The Role of Valuations in Tax Planning and Compliance

Managing long-term financial goals has always been difficult for many businesses, especially SMBs, which need financial stability. Given the situation, they can optimize finances by minimizing tax liability and ensuring compliance. To do this, you will need a precise business valuation in place. The role of valuation in tax planning and compliance is vital as it helps make informed business decisions.

• Minimizing Tax Liabilities
• Substantiating Tax Positions
• Complying with Tax Regulations
• Navigating Transactions
• Optimizing Tax Strategies

The article below explains how having a business valuation will help you optimize your taxes and stay compliant. So, let’s discuss further.

Tax planning, compliances, and business valuation

An accurate business valuation is important to any company’s continuous strategy. A complete understanding of the company’s worth is crucial for making informed decisions. Companies, whether public or private, need to be assessed for worth. Though a business valuation is necessary for several reasons, it is most important for tax planning and compliance. Let’s see how.

Understand the importance of valuation in tax planning

Your company will require a business valuation for tax-related situations like:

• Mergers & Acquisitions
• ESOPs
• Regulatory compliance
• For estate and gift taxation

The company valuation calculates taxes, including estate and capital gains taxes. For just and equal taxation, tax authorities depend on accurate appraisals. An accurate business valuation helps determine the correct amount of taxes the company owes, avoiding under or overpayment.

How do accurate valuations help businesses optimize tax planning strategies and minimize tax liabilities?

How does business valuation help with your tax planning and liabilities?

Business valuation will include your business’ tangible and intangible assets. Knowing the right value of these expenses can avoid under-estimating or overestimating resulting in tax efficiency.

A correct value is necessary to avoid errors and possible audits when determining any tax duty, including income tax, capital gains tax, etc. A family-owned business has complicated tax consequences from succession planning. To avoid fines and other legal issues, having an accurate business valuation is important so you can pay your taxes according to the law.

Role of valuations in tax planning and compliance

A business valuation can help in tax planning and compliance in your company through the following ways:

Minimizing Tax Liabilities

The business valuation generally includes assessing the company’s assets, such as:

• Property
• Investments
• Intellectual Property

You can ascertain the value of your business and find chances to lower tax payments by doing an in-depth assessment. With the real value of the assets known, taxpayers may consider strategies to reduce their capital gains or taxable income.

Substantiating Tax Positions

If you conduct an accurate business valuation, it helps you with proper documentation. Even during a tax audit, you will be in a better position to provide the necessary proof. Valuing your business will help you in tax planning and compliance and support businesses during tax returns.

Complying with Tax Regulations

Different company transactions will have different tax rules governing them. The transactions include Mergers & Acquisitions Transfer Pricing or Intra-group Transactions.

The tax authorities require businesses to comply with the applicable requirements in every instance. Is it possible to make sure of this? Yes, a sound business valuation is necessary to follow the law and avoid penalties if you don’t.

Navigating Transactions

If your company has plans to sell or acquire assets form partnerships or simply restructure your business.

A precise business valuation will help you do it effectively. It will help you know the total value of the assets involved, allowing taxpayers to make well-informed decisions to meet their tax goals.

Optimizing Tax Strategies

What is the main purpose of having a business valuation? To improve your tax planning and find opportunities for tax credits, deductions or incentives.

These are all based on the worth of assets and investments. Taxpayers can use business valuation to plan their taxes and comply with relevant tax regulations.

What are the Approaches to Calculate Business Valuation?

In general, there are three approaches to calculating your company’s value.

Income Approach

The basic idea behind the income approach is to calculate the current worth of your company’s potential future income. Valuation experts estimate the company’s future cash flows and discount it back to the current value at an appropriate discount rate. There are two methods to do this. They are:

• Discounted cash flow (DCF) analysis
• Capitalization of earnings

Example for calculation of Income Approach in Business Valuation

Consider a prominent hotel chain with steady cash flow and moderate growth. To value this company, we’ll use a 12% discount rate reflecting its risk.

