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Business valuation for business succession

Business valuation

Establishing a business’s value for buy-sell strategies must include some forethought including IRS considerations.

The IRS has determined the following eight factors should be considered in the valuation of closely held businesses.1

  1. Business nature and history
  2. General economic and industry outlook specific to the business
  3. The business’s book value and financial condition
  4. The business’s past, present and future earnings
  5. The business’s dividend paying history and capacity
  6. The business’s goodwill
  7. Prior sales of stock and the number of shares sold
  8. Market price of similar publicly traded companies

Business valuation techniques

Generally, there are five different approaches to the challenging task of valuing a business.

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Book value

Book value is essentially the stated assets less liabilities of the business. Determining value by this technique can be difficult.

  • Because stated book value often lists assets at cost, using book value without any modifications can misrepresent the business’s value. 
  • The business should be examined to determine whether assets are a substantial income producing factor:
    • If assets are a substantial income-producing factor, valuing the business based on the modified book value has some credibility.
  • The business's profits or loss should also be reviewed. The most significant pitfall of the book value is that it doesn't consider a business's ability to generate profit from the products and/or services it offers. As such, this method should only be used when the other valuation methods yield a lower value than the book value (or adjusted book value), or it should be used if a company has significant value attached to its tangible assets.

Agreed value

The agreed value method establishes a stated value inside a buy-sell arrangement.

  • The value is generally subject to an annual review process and can change by amending the arrangement.
  • An alternative valuation mechanism may be needed if the owner(s) cannot agree to a new value within a reasonable timeframe.

The buy-sell arrangement may provide a stated value. It may also state that if no modifications are made to that value within two years prior to the valuation date, outside appraisers will be used. This encourages business owners to update the stated value to keep it from becoming too low or too high.

Appraised value

The appraised value method uses a qualified, independent third party to appraise the business on a specific date. In this arrangement, either:

  • The two parties agree upon one specific appraiser, or
  • Each party hires its own appraiser, and the two appraisals are compared. If the two appraisals do not result in an equitable price, a third appraisal or an arbitration system generally establishes the appraised value. Although costly, the appraised value is generally the most accurate way to establish the value of the business.

Formula value

The formula valuation method establishes a specific formula inside a buy-sell arrangement to determine business value. This approach can produce fairly accurate results, but requires more planning than other valuation methods.

  • Items such as the capitalization rate and the method of determining the income factor must be decided before drafting the buy-sell arrangement.
  • Any modifications to the income number must be outlined in the buy-sell arrangement.

If these items are taken into account and an accurate formula is established, the value will not become obsolete should the owner fail to review the valuation annually, as may happen with the agreed value method.

Capitalization of earnings

The capitalization of earnings method applies a capitalization rate to an income figure based on average or weighted earnings over time. This calculation divides the annual income number by the capitalization rate, producing a total value based on the income and anticipated risk.

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1. Internal Revenue Service Ruling 59-60.

2. The business valuation is provided by BizEquity, an outside company not affiliated with Securian Financial, Minnesota Life Insurance Company or Securian Life Insurance Company. The estimated valuation is not to be relied upon for purposes of the sale of client’s business, calculating income, estate, gift tax or other tax reporting obligations, or any other purpose requiring a precise or definitive valuation. It is not to be used to establish a value that is intended to be legally exact and/or have a binding legal effect or to determine adequate (as opposed to minimum) levels of life or business insurance coverage.

Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

DOFU 10-2022

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