Tax

Revenue Ruling 68-609: How the Excess Earnings Formula Values a Small Business

Small business owners and CPAs: how Revenue Ruling 68-609 splits value into assets and goodwill, a worked example, and six questions to ask your appraiser.

By 409.AI Team - 2026-10-12

# Revenue Ruling 68-609: How the Excess Earnings Formula Values a Small Business

If you own a small company, or you advise someone who does, you have probably met a valuation that splits the business into two pieces: what the equipment, inventory and receivables are worth, and a separate number for "goodwill." That split usually comes from the excess earnings method. It has been around since 1968, it still shows up in divorce files, buyouts and estate returns, and the IRS itself wrote a warning label for it. This article explains what the method does, where it breaks, and what to ask when an appraiser uses it on your business.

What Revenue Ruling 68-609 actually says

Revenue Ruling 68-609 (1968-2 C.B. 327) asks one question: can the "formula" approach, meaning the capitalization of earnings above a fair return on net tangible assets, be used to find the fair market value of a business's intangible assets?

The answer is a conditional yes. The ruling says the formula may be used only if there is no better basis available for making the determination. That sentence matters more than the arithmetic that follows it. The IRS did not endorse the formula as a default. It described it as a fallback for situations where better evidence of the value of intangibles, such as actual sales of comparable businesses, is missing.

The ruling sits next to Revenue Ruling 59-60, which sets out the general factors for valuing closely held stock. If you haven't read that one, start with our walkthrough of the [eight factors in Revenue Ruling 59-60](https://www.409.ai/articles/revenue-ruling-59-60-small-business-valuation-eight-factors). The 68-609 formula is a tool inside that larger framework, not a replacement for it.

The four steps

The ruling describes the mechanics in plain terms.

1. Find the average annual earnings. Use a period of years before the valuation date, preferably not less than five, so one great or terrible year doesn't drive the answer. 2. Give the tangible assets a fair return. Take the average annual value of the net tangible assets and apply the return prevailing in the industry at the valuation date. If no industry figure is available, the ruling says a percentage of 8 to 10 percent may be used. 3. Subtract. Average earnings minus the return on tangible assets is the "excess earnings," the part of the profit that the machinery and inventory alone don't explain. 4. Capitalize the excess. The ruling says the excess may be capitalized at a percentage of, say, 15 to 20 percent. The result is the value of the intangibles. Add the net tangible assets and you have a value for the business.

Two details are easy to miss. The 15 to 20 percent is introduced with "say," so it is an illustration and not a rule. And the ruling allows a different rate when the appraiser can show it is realistic for the business in front of them.

A worked example

Take a regional HVAC service company. The numbers are hypothetical.

Earnings, after the owner's pay is normalised to what a replacement manager would cost, average **$240,000** over the last five years.
Net tangible assets (vehicles, tools, inventory, receivables, less payables) average **$500,000**.
No industry return is available, so the appraiser uses 9 percent, the middle of the ruling's range.

The return on tangible assets is $500,000 × 9% = $45,000. Excess earnings are $240,000 − $45,000 = $195,000.

Capitalized at 20 percent, the intangibles are worth $195,000 ÷ 0.20 = $975,000. Add the $500,000 of tangible assets and the indicated value is $1,475,000.

Now change one input. A rate of 30 percent, which an appraiser might defend for a business that depends on one owner and a handful of customers, gives intangibles of $650,000 and a total of $1,150,000. Nothing about the company changed. The value moved by $325,000 because of one percentage.

That sensitivity is the first thing to understand about the method. The ruling gives a range for the rate, but the rate carries nearly all the weight, and the reasoning behind it is judgment.

Where the formula goes wrong

The IRS flagged the "no better basis" condition for a reason. These are the places small-business engagements run into trouble.

The earnings aren't the earnings you think

The formula starts with earnings, and small-company earnings are rarely clean. Owner pay, family members on payroll, a car lease run through the business and one-time repairs all distort the average. If you haven't seen how those adjustments work, our guide to [owner compensation and add-backs in SDE and EBITDA](https://www.409.ai/articles/owner-compensation-add-backs-small-business-valuation-sde-ebitda) covers them. An excess earnings calculation built on unadjusted profit overstates or understates goodwill before the formula even starts.

