on the other hand, turns out to be worth the same $1 million, you're unlikely to find a buyer who will pay you the full amount in cash as of the date of valuation. To account for this fact, a discount from the "real" valuation of 10% to 30% is frequently allowed by the courts in tax cases. Of course, that presumes that you or your heirs would have to go to court to dispute the IRS over valuation of your business. It's more likely than you might think.