Steps for DCF Valuation:

Forecast Cash Flows – Project future cash flows. Here’s a sample for the next five years:

• Year 1 – $5,000,000
• Year 2 – $5,500,000
• Year 3 – $6,000,000
• Year 4 – $6,500,000
• Year 5 – $7,000,000

Terminal Value – Assume a 2% perpetual growth rate after year 5.

Discount Cash Flows – Discount each year’s cash flow to present value using the 12% discount rate. The present value (PV) of each cash flow can be calculated using the formula:

• PV = Cash Flow / (1 + discount rate)^number of years

The present values of cash flows are:

• Year 1 – $4,464,286
• Year 2 – $4,384,566
• Year 3 – $4,270,681
• Year 4 – $4,130,868
• Year 5 – $3,971,988

Terminal Value – $71,400,000

Discounted Terminal Value – $40,514,277

Total Present Value – Sum the present values of all cash flows and the discounted terminal value. This gives the company a valuation of $61,736,667

Capitalization of Earnings Method

Let’s consider a small company, Draze Ltd, which has the following financial information:

• Average annual net profit for the last three years – $100,000
• Appropriate capitalization rate – 20%

To calculate the business value using the capitalized earnings method, we divide the average annual net profit by the capitalization rate:

Business Value = Average Annual Net / ProfitCapitalisation Rate = $100,000 / 0.20 = $500,000

Draze Ltd’s estimated value is $500,000 based on the capitalized earnings method. This value represents the present value of the company’s future earnings, assuming the current level of profitability continues indefinitely.

Market Approach

Valuers use the market approach to assess similar companies sold or listed on a public exchange. Methods such as:

• Transaction analysis
• The guideline public company method

These techniques assess the company’s position relative to its competitors. Business valuation specialists can assist with tax planning by evaluating pertinent market data and transactions to ascertain the company’s fair market worth.

Example for Market Approach of Business Valuation

Transaction Analysis

Let’s consider a software company called “Techinx” which has strong growth potential. Let’s estimate its value using the Precedent Transaction or Transaction Analysis Method.

First, we need to identify recent mergers and acquisitions involving companies similar to Techinx. Some potentially comparable transactions could include:

• Acquisition of Company A by Acquirer X for $100 million (EV/Revenue multiple of 5x)
• Acquisition of Company B by Acquirer Y for $150 million (EV/EBITDA multiple of 15x)
• Acquisition of Company C by Acquirer Z for $75 million (EV/Revenue multiple of 4x)

Second, calculate the valuation multiples:

• Company A – $100 million / $20 million revenue = 5x EV/Revenue
• Company B – $150 million / $10 million EBITDA = 15x EV/EBITDA
• Company C – $75 million / $18.75 million revenue = 4x EV/Revenue

Apply Multiples to TechSol: TechSol has $30 million in revenue and the average EV/Revenue multiple is 4.5x:

• Estimated Value = $30 million revenue x 4.5x EV/Revenue multiple = $135 million

Therefore, based on the Precedent Transaction Method, Techinx could be valued at approximately $135 million.

Guideline Public Company Method

Let’s consider an IT consulting firm, Chronix Ltd., and identify comparable companies:

Comparable Companies:

• Company A – Enterprise Value (EV): $1,200,000, EBITDA: $300,000
• Company B – Enterprise Value (EV): $1,600,000, EBITDA: $400,000
• Company C – Enterprise Value (EV): $1,500,000, EBITDA: $375,000

Calculate the EV/EBITDA Multiples and their Average:

• Company A – EV/EBITDA = $1,200,000 / $300,000 = 4.0
• Company B – EV/EBITDA = $1,600,000 / $400,000 = 4.0
• Company C – EV/EBITDA = $1,500,000 / $375,000 = 4.0

Average EV/EBITDA multiple = (4.0 + 4.0 + 4.0) / 3 = 4.0

Now, let’s apply this multiple to Teal Ltd.:

• Assuming Chronix Ltd. has an EBITDA of $250,000:
• Valuation = Average EV/EBITDA multiple * EBITDA of Teal Ltd.
• Valuation = 4.0 * $250,000 = $1,000,000

So, the market approach valuation of Chronix Ltd. is $1,000,000.

