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How can I determine what my business is worth for estate and gift tax purposes?

Determining the value of your business is something you should not attempt to do on your own, especially because the IRS could challenge your valuation. Even the IRS acknowledges that no one true fair market value (FMV) exists for a closely held business. There are appraisers who specialize in determining the value of businesses. Your CPA may be one of these specialists or know someone who is.

FMV is defined by the federal estate and gift tax regulations as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” It is the sale price that a hypothetical buyer and seller would reach, not necessarily the price that the actual owner would agree to or the price that an actual buyer might be willing to pay.

You may have had your business appraised in the past for another purpose. As tempting as it might be, don’t use an old appraisal for a new transaction. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation.

Numerous factors might affect the value of a business. However, the IRS has identified a number of relevant considerations:

  • Nature of the business and history of the company
  • Outlook for the economy in general and an industry in particular
  • Book value and financial condition of the company
  • Earnings capacity
  • Dividend-paying capacity
  • Goodwill/intangible value
  • Sales of stock and the size of block to be valued
  • Market value of stock in comparable businesses

A number of different methods exist for determining the FMV for a closely held business. Generally, only an appraiser will know how to analyze these factors to reach a conclusion as to the FMV of your business.

Can I transfer my business through my will?

Yes, you can use your will to transfer your business interest after your death. You can also use your will to specify a long-term succession plan for your business if, for instance, you want one of your children (who may be currently active in the business) to take over and run it when you’re gone. Without such a clause in your will, your interest could possibly be distributed equally to all of your children, even though you did not intend that result.

A disadvantage of transferring your business through your will is that the full value of your interest will be included in your taxable estate. Unless you have made provisions for additional liquidity (e.g., by using life insurance), your heirs may be forced to sell the company just to pay the estate taxes.

Assets disposed of through a will are subject to probate, the court-supervised process of administering a will. Probate can be expensive and time consuming. It could also result in business interruptions, which in turn could result in a loss of customers and employees if confusion develops over who’s running the business and how it will continue to operate. The probate process is also public, which may allow others to discover details about your estate that you would rather not disclose.

Talk to your lawyer and your financial professional about your business interest and what you would like to happen to it at your death. Transferring your interest through your will is just one method that can be used. Other options (or combinations of options) can also be used to accomplish your wishes. Some methods may allow you to equalize distributions to your heirs without splitting up the business. Some can help you minimize the taxable value of your business interest. A buy-sell agreement can be drafted now to establish a plan for the future succession of your business interest. Trusts may also be used to help accomplish your goals. All of these strategies take time to plan and implement, so the best time to begin planning is now.

Don’t most small businesses fail?

Although it’s true that many new small businesses go under within their first year or two, there are usually reasons that can explain their failure. If you’re aware of the pitfalls associated with the start-up of a new enterprise, you can take steps now to maximize the chances that your business will succeed.

Don’t start a business you know nothing about. If you’re a pastry chef, don’t open an auto-body shop. Your experience, skill, and knowledge of the business you wish to run are key to its success.

You’ll want to conduct extensive market research to determine if the product or service you will offer is currently in demand. Define who you’re marketing to and target your message to them. Also, consider the most favorable time to market your product or service (e.g., toys at Christmas). Of course, another key to your success is location, location, location. Finally, plan your advertising campaign and consider how you will distribute your product or service.

Pay attention to your competition. Be sure your product or service offers your customers something your competitors do not.

Set up a written business plan detailing the design of your business growth. Organize a start-up team of people who have abilities you lack. Determine how you will obtain the capital to finance your project, and be sure you have adequate capital. More importantly, make sure you have enough to live on. Many new businesses do not generate income immediately. Finally, include in your business plan an exit strategy for closing the business should things not work out as you had hoped.

Can I borrow money from my wholly owned business?

Yes, you can borrow money from your wholly owned business. Generally speaking, the terms of the loan must be reasonable and must be properly documented. Otherwise, you run the risk that the IRS could reclassify the proceeds of the loan as compensation or dividends, leaving you with an unanticipated tax bill.

