The Internal Revenue Service publishes revenue rulings to assist taxpayers in the treatment of issues that may not be clear.  Revenue Ruling 59-60 (59-60) is the foundational ruling for valuing closely held business interests.  Initially, it applied for estate and gift tax purposes.  However, Revenue Ruling 65-192 expanded its application to income taxes and all federal tax issues.  In the opening paragraph, 59-60 says, "in valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes."  There is no general formula for valuation purposes applicable to the many different fact situations that exist.  All relevant factors must be considered.  To assist taxpayers in this area, 59-60 outlines eight factors to consider in determining the value of a business.  In this two-part article, we will briefly review these eight factors.

The Nature of the Business and the History of the Enterprise from Its Inception

Such an analysis will show how stable the business is, whether it has grown over the years, the diversification of its operations, and other facts that will allow one to determine the degree of risk involved in the business.  If a business changed its form, but carried on the same or similar operation(s) of its predecessor, the history of the previous business should be considered.  59-60 lists the business history that should be studied, but does not limit the study to these items.  At a minimum, we should consider "the nature of the business, its products or services, its operating and investment assets, capital structure, plant facilities, sales records and management, all of which should be considered as of the date of the appraisal, with due regard for recent significant changes." 

The Economic Outlook in General and the Condition and Outlook of the Specific Industry in Particular

Consideration should be given to the current and future economic conditions, at the appraisal date, in the national economy and in the industry or industries in which the business operates or with which it is connected.  It is important to know how the business performs compared to its competitors and the rest of the industry.  Equally important is how the industry in which the business operates competes with other industries.  Future competition, which may not have been a factor in the past, should be given consideration.  59-60 gives an example of a business with high profits due to a new product and lack of competition.  This situation tends to lead to new entrants into the marketplace, and thus competition that didn't exist in the past.  If the business is dependent on one key person, the loss of that person could have a depressing effect on the value of the business.  However, circumstances could be present that lessen the negative impact, e.g., loss of life covered by proceeds from life insurance and/or competent people to takeover the management of the business.

The Book Value of the Stock and the Financial Condition of the Business

It goes without saying that to value a business, we need to review its financial statements.  59-60 suggests beginning with comparative balance sheets for two or more years immediately preceding the appraisal date.  Additionally, we should consider a balance sheet at the end of the month nearest to the appraisal date if the year-end date and the appraisal date do not coincide.  Information in the balance sheet may require additional explanation or analysis.  If that's the case, we should obtain the information (usually from management) to clarify the financial position of the business.  The balance sheets of the business will provide the following information about the business:  its position of liquidity, the gross and net book value of its fixed assets, its working capital, its long-term debt, its capital structure and its net worth.  Any assets not essential to the business operations (nonoperating assets), e.g. investments in securities and real estate, should be noted.  Generally, nonoperating assets will have a lower rate of return than operating assets.  The nonoperating investment assets should be adjusted to their market value(s) for purposes of determining the book value of the business. 

The Earning Capacity of the Company

Profit and loss statements will assist in determining the earning capacity of a business.  59-60 suggests obtaining profit and loss statements for a representative period, usually five or more years, prior to the appraisal date.  Such statements allow us to understand the principal items of gross income, the principal deductions including prior items, interest and other expenses related to long-term debt, depreciation and depletion, officers' salaries, and charitable contributions, the amount of net income available to pay dividends, the rates and the amount of dividends paid on each class of stock, the amount of earnings retained in the business and adjustments to the earnings.  This information should enable us to distinguish between recurring and nonrecurring items of income and expense, operating and nonoperating income and expense, and to ascertain whether or not any line of business is operated at a profit or a loss.  Since potential future income is important in valuing a business, all information about prior income that will be helpful in projecting future income should be obtained.  However, be careful not to resort to arbitrary five or ten year averages without analyzing current trends and future prospects. 

Next week, we will review the remaining four factors to be considered in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are not available.