Strategies for Minimizing Tax Liabilities Through Business Valuation

The core motivation for minimizing tax liabilities for a business is that it increases profitability. But the benefits do not stop here. Since you have saved a major cost, you will have money for things like acquiring more clients and attracting talent. Thus, a good tax planning strategy can also be a competitive advantage. Effective tax planning also indicates an efficient management team that meticulously chases down cost-saving opportunities, a trait desired by investors.

To help you reap all these rewards, we will explore how you can minimize tax liability through business valuations, something that many companies overlook.

Tax liability and business valuation

Businesses face taxation right from formation to mergers, acquisitions, and even dissolutions. In addition to licensing fees, sales tax, property tax, and income tax, your business will also have to pay employee-related taxes like social security tax.

Tax liabilities can also arise out of sales of your business’ equity. In such cases, the taxes are levied on the parties involved in the transaction and not on your business. To determine the tax liability, the gain must be calculated, for which a valuation of your business is required.

For example, suppose you assume that your business is worth $50 million and each share is worth $50 when you are issuing employee stock ownership plans (ESOPs). You could offer the stock at $30, a discount, to boost your employees’ gains. However, if the company was worth only $45 million and each stock was worth only $45, your employees would have overstated their income by $5 for each stock owned!

Such mishaps can be avoided through accurate valuations. Now that we have discussed how business valuations can affect tax liabilities, let us explore how various strategies leverage business valuations for tax minimization.

• Strategic tax planning – Business valuations can be the cornerstone of your tax planning strategy. You can legally minimize tax liability through business valuations since they can potentially identify any inaccurately valued assets or unreported losses. Additionally, if you are issuing stock-based compensations, you are required to get 409A valuations of your business.
• Depreciation deductions – A valuation report will summarize the value of your business’ assets and liabilities. If you have overlooked any depreciation in your assets, you can discover this through the valuation report. Since the depreciation of assets is counted as an expense for accounting purposes, this allows you to reduce your reporting profits as well as your tax liability.
• Asset sales versus share sales – If you are pursuing inorganic growth, you will find yourself choosing between purchasing assets or shares. On one hand, purchasing assets only is expensive but it has tax benefits and helps you avoid any potentially hidden liabilities. On the other hand, purchasing shares can be cheaper as you get a discount for the liabilities you inherit. Additionally, if the business made any losses, this can reduce your reporting profit, leading to reduced tax liability. At such crossroads, reliable business valuations can help you make the best choices.
• Mergers and acquisition – In mergers and acquisitions, shareholders may retain their shareholding, receive monetary compensation for the same, or there may be a share swap of the companies involved in the transaction. Every party involved would want to avoid over-reporting their gains and paying more than the fair share of their taxes. So, once again, an accurate valuation can be your knight in shining armor.
• Estate and succession planning – When your assets are passed on to your beneficiaries as per your estate plan, they might have to pay an inheritance tax. When equity interests are passed on, the tax liability is calculated based on the company’s valuation. So, it is wise to transfer the equity interests when the company’s valuation is low. If you get business valuations periodically, you can minimize your beneficiaries’ tax liability by transferring more shares at low valuations than at high valuations.
• Tax indemnities and warranties – If you have to pay any pre-existing tax liabilities after you buy a business, it will really sour the deal for you. So, sellers will summarize their tax affairs in tax warranties and sign an agreement to pay pre-existing tax liabilities that were not discovered in due diligence, i.e. sign a tax indemnity agreement. The insights from tax warrants can be used to ensure an accurate valuation so that everyone involved gets a fair deal.

Methods for business valuation in tax planning

Here we discuss how different valuation methods can contribute to tax planning.

Asset-based valuation method of Tax planning

In the asset-based valuation method, every asset and liability of the business will be evaluated. This allows you to identify any over-valued assets, i.e. instances of unreported depreciation. This can be especially valuable when you own assets that are difficult to calculate depreciation for.

Let us take an example involving patents and trademarks of MD Engineering. Their balance sheet looks as follows.

The company operates in two equal-sized markets, Nebraska and Arkansas. However, it is revealed that the company’s patents and trademarks are not strong enough in Nebraska to deter copycat products. So, the actual value of the company’s patents and trademarks should actually be half of what is being reported on the balance sheet.