Troubles may arise if you fail to structure a loan that is reasonable, based on current market conditions. The IRS can impute interest on the loan if the interest rate is too low, which would result in the business paying taxes on interest that was not received.

The loan should be documented with a promissory note signed by you and an authorized representative of the business. The note should include details regarding the amount loaned, the repayment schedule, and the interest rate. You should make the payments as required under the agreement to avoid the reclassification of the loan. Consult your tax professional to make sure that your loan will pass muster in case of an audit.

How does a limited partnership work?

A limited partnership is a form of business ownership that consists of general partners and limited partners. There is no maximum number of either type of partner, but there must be at least one general partner. The general partners manage the partnership and are typically personally liable for all of the partnership’s obligations, as well as for the acts of the other partners on behalf of the partnership. Limited partners are generally exposed to such liability only to the extent of their investment in the limited partnership. However, they are not permitted to participate in management of the partnership without the loss of this liability protection. A limited partnership offers some flexibility when allocating profits and control. This flexibility can provide certain tax and business advantages for individual partners.

State law and the partnership agreement govern a limited partnership. Your partnership agreement should spell out the entire arrangement between the partners and state each partner’s share of profits and losses. In cases where the partnership agreement fails to address an issue, state law will dictate how the partnership is to operate. In these instances, your state’s version of either the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA) will determine how disputes are resolved.

I am buying a business. Can I make the seller sign a noncompetition agreement?

Yes. A noncompetition agreement can be either a distinct agreement or part of a sales contract. Its purpose is to prohibit the seller from working in or starting a related or competing business in a specified geographic area for a specified period of time.

If sensitive or confidential information (e.g., customer lists, pricing information, manufacturing or sales materials) is a component of the business you’re buying, you can require the seller to sign a noncompetition agreement. This will prevent the seller from starting a similar business or going to work for a competitor and walking away with the customers, the employees, or the know-how of the business you just bought. Simply put, it prohibits the seller from competing with you. You may also want to consider entering into noncompetition agreements with the seller’s employees.

A noncompetition agreement will be legally enforceable only if it is properly drafted. The courts will generally enforce a noncompetition agreement only if it is drawn narrowly, defines the interest you want to protect, and is related to what you want to achieve–namely, to prevent the seller from competing with you.

Note: Laws regulate the enforceability of noncompetition agreements in many states. They may be unenforceable in some states, and their enforcement may be limited in others. Consult an attorney to determine whether and to what extent noncompetition agreements are enforceable in your state.

A cell phone and laptop computer owned by my company were inside my briefcase when it was stolen. Will my company’s insurance cover the loss?

Maybe. Many employers’ business insurance policies cover laptops, cell phones, and other company-owned equipment that employees use off the business premises. But other companies may not insure such items, so you’ll need to ask your employer to find out for sure. If your employer’s insurance does cover the stolen items, you’ve probably got nothing to worry about. Otherwise, you should call your insurance agent to find out what coverage (if any) your own homeowners or renters insurance provides.

Unfortunately, you may not like the answer you get from your agent. Standard homeowners and renters insurance policies typically do not cover laptops and other equipment that you use mainly for business purposes. Even if your policy does cover these items, the coverage is probably limited (e.g., $250), and an out-of-pocket deductible may apply. If you’re lucky, though, you may have already purchased optional coverage (e.g., a business rider) designed to protect your business items under your homeowners or renters policy. Or maybe you even bought a separate insurance policy to cover your laptop or other equipment.

If not, talk to your agent about whether you should buy one of these forms of additional protection for the future. After all, you’ll probably end up using other company-owned business equipment at some point.

Can I change my business from a C corporation to an S corporation?

