The Active Investor: Tax

Monday, July 27, 2009

The Fair "Quantum" Value of a Business

Edwin Schrodinger used a famous thought experiment to try and explain part of Quantum theory. The experiment placed a cat (now known as Schrodinger's Cat) in an unobservable place where after some time there was a 50/50 chance the cat would be either dead or alive. Quantum theory considers the cat to be in a state that is both 50% alive and 50% dead until an observer sees the results. At that time, the probability fields collapse and the cat is either alive (although quite annoyed) or has forever passed on.

This finally answers the ancient philosophical question if a tree falls in the woods and no one is around to hear does it make a sound? We now know that the answer is "probably".

The IRS has defined a term Fair Market Value in Revenue Ruling 59-60 as:
"... the amount at which property would change hands between a buyer and a willing seller when the former is not under and compulsion to buy and the later is not under any compulsion to sell, both parties have reasonable knowledge of the relevant facts."

Such a simple definition creates many probabilities. The least useful are a seller's hope of how much it could be worth and a buyer's hope of how little. There are 3 reality-based paths to approaching the problem:
1) Asset Approach - the replacement cost not considering earning power
2) Income Approach - a discounted estimate of future cash flows
3) Market Approach - comparisons of similar businesses which have sold in the past.

Each of these methods have multiple methodologies which all yield different results and all of them have their appropriate application for specific buyer and seller circumstances. It is the job of the evaluator to accurately assess values based on all of them and then create the combination of probabilities that best represent the scenario described in IRS 59-60. They have to value the state of Schrodinger's cat before the observation. It's a professional opinion that needs to be done by a CPA Accredited in Business Valuation (ABV) or a Certified Valuation Analyst (CVA).

A survey by Inc magazine concluded the 75% of privately held businesses listed for sale do not successfully change hands. The culprit is generally the price. The seller has one probably in mind and the buyer another and they cannot agree. A certified Fair Market Value creates a common anchor for both parties to use in coming to an agreement. Having this common anchor creates the quantum Probably Field that almost always leads to agreement and a successful business sale.

What has happened is the intense observations already done during the valuation pre-collapse the quantum probably fields to a region known to be acceptable to the seller and limiting to a buyer. It's interesting how the intricacies of sub-atomic particles mirror the intricacies of complex business transactions, yet it's all the same universe always acting in the same way.

Image Credit: skuds

Monday, June 22, 2009

Choice of Entity

Image by Raymond Yee via Flickr

Anyone wanting to become an Active Investor, that is invest in their own enterprise, has to choose a legal form for the business. Making the best choice will require discussions with a lawyer on liability issues and a tax professional on tax exposure. In spite of all this advice, the Active Investor needs to make some personal decisions before consulting either.

A lawyer will seek to aggressively protect their client, including recommending a business form that will provide the best shielding for personal assets. While this is prudent, you should never fall into the illusion that a chosen entity type adequately protects you from potential legal actions. Many attorneys have been successful in proving an entity has not been maintained according to state law and this has exposed the owners personal assets to their complaint. Be aware of the liability protection a business entity can provide; but never depend solely on that. There are two things every business should maintain to protect the owner from liability - a passion for excellence (quality) and insurance. If these are not both built into the heart of any business plan, then there is an argument that the best choice of entity is employee.

Before discussing tax ramifications, there is also an issue the potential Active Investor should consider. It's been said 85% of the workforce are employees, 14% are self-employed, and 1% are business owners. Are you changing from employee to being self-employed or to being an owner? If the goal is to build and own an organization, tax considerations are somewhat different from trying to minimize a self-employed professional's tax exposure. Working out of a normal (C) corporation can create double taxation for the self-employed, which is very undesirable. Some type of "flow through" entity is often recommended. However, if the objective is to build an organization, the funds to grow the business need to come from future company profits. The C corporation has a low (15%) tax rate for it's first tier. This allows the small business to retain some earnings at that low tax rate for growth. If the profits would "flow through" to the owner to avoid double taxation, those funds for growth are effectively taxed at the owner's tax rate. Different intentions create very different tax strategies.

There are many more considerations that need to be considered with an attorney and tax professional. Successful business people often attribute much of their success to having a winning team of trusted advisers who have guided them through these and other issues. However, the secret of the adviser's success is having a client who has thought through what they really want and can give those advisers clear directions.