Category: Uncategorized

Preface: Selecting the right entity car for optimized taxes is complex. Appropriately choosing an entity for your business, that will support a lower tax burden often requires collaboration with your tax advisor. Flipping a coin is not advised.

Flagstone Crossings To Lower Taxes: What Entity is Right (Segment III)

Credit: Donald J. Sauder, CPA | CVA

Partnership entities are an association of two or persons taxed on a Form 1065 for Federal purposes. They can be general partnerships, limited partnerships, or multi-member LLC’s. The organization is a pass-through entity that does not pay income tax at the entity level but instead passes the profit and losses through to the company’s “partners” on a Form K-1 that is filed with the individual 1040s.

Partnerships vehicles provide flexibility to the allocate income, ownership, voting rights, and provide multi-owner features without the tax incorporation features. Partners received guaranteed payments for services instead of a W-2 as from a corporation. Ordinary income from the partnership is often subject to FICA taxes on the individual partner’s 1040 if they are active in the company. For tax purposes, this is a significant tax characteristic and decision maker between an S-Corporations and multi-member LLCs.

General partnerships are easy to setup, but often not advised since there is easier affordable liability protection with a multi-member LLC. General partnerships, however, permit an increased ability to raise capital, but because both debts and liabilities are attached to partners, hold certain risks.

Multi-member LLC’s are often considered a hybrid of a partnership and corporation. Since the profits pass through to members on a Form K-1, the tax benefits are often appreciated. Also, members have limited risk with liability on debts and the investment; they can also participate in management, permit corporations and partnerships to be members, and do not have restrictions on the number of active or inactive members.

Partnership tax flexibility and conventional attributes are a commonly debated tax topic among advisors. One such feature is treating partners as employees.

Quoting from Noel Brock’s 2014 article:  Treating partners as employees: Risks to consider

This error can have many tax consequences, not the least of which is the mistaken tax treatment of the partner’s income as wages subject to Federal Insurance Contributions Act (FICA) taxes under Sec. 3101, Federal Unemployment Tax Act (FUTA) taxes under Sec. 3301, and income tax withholding under Sec. 3402 (called employment taxes in this article), instead of self-employment income subject to self-employment tax under Sec. 1401 (Self-Employment Contributions Act (SECA)), which is not subject to wage withholding.

When Congress enacted the 1954 Code, it provided that a partnership could be an aggregate of its partners or a separate entity. Where no view of partnership taxation was adopted by a given Code provision, the view that was “more in keeping with the provision” should prevail. One Code provision that treats a partnership as a separate entity from its partners that was adopted in the 1954 Code is Sec. 707(a). It provides that, if a partner engages in a transaction with his or her partnership in other than his or her capacity as a member of the partnership, the transaction will, except as otherwise provided in Sec. 707, be treated as a transaction occurring between the partnership and one who is not a partner. Sec. 707(a) introduced the possibility that, given the right circumstances, a partner may hold the dual status of partner and employee in a single partnership.

Of note, is the numerous state Departments of Revenue that are now also looking at this tax perspective of employees as partners with increased scrutiny. The risks are substantial for established partnerships. Appropriate tax counsel and awareness of any tax risk are advised.

Selecting the right entity for your business startup is a tax decision that could include unknown long-term ramifications for any business owner. Say, partnerships, LLC, Corporation or sole proprietor? Agreed, Saint John Paul the Great said it well “The future starts today, not tomorrow.” 

This blog is only a summary of the pertinent features to tax planning for entity selection. Getting it right is not as easy as it seems because tax laws are complicated. Making the best decision for your business, that will support a lower tax burden requires collaboration with your tax advisor. Flipping a coin is not advised.

Preface: “I think it is very interesting in the beginning chapter of the story of Jesus, tax payments are an integral part at his arrival.” Quote from a Bible reader.

