Valuation Considerations Unique to a Particular Business

The general valuation factors provide a framework for valuation, but it is important to remember that some factors may carry more weight than others in a specific situation, and that additional factors may also be considered.

Type of Business

The type of business may affect the valuation. For example, earning capacity may be the most important factor in a business selling goods and services. An investment corporation holding real estate, on the other hand, may be more accurately valued by examining its net asset value.

Amount of Stock Owned

In a closely held corporation, the size of a shareholder's interest may affect the value of the stock. For example, the value of a minority shareholder's stock may be discounted due to the limited market for the stock. By contrast, a majority shareholder's interest may receive a higher valuation because of the control the owner is able to exert. However, a "blockage discount" may apply to reflect the fact that a large block of stock on the market at one time will tend to depress the price.

Sole Proprietorships and Partnerships

Some factors obviously do not apply in the valuation of a sole proprietorship or partnership. Nonetheless, the valuation process for sole proprietorships and partnerships is similar to the process used in valuing closely held corporate stock.

Setting a Price in the Buy-Sell Agreement

There are various methods for fixing a price for a buy-sell agreement. Regardless of the method used, however, it is imperative to remember that, for estate tax purposes, the price established must be fair and adequate when the agreement is made. Under IRC Sec. 2703, a purchase agreement entered into after October 8, 1990, may be disregarded in valuing a closely held business unless the agreement is (1) a bona fide business arrangement, (2) not a device to transfer property to family members for less than full and adequate consideration, and (3) comparable in its terms to those entered into by persons in arm's-length transactions.

The accumulated case law has created certain additional rules, which apply even if a particular agreement is not subject to IRC Sec. 2703 (e.g., because it was executed before October 8, 1990): (4) the estate must be obligated to sell at an owner's death, either under a mandatory agreement, or under an option held by the business or the surviving owners; (5) the sale price must be fixed by the agreement, either as a dollar amount or by some formula for determining the price; (6) the agreement must prohibit an individual owner from selling his or her interest during life without first offering it to the business or to the other owners at a specified price; and (7) the price set in the agreement must have been fair and adequate at the time the agreement was made.

If the price or value appears to be understated, or reflects some kind of discount, it should not automatically be used for estate valuation purposes. The value of the business interest for federal estate tax purposes is the fair market value at death (or the alternate valuation date). The price set in a buy-sell agreement will not necessarily fix the fair market value of a closely held business for estate tax purposes if the agreement is between closely related persons and is merely a scheme for avoiding estate taxes.