Yes! Business valuations are a must for estate and gift tax purposes. Estate valuation principles relating to business interests are in Regs. 20-2031-2 (f) and 20-2031-3. Gift tax valuation principles relating to gifts and bargain sales of a business interest are in Reg. 25.2512.3. Valuations for estate tax purposes are critical because the valuation determines the extent of federal estate taxes and tax basis of the business interest for the beneficiaries of the estate. Court cases have emphasized the need for contemporaneous valuations before filing gift and estate tax returns! These same cases stress the need for having a valuation professional with experience, training, and credentials. Upon IRS challenge, a professional valuation provides strong evidence of the value of a given interest established using widely-accepted methodologies.
Generally there are two discounts considered in the valuation of a closely held business: 1) Lack of Marketability (Liquidity) and 2) Minority Interest (Lack of Control). The marketability (or liquidity) discount will apply in most valuation situations of privately-held companies. The data used in developing the appropriate discount or capitalization rate applicable to the subject company’s cash flow measure is based upon empirical evidence associated with publicly traded companies. Continue reading
In its simplest form, the Capitalization of Earnings Method provides an estimate of value of a company by converting the future income stream into value by dividing by a capitalization rate that incorporates a required rate of return for risk assumed by an investor along with a factor for future growth in the earnings stream being capitalized. This results in a value based on the present value of the future economic benefits that the willing buyer will receive through earnings, dividends, or cash flow. The capitalization method is based on the Gordon constant growth model which uses a single period proxy of future earnings to determine the present value of the asset. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant. Extreme caution should be used when attempting to use this method, as applying a capitalization rate to the wrong “type” of earnings could spell disaster.