Flagstone Crossings To Lower Taxes: What Entity is Right (Segment II)

Credit: Donald Sauder, CPA | CVA

S-Corporations are selected for entrepreneurial businesses often for the asset protection of the corporate umbrella, in addition to lower FICA taxes. Since S-Corporations do not have FICA taxes assessed on net earnings with pass-through profits, and therefore no entity-level income taxes, numerous entrepreneurs can find substantial benefit in the S-Corporation election. An S-Corporation is a C-Corporation or corporate entity registered with the Department of State with that files with the IRS a Form 2553 that changes the tax structure upon approval. This tax advisor prepared form will convert the corporate level taxes to pass-through earnings on Form K-1 similar to a partnership.

The advantages of an S-Corporation with the asset protection feature under the corporate umbrella, hold risks for certain corporate activities from a legal term known as “piercing the corporate veil.”

https://www.law.cornell.edu/wex/piercing_the_corporate_veil

“Piercing the corporate veil” refers to a situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations.

As such, courts typically require corporations to engage in egregious actions to justify piercing the corporate veil. In general, this misconduct may include abusing the corporation (e.g., the intermingling of personal and corporate assets) or having [inadequate funds] at the time of incorporation. 

To fulfill the strand component, the corporation must be 1 of 3 things:

•The alter ego of the parent corporation or its shareholder(s)
•The corporation is used to avoid legal limitations upon natural persons or corporations
•The corporation is a sham to perpetrate a fraud.

Further, the court stated that “actual fraud” occurs when all 4 of the following take place:

•”a party conceals or fails to disclose a material fact within the knowledge of that party.”
•”the party knows that the other party is ignorant of the fact and does not have an equal opportunity to discover the truth.”
•”the party intends the other party to take some action by concealing or failing to disclose the fact.”
•”the other party suffers injury as a result of acting without knowledge of the undisclosed fact.”

A thorough analysis of all features is advised in any tax scenario for purposes of preventing the umbrella from blowing away.

Further to the benefits of S-Corporations in the pass-through taxation, and characterization of income in the form of tax-free distributions to shareholders. Also, the cash method of accounting is permissible in qualifying instances, and the entity has a higher sense of credibility from the legacy of corporation case law. Adding to the S-Corporation features, up to 100 shareholders are permissible with one class of stock, and conversion to the S-Election status are often easy, and maybe too easy, for either multi-member LLC’s, SMLLC’s, or C-Corporations. It is advised to counsel with a tax advisor before deciding the election of an S status for any business.

Looking at the detractors to the S-Corporation include corporate formalities and reports, board minutes and legal formalities within the State of domicile, and tax risks of termination of the S-Election status, restriction to 100 shareholders, one class of stocks, and salary requirements for shareholders who provide services to the business. Therefore payroll is required for S- Corporation who have only one or several shareholder-employees. The Tax Cuts and Jobs Act results in the following changes to S-Corporations that are now applicable.

S-Corp vs. C-Corp: How They Differ (and How to Decide)

The Tax Cuts and Jobs Act—which you might know as the Trump tax plan—will bring changes to both C-corp and S-corp taxation. The new laws take effect when business owners file their taxes in 2019 (for the business’s 2018 year).

There are two main things that small businesses need to know about the new rules:

The corporate income tax rate for C-corps has been cut from 35% to 21%.

Owners of S-corporations and other pass-through entities (like LLCs, sole proprietorships, and partnerships) will be able to deduct 20% of business income on their personal tax returns. This deduction expires in 2025 unless Congress extends the law.

It depends, says John Blake, CPA, and partner with New Jersey-based accounting firm Klatzkin & Company, LLP. He explains, “This will have to be analyzed on a case-by-case basis. In the tax reform, Congress built in the 20% deduction for pass-through entities such as S-corps to make up for the lower C-corp tax rates.”

What the New Law Means for S-corps

The 20% deduction for S-corps and other pass-through entities lets you save money. Businesses with less than $157,500 in annual income (for single filers) or $315,000 (for married joint filers) can take full advantage of the deduction.

There are limits to the deduction based on the type of business, the amount of income, and the number of wages you pay to employees. Professional service businesses like lawyers and doctor’s offices have the most limitations.”

