There are several common tax scenarios that require business owners to determine a justifiable dollar value for their companies. Business valuations are critical for gift and estate tax liability purposes, and/or to engage in the sale of your business. In all of these instances, business valuations determine the taxable value of your business interest, and that is not a figure you want to get wrong.
Reporting Gift and Estate Taxes
One of the most common tax purposes to drive a valuation is for federal estate tax planning and/or gift tax reasons. In this case, the fair market value of a company is absolutely necessary to determine your tax liability. The value applied to your business has a direct correlation to the taxes you will owe, whether they be gift taxes on shares you have given away or estate property taxes. If the value determined by the IRS differs from the value you used for your tax calculations, you or your estate could be liable for additional taxes. Valuations for estate tax purposes are especially complex because they are based on a body of laws and regulations that are always in flux, changing with new court decisions or government priorities.
Occasionally, owners choose to give all or part of their interest in a business away to a charity of their choice. Donations are typically made with cash, but corporations may also choose to donate stocks, machinery, real estate, or other assets. Should you find yourself in this situation, the IRS requires a business valuation as documentation to support the deduction for the years in which the gift was given. Assuming the fair market value of the donation is properly assessed, you are generally able to deduct that amount from your taxable income, thereby lowering your taxes and supporting a charitable organization at the same time.
Sale of Business/Succession Planning
The value of your business drives the capital gains taxes that result from a sale, so you will need to determine the taxable value of your business interest as accurately as possible. If you underestimate, you will likely overpay on taxes because you will miss out on certain tax-saving strategies. Furthermore, selling a business interest for less than fair market value can cause the IRS to deem the transaction a combination sale and charge you gift tax on the difference between the stated value and the value the IRS determined. Transactions from one family member to another are especially scrutinized by the IRS, but any sale involving a disparity in the fair market value versus the stated value will cause your transaction to be flagged. Unfortunately, by the time the IRS challenges the value, years could have passed, meaning that your additional tax liability will be compounded by accrued interest and penalties.
Similarly, if you overestimate, you could invest more time and money into the process than is necessary. The IRS could also deem an above fair market sale a gift from the buyer to you and charge you the resultant gift taxes. An independent business valuation helps you attain the highest possible fair price for your business, ensuring you profit while avoiding additional taxes and penalties. Valuations are also integral for buy-sell agreements for similar reasons.
Without a valuation from an independent, qualified appraiser, any of these tax scenarios could, unfortunately, implode. While the fair market value of a business is always open to interpretation, the IRS is much less likely to challenge professional appraisals based upon sound assumptions and ample supporting evidence.