David Zarlenga of H&J CPAs explores fair market value and provides a better understanding of what it is and how it is used.
When we talk about standards of value, we are defining the buyer and seller of a business. There are several standards of value, but the most common is fair market value.
Fair market value is determined by creating a hypothetical transaction between a hypothetical buyer and a hypothetical seller on the date of valuation. Due to the hypothetical nature of the parties, it does not consider the unique synergistic or strategic elements that may exist in an actual transaction between a particular buyer and a particular seller, so, in essence, both parties are considered to be in equilibrium with each other and to have the motivation to arrive at a price that is optimal price for both parties.
Fair market value is the standard of value to be used in all tax-related matters and, depending on which state you live in, may be required by law in litigation cases. For example, in Ohio, the law requires the use of fair market value before the courts.
The most important to know about fair market value is that it is a standard of value that sets the perspective of the buyer, of the seller, of the marketplace and the specific property being valued. Without the proper understanding and application of the standard of value, the valuation and its resulting value may be misplaced.
The question of the standard of value is one of the most elementary, yet most complex and important, questions to be answered at the outset of any valuation. Fair market value has been misinterpreted in numerous valuations and cases in the tax realm. It is important that it be interpreted properly in order to have a tax-related valuation hold up under audit or at trial. The importance of having the correct standard of value carries with it both economic impacts as well as the legal assumptions to be considered.