Same as there are varying opinions on hat choices, the right entity choice for optimized tax results is specific and unique for entrepreneurial ventures. The author suggests that the development of the smorgasbord menu for tax entity features would provide specific customization for entrepreneurs. Of course, this is in addition to the idea that firefighters and first-responders are entitled to an additional tax credit or tax rate benefit for the dedicated purpose of necessary community service.

Next, we will delve into partnership taxation for entrepreneurs.

 

Preface: Shining some sunlight on the business landscape, the Tax Cuts and Jobs Act of 2017, one favorite from the Trump law revisions, has brought surprising and welcome lower tax costs for all business owners, and nearly all selections of tax entities. This blog provide a perspective on what entity maybe right for your business.

Flagstone Crossings To Lower Taxes: What Entity is Right?

Credit: Donald J. Sauder, CPA | CVA

Say, taxes have never been plain or simple. Yet, maybe one day in the future; right? No risks in business owners envisioning that day? Let’s add the Canadian English expression “eh” to that question as a reader’s (and writer’s) agreement.

Choosing the right entity for your business startup is a tax decision with what could include unknown long-term ramifications for any business owner. Getting it right is not as easy as it seems. Making the best decision for your specific tax attributes, that will support a lower tax burden usually requires collaboration with your tax advisor. Often, optimized preplanning can easily pay big dividends with lower future year tax costs. Then again, time has always brought change, and with that change tax law revisions. Flipping a coin is not advised.

Shining some sunlight on the business landscape, the Tax Cuts and Jobs Act of 2017, one favorite from the Trump law revisions, has brought surprising and welcome lower tax costs for all business owners, and nearly all selections of tax entities. With those regulation revisions, in this blog we’d like to discuss some of the current applicable tax planning features for entrepreneurs 2019.

Sole Proprietorship or Single Member LLC’s

Independent contractors, entrepreneurial startups, and business ventures with only one owner can organize as a Schedule C tax entity. The taxes are filed with the owners 1040 tax filing. While this is the simplest approach to entity taxation, because it doesn’t require an independent and additional business tax filing, FICA taxes are always assessed on all earnings for both the employer and employer in a higher tax costs, exemplified in a coffee and tea type tax filing for higher income earners. Rates begin above 15% for FICA and income tax costs are added on top as an additional 15% to 30% for most tax payers.

Taxpayers who are FICA tax exempt, with an approved Form 4029 exemption, have a solid and favorable tax structure with the Schedule C in single owner businesses. A Single Member LLC (SMLLC) is taxed the same as a Sole Proprietorship, but has the LLC legal umbrella with the State Department. Talking with an attorney with regards to this optimal legal decision is advised.

A SMLLC also is eligible for the 199A deduction, that is a 20% deduction on qualified taxable earnings up to $207,500 for singles, and $415,000 for married filers. Certain service professions are excluded from the 20% deduction from 199A, but for the majority of cornerstone small businesses in the United States, the deduction substantially lowers tax costs with the current tax laws.

Quoting excerpts from WatsonCPAGroup.com here’s an example of the applicable 199A for a SMLLC.

The basic Section 199A Qualified Business Income pass-through deduction is 20% of net qualified business income which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket.

(2) DETERMINATION OF DEDUCTIBLE AMOUNT FOR EACH TRADE OR BUSINESS. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-

(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or

(B) the greater of-

 (i) 50 percent of the W-2 wages with respect to the qualified trade or business, or

 (ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property (in other words, prior to any depreciation).

Wilma makes $100,000 in net business income from her sole proprietorship but also deducts $5,000 for self-employed health insurance, $7,065 for self-employment taxes and $10,000 for a SEP IRA. These are not business deductions- they are adjustments on Form 1040 to calculate adjusted gross income. Her deduction is the lessor of 20% of $100,000 (net business income) or 20% of her taxable income, which could be less. This might change as the IRS clarifies.

