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How to Value a Business for Estate Tax Purposes

Picture this: you've built a thriving business, the pride of your life, and you want to ensure it passes smoothly to your family members and loved ones. However, estate taxes threaten to take a hefty chunk of your legacy. That's where business valuation comes in.

Business valuation is like appraising a piece of art—it's not just about the numbers on the balance sheet; it's about capturing the essence of your business, its potential, and its unique story.

Completing a business valuation should not be limited to issues around the owner's death.

Knowing your business's worth can help you benchmark against companies of similar size and make future business decisions.

But that said, business valuation is often done for reasons related to estate tax planning.

Why Business Valuation Is Crucial in Estate Planning

When it comes to estate planning as a business owner, a business valuation is indispensable because:

• Before transferring wealth, you need to know how much you're sharing. And the surefire way of knowing the amount of wealth you will transfer is by completing a business valuation.
• Knowing the amount of wealth you intend to transfer will facilitate accurate allocation, especially if there’s more than one beneficiary and multiple business interests.
• Knowing the size of your estate allows you to make strategic gifts throughout your life to avoid gift tax.
• Preparing a business valuation will help estimate the taxes your estate may owe. This lets beneficiaries know how much they will ultimately inherit after paying taxes.
• Valuing your business helps calculate the tax-free marital deduction for the surviving spouse.

Now that you know why valuing a business for estate tax purposes is important, let’s jump to how the actual valuation is done.

How to Value a Business

Business valuation is often done by Certified Public Accountants (CPA) with a professional designation called Accredited in Business Valuation (ABV). Business brokers can also assist sellers with a business valuation based on relevant comps and market trends.

However, as a business owner, you still need a basic understanding of the entire process. You don’t want to be in a position where your CPA or business broker is explaining stuff, and you’re blank.

The IRS prescribed valuation guidelines to guide professionals in the valuation process.

To a large extent, these guidelines are captured in the Internal Revenue Manual (IRM) 4.48.4 and Revenue Ruling 59-60.

Let’s go through some need-to-know provisions.

Business Valuation Methods

According to the IRS, businesses can be valued based on three methodologies as follows.

1. Income Approach (for commercial real estate and companies with predictable earnings)

Under the income approach, the value of a business is obtained by assessing its economic performance, especially its ability to generate revenue. For instance, the valuer will analyze recent sales, forecasted sales, recent cash flows, and projected cash flows.

2. Asset Approach (for unprofitable or closing businesses)

Under the asset approach, the value of a company is calculated based on the value of its assets. The IRS prescribes that assets should be valued at “Fair Market Value.” This refers to the market price of the tangible assets, assuming the transaction is between a willing buyer and a willing seller, and when all parties know all material facts.

3. Market Approach (for profitable ongoing businesses)

Under the market approach, also known as comparable analysis, valuers compare the financial metrics of similar companies and assume the same metrics will hold for the business being valued.

Aside from concrete financial data, the IRS requires professional valuers to consider other various factors, including:

• Nature of the business
• Risk involved
• The company’s industry
• Stability or irregularity of earnings
• Other relevant facts

The next step after determining the value of your business is to figure out your business’s tax liability.

Business Valuation: Tax Liability and the Basic Exclusion Amount

Under the 2017 Tax Cuts and Jobs Act (TCJA), businesses valued below $13.61 million can usually be passed on to beneficiaries without any tax obligations.

However, larger estates may be subject to estate tax on a graduated scale.

These larger estates may be subject to other taxes beyond estate taxes, including:

• Income tax
• Capital gains tax
• State and local tax

Factors That Lower the Total Value of a Business or Estate

Even if your business’s value is above $13.61 million, there’s a chance you can still avoid paying estate tax. This is because the tax code allows for some valuation discounts.

Factors that can lower the total value of a business include:

• Key Man Discounts: If the seller was literally the “key man” in the business—such that company performance may suffer in their absence—the value of the business can be lowered.
• Minority Discounts: When professional valuers value only 30% of a business, for instance, and this portion relates to a minority ownership interest, the value they calculate is discounted further. This reflects the lack of control by a minority interest.
• Marketability Discounts: Because they do not trade their shares on a securities exchange, closely held businesses are considered less marketable. This lack of marketability causes their values to be discounted.

What About a Business Appraisal?

While there can be some nitpicking here, business valuations and business appraisals are often used interchangeably. When selling a business, an independent appraisal provides an objective analysis of the company's fair market value. An appraiser may use a combination of all three valuation approaches to ensure a more comprehensive and accurate assessment of the business's worth.

Visit the BizBuySell Valuation Center to learn more about how to value a business for estate tax purposes. Quickly gauge the value of your business with the BizWorth Calculator or opt for a more comprehensive analysis with the BizBuySell Valuation Report.

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