The IRS created Revenue Ruling 59-60 to outline the methods and factors to consider when valuing closely held businesses for federal gift and estate tax purposes. Today, it’s often referenced in valuations prepared for other reasons, including divorce cases and shareholder disputes. Here’s a closer look at what it prescribes, including lesser-known details that you should be aware of.
Definition of fair market value
Revenue Ruling 59-60 is best known for defining fair market value as “the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
In other words, it’s a transaction-based price that considers the perspectives of both hypothetical buyers and sellers. It assumes the business interest would be given adequate time to sell and that both parties are well informed about the business and the market in which it operates.
This publication does much more than define fair market value. It also recognizes that business valuation is an inexact science, often resulting in “wide differences of opinion” about the value of a particular business interest.
Factors to consider
Even when fair market value isn’t the appropriate standard of value, valuation professionals still consider the following factors listed in Revenue Ruling 59-60:
- The nature and history of the subject company,
- The outlook for the general economy and industry,
- Book value and financial condition (from at least two years of balance sheets),
- Earnings capacity (from at least five years of income statements),
- Dividend-paying capacity (as opposed to dividends actually paid),
- The value of goodwill and other intangible assets,
- Previous arm’s-length transactions involving the subject company’s stock and the size of the block of stock, and
- Market prices paid in comparable transactions.
When evaluating these factors, experts analyze a business’s risks and financial results, as well as management’s expectations for future performance. Historical earnings and growth are relevant to a hypothetical investor only if this data can be used to forecast the subject company’s future performance.
Fine print
In its discussion of these factors, Revenue Ruling 59-60 describes several other factors that may affect the value of a closely held business. For example, when a business relies heavily on key people, its value may be impaired if those people leave. The adverse effect is especially pronounced if the business hasn’t implemented a succession plan or executed enforceable noncompete agreements with key people. Life insurance policies and competent management can offset these risks.
Another consideration is nonoperating assets. Investments, real estate and other assets that aren’t essential to a business’s normal operations may require a higher or lower rate of return. So, experts typically value them separately. They also adjust for income and expenses related to the nonoperating assets.
Likewise, adjustments may be required to the business’s historical earnings for income and expense items that aren’t expected to recur. Examples include revenue and expenses from discontinued product lines or a one-time windfall from an insurance claim.
3 valuation techniques
Revenue Ruling 59-60 identifies the following three business valuation approaches:
- The cost (or asset) approach: this technique looks at the business’s book value, its financial condition and the value of intangibles. A business’s value is determined by subtracting liabilities from the combined fair market value of its assets.
- The income approach: this methodology is based on future earnings and dividend-paying capacity. It typically involves converting the business’s expected cash flows to present value using a risk-based rate of return. The discounted cash flow and capitalization of earnings methods fall under this approach
- The market approach: based on the principle of substitution, this approach derives value from previous transactions involving the subject company’s stock or market prices of comparable businesses. Guideline transactions are used to develop pricing multiples (such as price-to-earnings or price-to-revenue) that are applied to the subject company’s financial metrics to estimate value.
An expert may choose to apply one or more of these approaches when estimating business value. However, Revenue Ruling 59-60 cautions against the blind use of averages when considering these approaches. It’s better to pick the technique that provides the most meaningful result than to simply average all three.
Practical valuation guidance
For nearly 70 years, Revenue Ruling 59-60 has provided helpful guidance for valuing a closely held business for federal tax purposes. But it’s also been cited in valuations prepared for a wide variety of nontax purposes. Whether you’re preparing for litigation, establishing a buy-sell agreement, or addressing gift and estate tax issues, a well-supported valuation is essential to informed decision-making and withstanding scrutiny.
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We highly recommend you confer with your Miller Kaplan advisor to understand your specific situation and how this may impact you.