Barney owns three rentals with net incomes of $20,000 and $5,000, with one losing $8,000 annually. These are aggregated to be $17,000. He would deduct 20% of $17,000.

https://www.watsoncpagroup.com/section-199a-deduction/

Yes, 199A regulations are very complex, and as new chapter to the tax laws, there are many regulation nuances that require tax advisor guidance for assurance of accurate tax compliance, including services, rentals, and other applicable tax planning attributes. Yet for SMLLC’s or sole proprietorships this tax deduction now saves and lowers single owner business taxes. It is also applicable to partnerships and S-Corporations as we will examine next.

Preface: Tom Jordan, Market President, Lancaster, Univest Bank and Trust Co. provides this weeks sponsorship contribution with the art of financing for business construction projects.

Construction Financing for your Business

Are you considering building your own building or doing a major renovation to your current building? If so, this article provides insight on the process of working with a bank to fund your project. When providing funds to support construction financing, the bank assumes the risk associated with the customer’s ability to successfully complete a proposed project on time and within budget. To monitor each project’s progress, costs and loan disbursements, the bank has an established construction loan administration process. This process is essential to effectively controlling construction risk and providing the client, contractor and bank with a predictable and smooth process…..

Read the entire article here.

 

Preface: Although there is not an exact formula to guide a business owner or manager through the process, asking the right strategic questions before every hire is always advised.

Help Wanted (Segment III)

Credit: Jacob M. Dietz, CPA

Advantages of Employees

One advantage of having employees, if the laws and taxes are complied with, is the safety and peace of mind of doing things right. You do not need to worry that the authorities will justly punish you for evil doing.

Another benefit can be a tax deduction. Under the federal tax system, there is a 20% Qualified Business Income Deduction that sometimes needs wages for it to take effect. The deduction is complex, and all the complexities of it are beyond the scope of this article.

Another advantage of an employee is that you may have greater control over when they do the work, and how they do the work. For example, if due to a scheduling conflict you need to move a job up two weeks, you may be able to rearrange the schedule of your employees so that they can do the work. If you are depending on a subcontractor, it may be harder to get them to rearrange their schedule.

Also, if you are finicky about what materials to use and how to do it, it may be easier to oversee an employee. While you could stipulate in a contract how a subcontractor works, you may find it easier to train employees more specifically than subcontractors.

 

Disadvantages of Employees

One major disadvantage of adding employees is the payroll taxes and insurance and filings that can come with payroll. One way of handling these administrative burdens is to hire a bookkeeping employee to do that. Another way is to outsource the payroll to a firm that handles much of the compliance and filings for you. Both options cost money.

Another disadvantage is that if you do payroll taxes wrong, there could be penalties. Outsourcing your payroll to experts can help minimize these risks.

There is also the potential to violate labor laws. That is beyond the scope of this blog and you can consult with an attorney for more information.

Checklist Before Hiring New Employees

Before hiring employees, consider going through a checklist.

1. From where will the money come to pay the employee (new sales, cost savings, etc.)?
2. Will there be additional overhead that comes with the employee (tools, taxes etc.)?
3. Will there be additional administrative work and compliance issues?
4. How will the new employee affect the bottom line?
5. How many hours of work do you have available, and for how many hours does the potential employee want to work?
6. Are there any legal issues or risks? Consider consulting with an attorney if there are risks.

Hiring employees comes with both advantages and disadvantages. Although there is not an exact formula to guide a business owner or manager through the process, asking questions before hiring can be wise. If the business knows how it will pay for the employee, it can make it easier than if the business hires an employee and cannot make payroll. Count the costs before putting out the “Help Wanted” sign.

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

Preface: Counting the costs accurately requires appropriate knowledge and expertise. The ability to ask the right questions are a quintessential value of business advisors, because with that question you often have opportunity to formulate an effective and right answer. Example: Doubling or tripling “fish on the line!” usually begins with a question too. 

Help Wanted (Segment II)

Credit: Jacob Dietz, CPA 

New Employee to Replace Subcontractors

Pay new employee by efficiencies Another situation may arise when a company wants to hire an employee to do work that a subcontractor was doing. In that situation, cost savings may pay for the new employee.

