The IRS originally created the landmark publication, Revenue Ruling 59-60, to outline the methods, approach, and factors to consider when valuing a closely held business for estate tax and gift purposes. Although it’s been around for nearly 60 years, today it’s often referenced in valuations prepared for other reasons, including divorce cases and shareholder disputes. With such a broad reach, it’s critical that valuators and attorneys understand the issues this guidance covers.
How is fair market value defined?
Fair market value is a transaction-based price that considers the perspectives of both hypothetical buyers and sellers. It assumes the subject business interest would be given adequate time to sell and both parties are well informed about the business and the market in which it operates.
Revenue Ruling 59-60 is perhaps 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.”
What are the eight factors to consider?
This publication does much more than define fair market value. It admits that valuation is an inexact science, often resulting in “wide differences of opinion” about the value of a particular business interest. Therefore, appraisers need to take a customized approach that considers eight factors:
- Book, value and financial condition (from at least two years of balance sheets),
- Nature and history of the subject company,
- Outlook for the general economy and industry,
- Market prices paid in comparable transactions,
- 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, and
- Previous arm’s length transactions involving the subject company’s stock and the size of the block of stock.
Valuators try to estimate a company’s future performance, as well as gauge their risk and financial condition, when evaluating the eight mentioned factors. For example, the second factor, nature and history of the subject company, demonstrates its historical levels of stability, growth and diversity (or lack thereof). These issues would be relevant to an investor if the subject company’s future performance is expected to mirror its past performance.
What’s hidden in the fine print?
Ruling 59-60 describes several other factors that may affect the value of a closely held business in its discussion of these eight factors, such as:
Nonoperating assets. Investments, real estate and other assets that aren’t essential to a company’s normal business operations may require a higher or lower rate of return. So, valuators value them separately when appraising a business. They also adjust for income and expenses related to the nonoperating assets.
Nonrecurring income and expenses. An adjustment may be required to the company’s historical earnings for income and expense items that aren’t expected to happen again in the future. Examples include revenues and expenses from discontinued product lines or a one-time windfall from an insurance claim.
Key people. When a company relies heavily on key people, its value may be reduced if they leave. The depressing effect is especially pronounced if the company hasn’t implemented a succession plan or required key people to sign noncompete agreements. Life insurance policies and competent management can offset these risks, however.
Revenue Ruling 59-60 doesn’t prescribe a universal capitalization rate for every company. Instead, rates of return on earnings must be determined based on the nature of the business, risk, and stability or irregularity of earnings. Riskier businesses generally require higher capitalization rates, which results in lower values (and vice versa).
Read the ruling
Revenue Ruling 59-60 is almost always cited in valuation reports in some way. But it’s surprising how few clients, attorneys and judges have read this landmark publication. It’s highly recommended to review this guidance before you depose a valuator, or question one on the stand. It clearly outlines the valuation process and can be helpful in crafting meaningful questions about a valuator’s qualifications and the approach taken in your case.
Weighing in on weights and averages
Before arriving at a final conclusion, business valuators consider lots of information and appraisal techniques first. Which information should be given the highest priority depends on the situation. When valuing a business that sells products or services, earnings and dividend-paying capacity are generally the focus. In contrast, asset values are usually more important when valuing investment or holding companies.
Revenue Ruling 59-60 cautions against the blind use of averages when valuing a business. If you apply the cost, market and income approaches, it’s better to pick the technique that provides the most meaningful result than to simply average all three together. Averaging the results “excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts of the case except by mere chance.”