Business Valuation Issues — If the IRS Allows Certain Business Expenses, Why Don’t They Count in Valuing a Business?

By Heather Deskins, CPA/ABV/CFF, CFE, CVA

The IRS allows businesses to deduct expenses that are both ordinary and necessary. An ordinary expense is one that is common and accepted in the trade or business. A necessary expense is one that is helpful and appropriate for the trade or business. An expense does not have to be indispensable to be considered necessary. Generally, the IRS does not allow businesses to deduct personal, living, or family expenses. However, if an expense is used for both business and personal use (i.e. use of an automobile), than the business is able to deduct the business portion only.

In placing a value on a business, the most common standard of value is fair market value. Revenue Ruling 56-60 defines fair market value as:

The amount at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Normalization adjustments are made to the financial statements to place the business’s financial information on an economic basis and remove items that a willing buyer would not necessarily consider in assessing the income or cash flow of the business. The business’s current management may view various expenses as appropriate business expenses and the IRS may agree. However, if the expenses are at the sole discretion of management / the owners, than the expense may be deemed discretionary and it may be appropriate to make an adjustment to remove such expenses. Some of the more common discretionary adjustments include:

  • Officer’s and owner’s compensation
  • Bonuses
  • Pension and other Employee Benefits
  • Owner’s perquisites
  • Entertainment expenses
  • Charitable contributions
  • Automobile expenses
  • Dues
  • Compensation to family members
  • Rent expense (if not an arm’s length lease)
  • Interest expense
  • Depreciation expense
  • Any expense deemed personal

Even though these expenses may be deductible for tax purposes, does not mean that a willing buyer would choose to spend the same amount for a particular expense. For example, let’s look at a car dealership. The business purchases season tickets to a major sporting event. During the sporting season, the dealership owner takes a few employees to the sporting event and expenses the tickets as entertainment. A willing seller may view this expense as discretionary and an adjustment may be made to remove such expense.

If you have a client that is dealing with this issue or is in need of having their business valued, please feel free to call P.D. Eye Forensics to discuss the situation further.

Heather Deskins, CPA/ABV/CFF, CFE, CVA

Heather Deskins,

Managing Member
P.D. Eye Forensics, LLC