Imagine a remodeling company that specializes in remodeling bathrooms. In the past, they always subcontracted the electrical work. Now, they add an electrician employee team to do that. Even though there may be no increase in sales to pay for the new employee, they may save enough money on subcontracting work to pay for the new employee. An employee will likely have a lower per hour rate than a subcontractor.

There are other costs from an employee, however, in additional to the hourly rate. For example, the employer may be paying employment taxes, tools, uniforms, etc.

In the electrician example, the remodeling company could perhaps get by with less tools when they subcontracted out the work. If they bring the electrical work in-house, then they may need to make some tool purchases. The company can run some calculations on what those additional costs would be per working hour.

Consider Number of Hours to be worked

With a subcontractor, the remodeling company can structure the relationship so that the subcontractor only helps on jobs on which they are specifically contracted. If the remodeling company does not have any jobs currently running on which they need the subcontractor, then they do not pay the subcontractor a dime. Sometimes that can be done with a part-time employee as well, but the employee may want to work at least a minimum number of hours per week.

If that is the case, then the employer may pay him even if he is not doing the type of work that they would want him to do, if that work is not currently available. If that happens frequently, then the remodeling company may want to increase its calculation of what the employee is costing per hour for electrical work. To have the employee available to do wiring, they may need to pay that same employee to sweep the shop floor and sort screws occasionally.

When replacing a subcontractor with an employee, consider how many hours you have available, and how many hours the new employee will want to work.

Preface: Business is booming for John. He works almost all the time. He wants to spend less time working in his business and attend to some responsibilities outside work. What should John do?

Help Wanted

Credit: Jacob M. Dietz, CPA

“Help Wanted.” Many businesses are hiring these days. Should you hire? If you hire, how will you pay the employee? That answer will vary from business to business and situation to situation, but a general understanding of possible pros and cons of employees, and how to pay for them, may help prevent the unpleasant circumstance of having an employee and wishing you did not have one. This article explores some of the reasons to hire, some of the ways to pay the cost of employees, and some of the advantages and disadvantages of hiring.

New Employee to Assist Owner

Pay new employee from current profits First, let’s look at hiring a first employee to assist an owner, and how to pay for him. Imagine John has his own business, a handyman services company. John travels to homes and fixes faucets, installs shelves, replaces showers, and many other services that homeowners like to outsource. John’s business is a single-member LLC, and he does all the work himself without any partners, subcontractors, or employees.

Business is booming for John, and he has more work than he can handle. He works almost all the time. He wants to spend less time working in his business and attend to some responsibilities outside work. What can John do?

One option is to hire his first employee to help him. If John hires a new employee, how will John pay for him? For John to pay the employee, the money needs to come from somewhere.   If John is working significantly more hours than he wants to and is making significantly more income than he needs, then John may be able to keep the same volume of sales and just hire a part-time person to take some of the earnings and some of the hours. For example, if John would like to work 20 fewer hours per week, and has enough excess income to pay a part-timer, then he could hire a part-timer to work some of John’s hours so that John could work 20 fewer hours per week. This arrangement frees John up to focus on his other responsibilities.

It may be hard to find a part-timer who will do quality work for 20 hours per week. Also, some business owners may not have 20 hours of available work and the corresponding profits to hire a new employee. What can a business like that do?

Pay new employee by increasing sales Assume that John only wanted to cut his hours by 5 hours, and that the part-timer he hired wanted to work 25 hours. Based on John’s current earnings, he could only pay the new part-timer for 5 hours per week.

If John has sufficient working capital (short-term assets left over after subtracting short-term liabilities) in his business, and potential customers, then John may be able to hire the new part-timer and add new customers and projects to help pay for him. The new customers may not come in fast enough to immediately pay for the wages of the new employee, but John’s working capital, if it is sufficient, may help him get through those lean times of waiting to increase sales. It can be less stressful if John has sufficient working capital to draw on, and if he is realistic about how fast the new sales will come in. If John has no working capital on which to draw, and if the sales do not come in quickly, then John may find himself in the unpleasant circumstance of struggling to pay his employee and vendors.

