With the sunset of the increased lifetime estate tax exemption amounts coming up at the end of 2025 (as of Jan. 1, 2026, the current lifetime estate and gift tax exemptions will be reduced by 50%, adjusted for inflation), many high-net-worth business owners will be revisiting their estate plans to take full advantage of exemptions. A critical piece of the estate planning process involves valuing the business to determine the appropriate interest to be transferred.  

Valuation methods

The valuation of an operating business conducted by a qualified appraiser will utilize one or more accepted methods under the asset approach, income approach and market approach. The appraiser must consider all three valuation approaches, even though one or more of the approaches may be excluded. The appraiser should explain why any approaches were not used so the analysis won’t be open for challenge in the event of an IRS audit.

Valuation methods used under the income approach include the capitalization of earnings (COE) method and the discounted cash flow (DCF) method. The COE method uses the company’s historical earnings to project the future performance of the company, while the DCF method is used when future operations are not expected to resemble historical or stabilized operations. The COE method requires two components to determine value, the historical earnings amount and a capitalization rate (Cap Rate) to apply to historical earnings. While the DCF method also requires the development of a discount rate (similar to the Cap Rate except for a long-term growth component), it also requires the appraiser to obtain a forecast of future earnings and cash flow for a period of time until the company’s operations are expected to stabilize. Since many business owners do not prepare financial forecasts in the normal course of business, this exercise can be time-consuming. However, when the historical results do not reflect expected business conditions going forward, the results of the two methods can be drastically different. Financial projections that differ significantly from historical results need to be explained in sufficient detail, especially if the results suddenly show a decline in revenues or earnings that will result in a lower value. 

Valuation methods under the market approach include the guideline public company (GPC) method, the comparative transactions (CT) method, and transactions involving the company’s own stock. Again, it is tempting for appraisers to automatically eliminate the GPC method, stating that there are no public companies that are exactly like the subject company to be valued. Public companies are generally larger and have a more diverse product or service offering than smaller privately owned companies. However, it is not necessary for guideline public companies to be exactly the same as the subject company, especially if there are other factors that may enhance comparability. Eliminating this method from consideration without a reasonable analysis of differences between the companies and adjustments that could be made to the multiples to account for the differences, is an invitation for the IRS to challenge the valuation and develop their own GPC analysis which typically results in a higher value that the taxpayer will need to defend against. 

If the CT method is used, the transactions should have occurred within a reasonable period from the Valuation Date, and should provide enough information about the financial terms of the transaction to be useful in making comparisons to the subject company. For example, it should be clear whether the transaction involved the sale of a company’s stock or its assets. If it was an asset sale, what assets were actually sold and what liabilities were assumed would have a material impact on the reported implied valuation multiples. Of course, transactions in the subject company’s own stock can be the best source of value, if they were arms-length transactions, negotiated between unrelated parties, and not subject to a pre-existing formula or other agreement that locked in the price.    

The asset approach to valuation assumes that a business is worth the aggregate value of its assets and liabilities adjusted to fair market value. It’s not often used as a valuation method for operating businesses because the company’s balance sheet may not contain all or any of the intangible assets that may exist in a profitable operating company. Accounting for and valuing each of these intangible assets can be time-consuming and expensive. However, the adjusted net asset method can be used to establish a floor value for the business when the income and market approaches are producing values that are at or below the net asset value. Not considering the asset approach in these circumstances, can result in an understatement of the value. Additionally, there are some industries in which the asset approach is commonly used to establish value.

Valuation discounts or adjustments

Other important considerations in valuing an interest in an operating business are the levels of control and marketability associated with the interest. A few key prerogatives of control are:

Can the Subject Interest…

• Set operational and strategic policy and change the course of the business model?
• Determine the amount of management compensation and prerequisites?
• Acquire and/or sell significant business assets?
• Borrow funds or refinance debt on behalf of the business?
• Sell, recapitalize, or liquidate the business entity?
• Control the timing and amount of distributions?

Discounts for lack of control are recognized when the subject interest can’t control the management or operations of a business. The provisions above can be considered when determining the level of control a subject interest retains over the business. The amount of discount also depends on how the total business value was initially determined, including whether any control adjustments were made to the reported earnings or capital structure of the business. A combination of these considerations and market data are used to develop the appropriate amount of discount for lack of control.

Marketability factors include:

• Transfer restrictions (It should be noted that pursuant to IRS Section 2703, for estate, gift, and generation-skipping transfer tax purposes, there are certain limitations around the consideration of transfer restrictions on marketability discounts.)
• Capacity to make distributions to owners 
• Prospects and timeline for a sale of the business
• Existence of any put rights
• Pool of potential buyers
• Access to and quality of financial information

A discount for lack of marketability may be appropriate when the subject interest is not freely traded on an active or secondary market. The discount relates to the inability to convert the ownership interest to cash quickly, with a minimum of transaction costs, and a high degree of certainty of realizing the expected proceeds. Marketability discounts are typically quantified using a combination of published academic studies (such as restricted stock studies and pre-IPO studies), option pricing models, and an assessment of the qualitative factors listed above. For planning purposes, if a business sale is being contemplated, it is beneficial to complete a gift tax valuation months ahead of time, as the shorter the period of time is until a liquidity event, the lower the discount will be for lack of marketability. 

A critical element in applying discounts as part of the valuation process for operating companies is making sure that the valuation meets the adequate disclosure requirements contained in the Treasury regulations. If the adequate disclosure requirements are not met, it prevents the clock from starting on the limitations period for the IRS to examine the gift tax return.  

The above are only a few key considerations that can be overlooked when performing valuations of operating businesses. We recommend the use of independent, accredited business valuation professionals when performing this work for gift and estate tax purposes to avoid overlooking issues like these and others that are beyond the scope of this article.