It pays to know the value of your business

Nation's Business, March, 1996 by Mary Rowland

Merchants try electronic cash; buy-sell agreements that dodge the alternative minimum tax; advice on bond funds.

Consider how Gary Trugman goes about his work. Once, to estimate a car-wash facility's weekly receipts without the owner's knowledge, he hired students to count cars. Another time, to put a value on a pizza parlor, he obtained copies of subpoenaed records that would show how many pounds of flour the business used each week, enabling him to estimate how many pizzas it sold.

Or take Kalman Barson. He sometimes poses as a customer in retail establishments so he can watch the traffic flow and note how much customers pay for a sandwich, or a beer, or a hair-cut. He reads a doctor's appointment book--obtained by a plaintiff's lawyer--as "a road map to figuring out what the doctor's real income is."

In his search for hidden income, Barson also ferrets out perks that small-business owners accord themselves. For example, an owner might take a vacation where his trade organization is having an annual meeting and "convert the vacation into a business expense so he can deduct the whole thing," Barson says.

If their tactics led you to assume that Trugman and Barson are Internal Revenue Service agents, you're wrong. They're business appraisers based in New Jersey, Trugman in Morris Plains and Barson in Bridgewater. And their business-appraisal methods should jar any small-business owner who has not had a formal valuation done.

Business valuations are critical for a number of purposes, including mergers, estate planning, divorce, setting up employee-compensation programs, buy/sell agreements, and insurance claims.

If your valuation is not accurate, you could be in store for a costly surprise. For example, in Trugman's first valuation assignment, in 1984, he was asked by a lawyer in a divorce case to look for unreported income. He found $94,000. And that was before he had any training in the field.

A business owner could hardly expect a less-diligent effort by the IRS. There has been much publicity about the trillions of dollars accumulated by the generation of Americans who began building their careers and businesses in the period of prosperity following World War II. Up to $10 trillion will pass from these Americans to their children, and much of it is held in family businesses.

The IRS has heard the good news, too, and is anticipating all the estate taxes that will be due on this accumulated wealth.

Further, the agency has already geared up for audits of small businesses through its Market Segment Specialization program, which trains auditors to scrutinize particular industry segments. (See "New IRS Audits Mean Business," April 1995, Page 62.)

Under the program, begun in December, industry specialists are searching for unreported income in businesses in 100 industries, with an audit guide for each industry.

Consider the case of Ford Storage & Moving Co., in Omaha, Neb. When entrepreneur Ray Ford died in 1988, his estate claimed that his equity in the company was worth $994,000. The IRS put it at $2.5 million.

This past May, after a seven-year legal battle by Ford's estate, an appeals court upheld the U.S. Tax Court's decision that Fords equity was worth over $2 million. "The kids ended up with a $500,000 tax liability," says Edward Mazza of White Nagle Mazza Inc., a Cleveland-based business-valuation and investment-banking firm.

But the miscalculation of how much the business was worth isn't unusual. On average, the IRS finds businesses to be worth 150 percent more than the value reported by the taxpayer, Mazza says.

That's because most business owners use a variety of formulas or rules of thumb that don't pass muster with the IRS, such as book value--which is almost always lower than market value. IRS regulations make it clear that a business must be valued at "fair market value," arrived at in an "arm's-length transaction," which means looking at both the financial particulars of a company and the industry in which it does business. What it boils down to is that your business should be appraised by an independent appraiser.

Yet a 1995 survey by Loyola University Chicago and the Arthur Andersen Center for Family Business in Houston found that just 18 percent of the nearly 4,000 businesses that responded had official appraisals.

The IRS has turned up the heat on this issue in the past decade, according to Trugman, who is the author of Conducting a Valuation of a Closely Held Business, a training guide written for the American Institute of Certified Public Accountants.

The IRS bases its actions on Revenue Ruling 59-60, issued in 1959 and still the most important ruling on the subject of valuation.

The rule says a business must be valued at fair market value, and it defines that as "the amount at which the 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 having reasonable knowledge of the relevant facts."