End of Segment I

 

Preface: The art and science of the process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise can be likened to an auction for rare collectibles; opinion and values often marginally vary. To achieve a transaction of an enterprise at a set price, two types of contributions must occur 1.) ample enterprise liquidity for business owners, 2.) appealing business opportunity to employ assets for an enterprise investor(s).

Profitability and Business Valuation:  Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment IV)

Credit: Donald J. Sauder, CPA | CVA

A restrictive buy | sell agreement is another prime example of why a business valuation could merit a reasonable discount for lack of marketability. An investment asset with lower liquidity has a necessary discount to account for the uncertainty and time commitment to successfully transact the organization. This is the driving purpose of marketability discounts. Marketability discount rates can range from ten to fifty percent depending on the marketplace.

In addition to lack of marketability discounts in valuation, minority discounts can to be necessary for adjusting business values if an interest lacks control of the following: set management compensation, make cash distributions, elect or appointment management, set company policy, or make capital expenditure decisions.

The marketability and minority discount features are commonly omitted in non-accredited valuations and therefore result in a skewed appraisal. Valuation discounts require comparisons to market data and the marketplace environment the accurately determine fair and applicable discounts. Accredited appraisers have the required and necessary valuation tools and market analytics to prepare and substantiate fair market business values more accurately.

Valuation analysts should be appreciated for the reasons included expertise required to accurately analyze fair and adequately documented appraisal value, i.e. the valuation report. This encapsulates appropriate capitalization rates, marketability discounts, minority discounts, goodwill premiums, and other factors that are often elusive to the untrained eye.

A bona fide business appraisal includes all documents for an independent analyst to calculate from comprehensive report data, an independent value for the business.  Accredited reports provide clear analyst representations of the business value at the appropriate date of appraisal, including financial statements, analysis, narrative and detail of valuation model and capitalization rates.

The Market Approach to Valuation

Market approaches to valuations apply prior market transactions to determine an enterprise value based upon metrics such as sales multiples or seller’s discretionary earnings multiples. Again, business appraisals should have at least two comparison approaches to triangulate business value accuracy and reasonableness, i.e. market approach and income approach are two common value double checks.

Why is an appraisal a value prophecy? An appraisal is a prophecy to the future value of cash flows of a business to prospective buyers whether that buyer is an internal or external party. Just like stock prices of publicly traded businesses range from day, so do business values for private enterprises. Value range, based on cash flows from operations, risk profile of the investment environment, and characteristics of the business asset.

When an appraisal is necessary for estates, gift taxes, buy | sell transitions and other pertinent business valuation purposes, obtaining an objective, conflict free appraisal requires in-depth expertise and an understanding of specific business industries.

The art and science of the process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise can be likened to an auction for rare collectibles; opinion and values often marginally vary. Yet with appropriate models for financial market participants to determine the price(s) they are willing to pay or receive as a value to achieve a transaction of an enterprise at a set price, contribute to enterprise liquidity for business owners, and a business opportunity to employ assets for enterprise investors.

Preface: Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment III)

Credit: Donald J. Sauder, CPA | CVA

What is a Right Rate of Return?

At the heart of all business valuations is a marketplace rate of return on a business “investment”. This is often either a mathematical divisor or a multiplier. If you are investing in a bank certificate of deposit, rates vary from bank to bank. So likewise do dividend rates from business to business, and net earnings also fluctuate. For instance, if you invest in dividend stocks, what is your expected rate of return on the investment? Always, the higher the risk, the higher the rate of investment return on that asset. Managing the entire chess board of investment rates of return, (a.k.a. investment yields) is the Federal Reserve in the United States.

When an assessment of value is generated on a business, immediately generated is a correlating assumption as to how the credit markets will provide liquidity both for investors and consumers in the future. Liquidity and velocity of money are indicators to economic stability.