Asset Approach

This approach’s foundation is valuing a company’s assets and liabilities. Methods including:

• The liquidation value
• The adjusted net asset approach

The valuator who uses the asset approach subtracts all the assets from the total liabilities to determine the business’s worth. Real estate and manufacturing companies with many assets may find this simple approach helpful.

Example for Asset Approach of Business Valuation

Liquidation Value Method

Let’s consider the assets and liabilities of Grow Ltd.:

Assets (Liquidation Values)

• Property – $400,000 (Book Value: $500,000)
• Equipment – $50,000 (Book Value: $100,000)
• Inventory – $20,000 (Book Value: $20,000)
• Accounts Receivable – $20,000
• Cash – $20,000
• Total Liquidation Assets – $510,000

Liabilities

• Current Liabilities: $50,000 (Accounts Payable: $40,000, Short-term Loans: $10,000)
• Long-term Liabilities: $150,000
• Total Liabilities: $200,000

Liquidation Value Calculation

• Liquidation Value = Total Liquidation Assets – Total Liabilities
• Liquidation Value = $510,000 – $200,000
• Liquidation Value = $310,000

So, the liquidation value of Grow Ltd. is $310,000.

Adjusted Net Asset Value

Consider a small example of a business valuation using the Adjusted Net Asset Value (ANAV) method. Here’s a table showing the book values and adjusted values for the assets and liabilities of Tech Innovators Ltd.:

Adjusted Net Asset Value Calculation:

• Adjusted Net Asset Value = Adjusted Total Assets – Adjusted Total Liabilities
• Adjusted Net Asset Value = $540,000 – $95,000
• Adjusted Net Asset Value = $445,000

The adjusted value considers more realistic market values of assets and any potential reductions in liabilities, providing a more accurate valuation of the company’s worth.

What are some Common Challenges in Performing Valuations for Tax Planning and Compliance purposes?

While you do a business valuation for tax planning and compliance, you may have to face the following challenges:

• Properly Relying on Financial Projections – One of the main challenges you might face in performing valuations is its accuracy and dependence on financial projections. Tax authorities will pay close attention to confirming this. So, always use accurate valuation methodologies and document the valuation to support these projections.
• Capturing the Impact of Transaction Structures – How valuators evaluate assets or businesses for tax purposes can significantly impact the kinds of transactions. Accurately taking into consideration the particulars of the transaction, valuators must account for:
  • Earn-outs
  • Contingent payments or
  • Non-compete agreements

• Bridging Time Gaps – You must conduct the business valuation on time for tax reasons, that is, at the time of the real purchase or sale. That is not the situation, though. Bridging the interval between the tax event and the valuation date could be difficult. Dealing with this calls for taking into account things like:
  • Market conditions
  • Economic Factors
  • Business performance

• Reflecting Tax Attributes – Legal and regulatory compliance requires you to take into account particular tax characteristics, including:
  • Net Operating Losses (NOLs)
  • Tax credits
  • Deferred tax liabilities

• Treating Intercompany Debt – The valuer should consider transfer pricing rules if your business valuation involves intercompany transactions. It includes assessing the terms of debt, including:
  • Interest rates
  • Maturity rates
  • Repayment terms

• Documenting Rationale – We know the main reasons for having a business valuation are tax planning and compliance. So, to double-check this, the tax authorities will ask for detailed documents supporting the business valuation. Though this may sound easy, documenting all the aspects of business valuation can take time and effort, making the process challenging.

