Business Valuations: The IRS Angle
Business appraisals or valuations can furnish vital planning information and help mitigate risk. Indeed, business valuations furnish documentation to support new financing, providing the evidence lenders need. An independent evaluation may encourage lenders to offer favorable rates. But wait — the IRS has undervalued or overvalued your business.
What are the IRS rules and guidelines about business valuations? The IRS uses several factors to determine the value of a business for tax purposes:
- First, the agency will consider the nature of the business. A new business run by a sole proprietor may have less chance of success than an established manufacturing company does.
- The IRS will take into account your firm's economic outlook and the condition of the industry in which you operate.
- It will also look into certain financial information used to value the business: net book value — assets minus liabilities, historic and projected earnings, and overall financial condition.
Note that IRS challenges to business valuations are not unusual.
You may want to hire an experienced, accredited business appraiser who focuses on business valuation full time. Try to make sure that the firm is established and will be around in two to three years in case you get audited by the IRS.
Suppose you want to be given the chance to evaluate whether the assessment made by the IRS was arbitrary and excessive? In a gift tax case from the fall of 2016, the IRS relied on the valuation of a taxpayers' business in computing its assessment against them—potentially giving the taxpayers a second chance at offering their own valuation evidence.
Is an IRS assessment based on business valuation evidence provided by its own expert arbitrary and excessive? The IRS obtained a valuation of the company and the firm tried to show that the IRS's assessment was arbitrary and excessive by challenging its expert's methodology. The First Circuit of Appeals Court ruled that the taxpayers should have been given the opportunity to rebut the valuation and show that the assessment was indeed arbitrary and excessive. The appellate court said that the Tax Court may consider additional evidence, including a new valuation.
The Court of Appeals sided with the taxpayers, saying that they have the right to rebut the IRS's expert valuation, and if successful, to obtain a fresh assessment from the tax court. Doubt therefore was cast on the IRS's expert valuation, but the onus was on the taxpayers to show that the IRS's determination was arbitrary and excessive. The Court of Appeals authorized the tax court to consider a new expert evaluation.
As with many financial-related court cases, the results were complicated. That's all the more reason to arm yourself with a valuation specialist who has high credibility and who has effectively defended valuation methodologies against the IRS. A professional's understanding of the issues surrounding valuation and related tax implications will reap you long-term benefits.