Correspondingly, in stable economic conditions, business valuations are higher than in recession conditions. This difference includes, among a multitude of factors, the access to credit for buyers, purchasing power of customers, and the effective rate of return on the investment in that higher risk business environment.

Higher investment rates of return result in lower business value, and lower rates of return result in higher business value because of the investment yield on the business assets. Determining the appropriate rate of return on a business is the work of financial market participants. For instance, valuations can sometimes use an addend approach for a capitalization factor, such as a risk-free rate e.g., Treasury bonds, adding on an equity risk premium rate, with a size premium rate addition, and then frost an industry and company risk premium rate for a summed market rate of return on the investment.

Capitalization rates when they are multiples are a certain percentage. For instance, a three-times multiple is essentially a 33% rate or return for the investment, and a four-times multiple is a 25% rate return. The rate is obtained when dividing one with the multiple. So, a 20% capitalization rate is a five-times multiple of cash flows.

Normalized net income, EBITA, or operating cash flows, and tax effective adjustments and extraordinary earnings or expenses are all part of valuation. Yet appropriate capitalization rates on those earnings can lead to many varying opinions among business valuators.

What about Buyer Discounts?

One precisely misunderstood feature of business valuation is necessary and reasonable discounts for lack of marketability and lack of control or minority interests. Simply capitalizing normalized earnings is not the final value of a business. Too often overlooked among entrepreneurs, there are substantial differences between business ownership of a publicly traded business and that of a private enterprise as an investment. Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

When valuing a business with a potential and ready buyer, it does not change a fair market value of an enterprise. Fair market value is the price at which two bidders would agree to both purchase the business. When you bid on an asset at an auction, the final bid is not fair market value. It is the second to last bid supposedly because you could immediately sell the purchase for that price in the marketplace. Only you bid that final sales price for an auction asset, and therefore, the asset doesn’t hold that value to any other marketplace participants, other than to your final bid. Does the highest bidder always win?

Preface: Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Factor B is the business’s excess earnings that result in premium valuation from a rate of return on investment from the intangible assets cash flows of management decisions, employee activity, patents, processes, etc. Excess earnings are the net revenues above the ceiling of equity market rates of return on the tangible assets. For example, if a business produces substantial earnings above equity risk premium rate of return on tangible assets the business can appraise for a higher value, because it is a profitable investment grade asset. The key term is investment grade asset.

Economic and industry growth are also added to the goodwill equation with Factor C including the organizations ability to attract new customers and create more products, increase top-line sales volume, and strengthen cash flows. Of note is that recurring revenues  have higher goodwill multiples than transactional revenues, i.e. a bicycle shop has a different economic and industry growth characteristic than a farmer’s market stand, or a car wash.  Therefore the goodwill factors are for these reasons traditionally unique from industry to industry with an expert appraisal value.

Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history!

The Type of Goodwill Matters

Let’s look for a moment at the following picture of personal goodwill. Personal goodwill is from relationships developed between customers or suppliers and a business. The value that it adds for appraisal purposes is certainly controversial for many valuation analysts. One such legendary example of personal goodwill valuation is the Martin Ice Cream Co. v. Commissioner.

In Martin Ice Cream Co. v. Commissioner valuation negotiation with the Tax Court, the final ruling was that intangible assets encapsulated in the shareholder’s personal relationships with key suppliers and key customers were not assets of the shareholder’s corporation. Why? Because there was no corresponding employment contract or non-competition agreement between the selling shareholder and the corporate entity.  In this case, the shareholder, Arnold Strassberg, had developed personal relationships with his customers over a duration of approximately twenty plus years.  For the background, in 1974 the founder of Haagen-Dazs asked Mr. Strassberg to assist with his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.

The tax court essentially ruled that the goodwill was not a corporate asset because while at the corporation, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques; there were no legal contracts for his services on behalf of corporate operations.

This tax opinion, can reduce the value of a certain corporate stock appraisal because it is personal goodwill and not corporate goodwill, yet that value is still an asset. This area of tax law is best deferred to experts, because it is a double-edged sword in business appraisals depending on if you’re a buyer or a seller.