Transitioning a family-owned business? Avoid these costly valuation mistakes

Passing down a family-owned business is one of the most significant financial decisions an owner will make. A well-executed valuation is necessary for estate planning, gifting, and tax compliance, making it a key step in preserving generational wealth.

The Internal Revenue Service (IRS) requires a qualified business appraisal for estate and gift tax filings. Without one, families risk audits and financial repercussions.

Why a Business Valuation Matters and the Risks of Getting It Wrong

Transferring a business to the next generation involves more than just signing over ownership. A well-documented valuation meets compliance requirements, reduces family conflicts, and helps avoid unnecessary tax liabilities. Miscalculating value can lead to overpayment or underpayment of estate and gift taxes, impacting family wealth.

Failing to conduct a proper valuation can have serious consequences:

• IRS penalties for inaccurate appraisals can reach up to 40% for substantial misstatements.
• IRS disputes may require outside experts to reassess the company’s worth, adding costs and delays.
• Without a qualified appraisal, the statute of limitations for IRS audit review does not start, leaving the company open to scrutiny for years after ownership changes.

Common Business Valuation Mistakes to Avoid

Failure to Act

After an appraisal, families must transfer ownership according to the estate plan. Delaying action can result in the senior generation passing away with a controlling ownership stake, preventing their heirs from accessing tax-saving valuation discounts.

Miscalculating Valuation Discounts

Estate planning often involves transferring minority interests—shares that lack control over business operations. The IRS allows discounts for:

• Lack of Control: When an owner does not have decision-making power.
• Lack of Marketability: When shares cannot be easily sold in the open market.
• Lack of Voting Rights: When shares have no voting powers.

Failing to apply these discounts appropriately can lead to overvaluation, causing families to pay more in taxes than necessary.

Mixing Personal and Business Expenses

It is not unusual for business owners to pay personal expenses through the family business. However, for an accurate valuation, these items must be removed from the profit and loss statement to present the company’s actual earnings. Other common adjustments to earnings are for family member compensation, rent (if the company leases real property from a related entity), and other related party transactions, such as loans.

Poor Financial Record-Keeping

Many closely held businesses lack sophisticated accounting systems, making it difficult to extract the correct financial data. Poor record-keeping can:

• Create valuation inaccuracies.
• Raise red flags for IRS auditors.
• Lead to higher appraisal costs due to additional work needed to clean up financials.

A professional accounting team helps companies organize financial records and improve transparency, resulting in a more reliable appraisal.

The Business Valuation Process

At Elliott Davis, our structured appraisal process supports consistency and compliance. Here’s how our approach works:

Step 1: Gathering Financial Information

• Read historical financial statements, tax returns, and important corporate documents.
• Analyze financial statements and compare to industry peers.
• Assess how the economy impacts the industry and weigh important industry factors.
• Discuss potential adjustments for non-recurring or discretionary expenses.

Step 2: Aligning Legal & Tax Strategies

• Work with legal counsel and management to optimize planning.

Step 3: Management Interviews & Business Analysis

• Conduct management interviews to understand operational nuances.
• Analyze how the company fits into local and national industry trends.
• Address potential risks and opportunities in the business model.

Step 4: Inputting Data into Valuation Models

• Apply IRS-approved methods, such as market approach, income approach, and asset-based approach to data collected in previous steps.

Step 5: Drafting the Valuation Report

• Prepare a comprehensive report (typically 70+ pages) that includes:
  • Business background and industry outlook.
  • Financial analysis of historical results.
  • Expected performance forecast, if appropriate.
  • Suitable methodologies.
  • Applicable discounts.
  • Conclusion of value.
• Provide the report to the client and legal team for review before submission to the IRS.

Pro Tips to Achieve a Proper Business Valuation

• Provide comprehensive financial records and operational details, which form the foundation of an accurate assessment.
• Don’t rely on automated appraisal reports. While convenient, they often lack the depth needed to capture an organization’s unique characteristics and may invite IRS scrutiny.
• Engage experienced professionals for a well-supported valuation that reflects the business’s true worth and can withstand regulatory review.

We Can Help

At Elliott Davis, our certified appraisers provide IRS-compliant, defensible valuations for family-owned businesses and high-net-worth families, in alignment with their estate planning goals.

Contact us today to schedule a consultation.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.