The tangible-asset return is a guess presented as a number

The 8 to 10 percent figure applies when no industry figure exists. It is a placeholder from 1968. An asset-heavy business, such as a trucking firm, earns its tangible assets more than a consultancy does. Using the same percentage for both pushes value between the two buckets without any evidence.

The capitalization rate hides the risk

A single rate is supposed to capture everything about the intangibles: customer concentration, key-person dependence, how long the goodwill will last and how fast the industry is changing. When an appraiser picks 20 percent and doesn't build the number from the facts, the report has a conclusion but no reasoning. You can ask a simple question: why this rate and not five points either way?

It treats all goodwill alike

A dentist's practice, a plumbing company and a software reseller all have intangible value, but it sits in different places. Some of it belongs to the owner personally and walks out the door with them. Some belongs to the enterprise: contracts, brand, trained staff. The formula produces one lump. Matters like divorce and buyouts often turn on exactly that distinction, and the formula doesn't draw it.

Why it still gets used

If the IRS called it a last resort, why do you still see it? Because for a small company, better evidence is often thin. There may be no public comparables, few transaction records and no market for the shares. When an appraiser documents that, using the formula is consistent with the ruling's own condition.

It also remains a common cross-check. A value from market transactions or from discounted cash flow can be tested against the implied value of intangibles: does the goodwill the formula would produce look close to what the other methods say? A large gap is a prompt to look harder at the inputs.

You'll most often see it in these situations:

**Buyouts and buy-sell triggers.** A formula in the agreement, or an appraiser asked to apply one, may use excess earnings. Our article on [buy-sell agreement valuation after Connelly](https://www.409.ai/articles/buy-sell-agreement-valuation-connelly-life-insurance) shows how much the wording of the valuation clause matters.
**Estate and gift filings.** Where a closely held business is part of an estate, the value feeds the return. If you're weighing deferral, see our piece on [Section 6166 and closely held business valuation](https://www.409.ai/articles/section-6166-estate-tax-deferral-closely-held-business-valuation).
**Lender appraisals.** A change of ownership financed with an SBA loan needs a defensible value. We explain what lenders expect in [SBA SOP 50 10 8.1 and business valuation](https://www.409.ai/articles/sba-sop-50-10-8-1-business-valuation-change-of-ownership).
**Asset sales.** After a sale, the price is allocated across asset classes for tax reporting, and goodwill is the residual. The mechanics are in our guide to [Form 8594 and asset allocation in a small-business sale](https://www.409.ai/articles/form-8594-asset-allocation-small-business-sale).

Questions to ask when your report uses it

You don't need to be a valuation professional to test an excess earnings analysis. Ask the appraiser:

1. Why was this method chosen? The answer should reference the lack of better evidence, which is the ruling's own test. 2. How many years of earnings, and what adjustments? Five years is the ruling's preference. Anything shorter should be explained. 3. Where does the return on tangible assets come from? An industry source is better than the 8 to 10 percent default. 4. How was the capitalization rate built? Look for named risk factors, not a bare number. 5. What do other methods say? A second approach that lands close gives the conclusion support. One that lands far away needs an explanation. 6. How much of the goodwill is personal to the owner? This matters whenever the owner is leaving or the interest being valued is a minority one.

An appraiser who can answer all six in writing has done the work. An appraiser who can't has handed you a number that the other side's expert can take apart.

The takeaway

Revenue Ruling 68-609 is not a shortcut to a small-business value. It's a documented fallback with a simple structure and one very sensitive input. Use it when better evidence really is missing, build the capitalization rate from the facts of the company, and check the result against another method. If your situation involves a loan, a buyout, an estate or a sale, our [small-business valuation service](https://www.409.ai/products/smb-valuation) delivers an expert-reviewed fair market value report that sets out which methods were considered and why. This article is general information, not legal, tax or accounting advice for your facts.