• Pete Dziedzic

Tier One: Valuing a Closely Held Business for Estate Planning

For those who own a closely held or family business, an often overlooked part of their estate planning is assigning a value to that business. This is important because upon the death of the business-owner, a valuation will need to be completed in order to properly calculate the estate tax liability. Periodically obtaining a valuation during the life of the owner can help forestall issues for the estate.

Unlike in a sales transaction where the business-owner is seeking the highest potential valuation of the business, for estate planning purposes a lower, or discounted, valuation is ideal. This will help lower the value of the estate or the value of a gift to a trust or other family member.


Care must be taken with the valuation for lurking in the shadows is the Internal Revenue Service! The last thing an estate needs is to face an IRS audit and the estate either has poor documentation (or none at all) about the business valuation used in the estate tax return and/or faces a disputed valuation.


This post will take a look at some key factors to keep in mind when assessing a value as well as look at the consequences of a disputed valuation.



Fair Market Value and Valuation Methods

One step to take that may help the process is to obtain a valuation of the business every few years. Not only will this make the evaluation at death for the estate easier, it also can be handy in the event there is a buy-sell agreement that requires a price calculation. Furthermore, it provides evidence that can be used if there are any issues with the IRS regarding the estate’s valuation of the company.

Generally, there are three separate approaches that are used to value a closely held business:

  • Income Approach- value is based upon the income a business is expected to generate.

  • Market Approach- value is based upon past sales of the business or of a similar business.

  • Asset Approach– value is based on the business assets.

No one approach is correct and which is used will largely be situational and depend on a number of factors, including the type of business and the industry it operates in. And any of the three can be appropriate when it comes to how the IRS views the issue.

Speaking of the IRS, fair market value (FMV) is the definition most often used by the IRS in valuing closely held businesses. It is the price at which property would change hands between a willing buyer and a willing seller who are both independent and non-family members and where both parties have reasonable knowledge of the relevant facts, and neither party is under any pressure to buy or sell. As you can see, any of the three approaches could therefore satisfy the IRS test.


Discounting Valuation for Minority Interest

It is from the fair market value that applicable discounts can be applied for estate planning purposes. Once an estate plan is created, it is important to maintain a current and well-documented valuation, including discounts, to have on-hand in case a death occurs.


For example, when there is a minority stock interest in a closely held business, a discount

may be granted for estate purposes when it is included in the owner’s gross estate or when a gift of that interest is to be made to a trust or a family member. The discount is usually granted because the minority interest itself carries no ability to influence company decisions or policy. This reduces the marketability of the minority interest to anyone but the controlling shareholders. Beware, a minority interest that cannot influence policy but is large enough to swing a vote could have a valuation discount challenged by the IRS.


Disputed Valuations

Since there are so many factors affecting the value of a business, disputes between the taxpayer and the IRS involving valuations are common. The IRS has acknowledged that there is no one, true, fair market value for a closely held business, so the area is open to interpretation. However, a taxpayer should be aware that there are civil and criminal penalties for inaccurate valuations, both lower and higher, so aggressive calculations should be avoided.


If the valuation is found to be too low, the IRS can deem the transaction a combination of a sale and gift and assess gift tax and penalties, with interest, on the difference between the value you received and the value the IRS calculated. While the gift tax may be offset by a taxpayer’s lifetime federal estate tax exemption, the penalties and interest cannot be and may represent the bulk of the punishment. Penalties are listed in IRC §6663 and are based on a percentage of the difference between the final determined value and the value originally reported on the tax return.


There is not a penalty if the value on the tax return is more than 65% of the final determined value. However, a penalty of 20% is applicable if the value on the return is between 40% and 65% of the final determined value and a 40% penalty is applicable if the original value is 40% or less of the final determined value.


If a business is valued too high, a sale at above fair market value could be deemed a gift from the buyer to the original owner and be subject to gift tax.

While a business valuation will not guarantee that a transaction will go unaudited, if performed correctly, it can be used to lock in a three-year statute of limitations for the IRS to act.


Tier One Planning

When tying the valuation of a closely held business to an estate plan, it isn’t enough to mention a client should consult their legal and tax-planning advisors. Here, having one’s attorney, CPA and life insurance professional working in close coordination (maybe even in the same room!) is key to a successful outcome.


Read our companion Tier One Interview with James Joyce by clicking here.


Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.

© 2020 Life Insurance Strategies Group, LLC. 

  • White LinkedIn Icon
  • White Instagram Icon
  • White Facebook Icon
  • White Twitter Icon