What Is the Fair Market Value for a Closely Held Business?
Fair market value is the sale price that strangers would reach. Fair market value is defined by the Code as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” It is the sale price a hypothetical buyer and seller would reach, not the price that the actual owner would agree to or the price an actual buyer might be willing to pay.
Fair market value doesn’t necessarily equal sale price. You might think that a company’s sale price—for example, the actual sale price or the price set in a buy-sell agreement—would be the same as its fair market value, but this is not necessarily the case. The problem is that many transactions—especially those involving a closely held business—are not between strangers. If a sale is between family members or friends, the sale price may reflect that relationship.
For example, you might be willing to sell your car to your son for $3,000, to your friend at work for $7,000, to your neighbor for $10,000, or to your brother-in-law for $15,000. None of these prices are necessarily the fair market value for the car because you have set your prices based on emotional factors, like a desire to help your son and to take advantage of your brother-in-law.
Fair market value for a closely held business is open to interpretation. Valuation is more an art than a science, in spite of all of the numbers and the mathematics and economic analyses that surround the valuation process. Even the IRS acknowledges that there is no one, true fair market value for a closely held business. In the IRS Valuation Guide for Income, Estate and Gift Taxes, the IRS says that in determining fair market value, “there is no mathematically ‘right’ answer, only a range of possible right answers which can be supported by convincing and logical reasoning.” In another statement, the IRS explains that “a determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift taxes. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science.”
Why Should This Matter to You?
The IRS is on the lookout for sales below or above fair market value because such a sale could also be a gift. The difference between the fair market value and the sale price is a taxable gift.
Example(s): Barry owns a cabin that has a fair market value of $20,000. He sells the cabin to Joe for $4,000. Barry has made a $16,000 taxable gift to Joe–the amount that Joe underpaid for the cabin.
Barry owns another cabin that has a fair market value of $40,000. He sells that cabin to Shirley for $75,000. Shirley has made a $35,000 taxable gift to Barry–the amount Shirley overpaid for the cabin.
This is not to say that the IRS will characterize every bargain or every overpriced sale as a gift. The critical factor is the relationship between the buyer and seller. In the example, the likelihood that the IRS would characterize the amounts over- or underpaid as gifts is much greater if the parties were family members as opposed to total strangers.
What Factors Are Considered in Determining Fair Market Value?
Countless factors might affect the value of the business. However, the IRS has identified a number of relevant considerations:
- Nature of the business and history of the company
- Outlook for the economy in general and an industry in particular
- Book value and financial condition of the company
- Earnings capacity
- Dividend-paying capacity
- Goodwill/intangible value
- Sales of stock/size of block to be valued
- Market value of stock in comparable businesses
Caution: Unfortunately, merely knowing the types of factors that might be relevant in determining the fair market value for a closely held business isn’t of much use. Generally, only an appraiser will know how to analyze these factors to reach a conclusion as to the fair market value of a closely held business.
How Can You Determine the Fair Market Value of Your Closely Held Business?
Estimates are possible, but you really can’t expect them to be accurate (and they could be significantly off). There are some very simple ways to estimate the value of a closely held business. Typical rule-of-thumb estimates are based on:
- Industry percentage return on value of assets
- Percentage of annual billings
- Multiple of average cash flow
You might want to consider them, but only as very rough estimates.
Caution: Take any estimate with a grain of salt. This area is so complex and subject to interpretation that your estimate could easily be wrong by 100 percent, 1000 percent, or more.
Old appraisals are probably irrelevant. You may have had your business appraised for another purpose and think that the old appraisal is its fair market value. Unfortunately, that appraisal is probably irrelevant. Even if it is current, it was probably determined for a different purpose, and that makes all the difference.
For example, if you had the entire business appraised, and you own one-third, the value of your interest isn’t one-third of the total value—it may be 15 percent to 75 percent less (called valuation discounts) because part ownership isn’t worth as much as sole ownership.
If your business depends on your skill—for example, clockmaking—and you have an appraisal to get a loan, that value is irrelevant to the price that your estate will get for the business at your death. At your death, your company’s most important asset—you—will be gone.
A new appraisal specifically to determine the fair market value of your business will give you the best chance of determining its actual fair market value. Generally speaking, fair market value is determined based on one of three approaches:
- Asset approach: value determined based on the value of the company’s underlying assets and liabilities.
- Income approach: value determined based on the company’s earnings.
- Market approach: value determined based on the sale of interests in this company or comparable businesses.
Your appraiser should consider all three approaches, as well as the specific methods within them, and will decide on the most appropriate one for your business.
If you have questions, contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