Yes. A C corporation may elect S corporation status if it satisfies certain requirements:

  • It must be incorporated in the United States
  • It must have no more than 100 shareholders (members of a family may be treated as one shareholder)
  • Shareholders must be U.S. citizens, resident aliens, estates, other S corporations, or certain qualified trusts
  • It can have only one class of stock, although both voting and nonvoting shares of the same class are allowed
  • All shareholders must consent to the election in writing

The principal advantage of electing S corporation status is that it allows corporate income to pass through to you and other shareholders and be reported only once as personal income. This avoids the double taxation of C corporation earnings, which are taxed once as corporate profits, and then again as personal income when dividends are distributed to shareholders. In addition, once S corporation status has been elected, you can deduct the corporation’s losses against your own personal income up to certain limits.

When a corporation elects S corporation status, it retains that status for all future years unless it revokes or terminates that status. To convert from a C corporation to an S corporation, you must file Form 2553 with the IRS. It should be signed by the person authorized by the corporation to do so and by the shareholders, then filed on or before the 15th day of the 3rd month of the corporation’s tax year.

Because of the tax implications of this decision, consult an experienced tax professional before you elect to change from a C corporation to an S corporation.

Can I deduct home office expenses?

If you use part of your home to conduct your trade or business, you might be able to deduct certain related expenses. To qualify for the home office deduction, you must pass certain tests.

You must use part of your home regularly and exclusively for your trade or business. Exclusive use means that this space is not used for any nonbusiness purpose, such as watching television, during the tax year of the deduction. If the space is used for business only sporadically or occasionally, you may not meet the regular use test.

Also, your home office must be used as either (1) your principal place of business or (2) a place where you meet customers, clients, or patients in the normal course of business. You may also be able to take a deduction if you use part of your home to perform administrative or management duties and you have no other location to do this work. If you are an employee and work from home, the business use of your home must be for the convenience of your employer in order to take the deduction.

Certain expenses for a separate structure, such as a garage, may be deductible if the structure is used regularly and exclusively in connection with your business or trade. A separate structure that’s used in this way does not have to be your principal place of business, or a place where you meet customers, to qualify for the deduction.

If you qualify under these tests, you can deduct certain expenses related to the business use of your home, but your deduction is limited by the percentage used for business and the deduction limit. You can deduct both direct and indirect expenses that apply to the portion of your home that you use for business purposes. Direct expenses are costs expended solely on the part of your home that you use for business purposes, and these can be deducted in full (subject to the deduction limit). They include such expenses as painting, and installation of separate telephone jacks and wiring. Indirect expenses are costs that benefit your entire home, including the portion you use for business. Indirect expenses include mortgage interest, property taxes, insurance, and so on. You may deduct a percentage of these expenses. You may use a square footage calculation or any other reasonable method to compute the business portion of indirect expenses.

If you are self-employed and not a farmer, you must file IRS Form 8829 to take advantage of the home office deduction. IRS Publication 587, titled Business Use of Your Home, offers more information on taking this deduction.

How can I boost the morale of my employees without incurring huge expenses?

Often, the success or failure of your business can depend on the sense of satisfaction and well-being–the morale–of your employees. High employee morale increases productivity and reduces employee turnover, complaints, absenteeism, work errors, workplace harassment, and even violence. If your employees are discontented, try to figure out why. Then, begin a program to resolve the problem as best as you can.

You can start by placing an anonymous suggestion box in a discrete area, conducting monthly focus groups, having employee-only lunches, and holding employee reviews. Hopefully, your employees will express their concerns and offer suggestions that will help you improve the situation. They may show more interest in becoming involved in the running of your business, and be happier when you show them that you’re interested in their welfare.

Next, you can increase employee self-esteem by treating employees with fairness, honesty, and respect. You’ll also want to keep them in the loop about what’s happening in the business by giving them both the good news and the bad. Well-informed employees will often go the extra mile to ensure that a job is done well and on time.

Finally, think about rewarding your employees and showing them that you do value and appreciate them. It costs nothing to say “Thank you” and shake an employee’s hand, but it can mean a lot. Try congratulating your employees on a regular basis for a job well done, personally thanking them for extra efforts or commitment, and showing your appreciation with little celebrations such as office lunches or bouquets of flowers on special occasions.