So, the total assets will drop by 50% of $1.2 million which is $600 thousand. This drop in the value of assets will reduce MD Engineering’s net profits and thus, reduce its tax liability.

Income-based valuation method of Tax Planning

Income-based valuations involve forecasting your future cash flows based on your historical cash flows and discounting them to find their present value. In this approach, items like depreciation and amortization will be scrutinized. So, once again, if there was an asset that was over-valued, you can learn this through the income-based valuation.

Let us look at an example involving ACML Corp’s incorrect depreciation. This is their income statement for 2023 and 2024.

Now, you may notice that the company has a constant depreciation over the two years. This happens when a company uses the straight-line depreciation method where the depreciation is calculated as:

• Depreciation = (Asset cost – salvage value) / Total life in years

However, ACML Corp had recently bought a new fleet of trucks for which depreciation has not been counted. Once the depreciation of the new fleet of trucks is added to the income statement, the net income of the company will drop and so will its tax liability.

Excess earnings method

The excess earnings method is a handy way to derive the value of your intangible assets. It involves calculating a fair return on your tangible assets. Then, this fair return will be subtracted from your actual revenue. Then, by applying an appropriate capitalization rate to this figure, you will arrive at the value of your intangible assets.

Let us look at an example, Suppose a business earned $3 million while having tangible assets worth $20 million and goodwill as its only intangible asset. If a fair annual return on its assets would be 8% or $1.6 million, then the rest of $1.4 million must be attributed to its intangible assets.

Let us assume that 10% is a fair capitalization rate. So, the value of goodwill of this business will be $1.4 million divided by 10%, which is $14 million.

By setting a reasonable price for your intangible assets, you can avoid misreporting your financial statements, which is key to determining your tax liability.

What are the consequences of inaccurate business valuation for tax purposes?

The tax consequences of inaccurate business valuations can push you down a vicious spiral. Let us see what this vicious downward spiral can look like:

Legal and Tax Compliance Issues

To start with, an inaccurate business valuation can mean that you have over-reported your income, under-harvested your losses, and ultimately, been over-taxed. Since valuations are sometimes based on historical cash flow, an inaccurate valuation raises suspicion of misreporting income.

If you operate through multiple entities in different tax jurisdictions, this can snowball into an even bigger issue. Authorities may suspect that you violate transfer pricing rules to take unfair advantage of lower taxation in certain jurisdictions.

Additionally, if you issue stock-based compensation at valuations that are later found unreasonable by the IRS, your employees will face tax penalties, increased taxable income, and a higher-than-usual interest on unpaid taxes.

Increased Tax Liabilities

Inaccurate valuations can arise from undervalued or overvalued assets. So, the gains from the sale of such assets will be incorrectly taxed. Either you will be over-taxed because your capital gain was overstated, or you will face penalties or even criminal charges for misreporting your income when the IRS discovers this.

If you distribute an undervalued equity interest via gifts or estate planning, it will initially attract an inaccurate and lower inheritance tax or gift tax, but, when this is discovered, it will lead to expensive tax liabilities.

Strategic Planning and Decision-Making Challenges

If your assets are inaccurately valued, you will struggle to calculate the depreciation. In turn, this will make it difficult to estimate how long the assets will be useful. All of this makes it extremely difficult to make income projections for your business. So, you will be left with misleading financial reports that will form the basis for ineffective tax planning strategies. Since assessing your current and future tax liabilities will be difficult, it will affect any mergers and acquisitions you want to pursue as your tax warrants will not inspire confidence.

Get professional advice from Eqvista to minimize your tax liability through a business valuation

By now, you must have realized how important it is to get an accurate business valuation. If you do not get this right, it can lead to expensive tax liabilities or even criminal charges. And performing valuations is no walk in the park either.

You will have to invest time in understanding the relevant tax laws and regulations and keep up with any changes that occur to them. You will also need extensive knowledge about the market for your assets and the equity in companies like yours.

However, minimizing your tax liability need not be out of your reach. At least not with Eqvista. We offer affordable and accurate business valuations as well as tax consultation services. Contact us to know more!