What are some Potential Risks of not Incorporating Valuations into Tax Planning and Compliance Strategies?

We saw the potential challenges in conducting business valuation for tax planning and compliance. What happens if we do not incorporate valuation for these purposes? We will understand that now.

• Overpaying Taxes – What if you do not use business valuation for tax planning? We will end up paying more than the actual. There is a chance that we might overestimate the company’s assets and pay higher than necessary.
• Failing to Substantiate Tax Positions – Business valuation is more of a proof that your company’s worth is correct, which supports tax positions for returns. You may not have proper documents during a tax audit without an accurate business valuation, increasing the chances of risk disputes.
• Non-Compliance with Tax Regulations – If you are planning to transfer property or during an M&A, you should have a business valuation comply with the differing tax rules. What happens if you do not do it?
  • Non-compliance
  • Penalties
  • Interest charges and
  • Potential legal issues
• Suboptimal Transaction Structuring – You must organize your business transactions to minimize taxes. How do we carry that out? A precise business valuation is the way to lead. You could miss the chance to reduce the tax effects and pay unnecessary taxes if you don’t conduct a business valuation.
• Missed Opportunities to Maximize Tax Attributes – As we know, tax attributes cover:
  • • Net Operating Losses (NOLs)
    • Tax credits or
    • Depreciation deduction.

You need to do a business valuation to consider all these. Without this, you may miss the potential opportunity to reduce your taxes.

Seek Professional Assistance for Tax Planning and Compliance

If you plan to have your business valued for tax planning and compliance, seek professional help to make the job easier. The following are the ways through which they can help with your business valuation:

• Expertise and Knowledge – The professionals will have the related knowledge in conducting the business valuation. Valuation experts with years of experience and an in-depth understanding of business valuation concepts.
• Time Savings – A business valuation involves several methodologies and concepts that might be time-consuming.
• Compliance – You will need credible business valuation from certified valuators. NACVA-certified experts with a thorough knowledge of business valuation concepts, giving you credibility to use your valuation report for tax compliance.

Tax Consulting Service of Eqvista

Eqvista offers a comprehensive range of tax planning and compliance services, ensuring that businesses can manage their equity compensation efficiently and comply with all relevant regulations. Here are some key ways Eqvista can assist you:

• Eqvista’s experts identify potential tax risks and opportunities related to equity compensation and help clients make informed financial decisions about equity taxation.
• The process involves meeting with tax professionals, preparing tax planning for the equity structure, assisting with complex tax considerations, and providing suggestions.
• Eqvista offers filing services for 83(B) elections, Form 3921, Rule 701 compliance, and Qualified Small Business Stock (QSBS) exemptions.

ASC 718 Stock Expensing Compliance

• Eqvista helps companies comply with ASC 718 stock expensing rules for equity compensation.

ISO Limits and Rule 701 Compliance

• Eqvista ensures companies follow the ISO limits and Rule 701 compliance requirements for equity compensation plans.

Year-End Tax Reporting

• Eqvista oversees year-end annual tax reports, Forms 3921 and 3922, for equity compensation.
• They also handle K-1s for LLCs related to equity.

By leveraging Eqvista’s tax consulting, compliance, and reporting services, businesses can offload their equity compensation tax complexities and focus on growing their operations while remaining compliant with relevant regulations.

Leverage Eqvista For Effective Business Valuations for Tax Planning and Compliance

The first step to complying with legal rules is to get your business valued. A precise business valuation can help you look for opportunities to reduce the company’s tax liability and stay compliant.

Business valuation reports include thorough analyses of multiple factors, so getting them done by a professional can help improve their accuracy. Here is where Eqvista can help you. Our valuation experts can help you better grasp your company’s worth through their expertise working with several companies in different industries.

We also have extensive experience issuing and administering cap tables, company shares, and value reports. Contact us today to avail of our services and learn more about how we can help with your business valuation!