10 Things Your Business Valuation Report Must Include for Estate Planning

For every business owner involved in estate planning, it’s crucial to find an appropriate business valuation expert that will prepare a highly defensible business valuation report that is submitted to the IRS. Reports that follow state-of-the-art valuation process, completely justified, and supported with all relevant citations become highly defensible, whilst on the other hand those that are poorly done are much more exposed to audits, investigations, improper taxation, penalties, fees, and at worse, costly litigation.

Here we will explain 10 items that your business valuation report should include:

  1. Business valuation expert

First and most important is that the appraiser preparing your report should be an expert with relevant education, experience, and/or membership to professional appraisal associations via their certification. By following these criteria, the accredited appraiser should provide a level of quality that reduces your risk of adverse outcomes. This is because they have to follow a particular framework and industry standards, giving a baseline of quality required for such a service. In saying this, the accreditation alone does not mean that high quality is guaranteed, so do your homework. See our guide here on how to successfully navigate the selection process of your appraiser.

  1. Valuation Date

The valuation date of a business appraisal is crucial as any conclusion of value is only to a specific point in time. The value of an asset does not stay the same regardless of time, in fact, it can change significantly from one day to the next, by way of closing a new client that increases profits by 20%. For estate planning, the date of gifting or date of death are the most common valuation dates.

  1. Purpose of the Valuation

The purpose of an appraisal will define the type of ‘standard of value’ (step #11) to derive. A standard of value will change the perspective through which your business is valued. In the case of estate planning the IRS requires that the standard of value is fair market value which they define as:

“[T]he price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.”

For this reason, as estate planning is done under a hypothetical transaction, where the amount of tax to be paid should be fair, the fair market standard is required, and not investment, strategic, synergistic value will suffice.

  1. Outline of the Valuation Process

The description of the appraisal process is key because it will inform the reader of assumptions considered, any hypothetical conditions, and any limiting conditions and restrictions that affected the analyses, opinions, and conclusions of the business appraisal presented. Business valuation is as much art as it is science, which is affected by many assumptions and conditions, for this reason each must be included in the report to assure proper process and assessment when scrutinized.

  1. Information Considered

All data and information used in determining the value of a business should be included with enough detail in order for any person that reads the report to be able to replicate the process and arrive at the same conclusion.

  1. Valuation Approach(s)

There are different valuation approaches that can be applied in a business valuation, all three approaches, Income, Market, and Asset approach, must all be considered with one or more correctly applied, depending on which are determined appropriate. The explanation should include the reasoning behind the selection process of the approach(es), application and conclusions.

  1. Valuation Method(s) Applied

Each valuation approach has one or more valuation methodologies, and all valuation reports should express in detailed the different methods applied. Including an explanation of the selection of each method and the procedures followed in their application. For example, in the income approach, an appraiser may choose the discount cash flows method or capitalization of earnings method. Although both methods are within the income approach, they are fundamentally different and depending on the individual case facts, one is more applicable than the other. These decisions should be explained in detail in the valuation report.

  1. External Information Relied Upon

Any specific external sources of data relied upon must be included in the valuation report, with specific detail as to their use and application. For example, comparable information such as comparable transactions, (the sale of similar businesses / interests), the use of empirical studies for identifying the cost of capital and relevant discounts, and so on, must be included in the report. This is so the reviewer of the report (the IRS) can verify the source of the inputs used and reconstruct the value.

  1. Factors of Analysis Required

Per the IRS revenue rulings, there are 8 factors which require careful analysis in a business valuation:

  1. Nature and history of the business
  2. Economic and industry analyses
  3. Book value of the stock and financial condition of the business
  4. Earning capacity
  5. Dividend paying capacity
  6. Goodwill or other intangibles identification if applicable
  7. Sales of the stock and size of the stock to be valued
  8. Market price of publicly traded stock in the same or similar line of business

These 8 factors should always be considered but this doesn’t mean that they are always relevant for all businesses. Furthermore, depending on the case, a business may require many other factors to be carefully analyzed.

  1. Reasoning Behind Valuation Discounts

Valuation discounts can be one of the most essential parts of a business valuation when applicable as discounts applied for the valuation of closely-held businesses can reach up to 70% of its equity value under certain circumstances. There are several potential discounts applicable, see this article that explains them in more detail. Given the impact that these have on a business’ value, this is one of the most heavily scrutinized parts of the valuation and hence, requires a careful and detailed explanation in the report.

In conclusion, following a specific report structure for estate planning purposes is critical to developing a conclusion of value that is defensible, helping to avoid challenges from the IRS that can result in audits, investigations, penalties, fees, and or litigation. Ensure that when undertaking your business valuation your selected appraiser has adequately covered these 10 items.