Challenging macroeconomic conditions, including credit and financial market conditions, have inevitably impacted the values of most family owned businesses - even if the business itself is doing well. These troubling conditions may present many owners with an opportune time to transfer the family business while simultaneously minimizing the tax consequences.
In today’s market, many of the valuation metrics, such as multiples of value to EBITDA, are lower than in recent history. The trailing twelve months earnings streams of many companies are also lower and the immediate foreseeable earnings streams are expected to continue to be stressed. Low value multiples, against lower performance measures of the company, result in significantly reduced valuation conclusions. A reduced value is not something a business owner wants to hear about, but you can at least take advantage of this grim reality.
In general, the primary means of transferring ownership of a company to the next generation is to sell it, gift it or a combination of the two.
Today's lower valuations can reduce the transfer tax exposure and/or make the potential sale of the company much more affordable for the next generation. The current conditions also provide an opportunity to leverage the estate and gift tax exemptions. For example, if you are gifting under the $13,000 annual exclusion, you are able to gift a larger portion of the company because the interest units will likely be valued at a significantly reduced value compared to just one year ago. Right now, the value of interest units might be lower compared to any time during the past decade. The family business owner has an unprecedented opportunity to give larger blocks of ownership interest in the company to the next generation and still stay within the limits or to at least minimize tax exposure.
Under the current gift exclusions in place, you and your spouse can each gift $13,000, a total of $26,000 for 2009, to each eligible person without triggering the so-called gift tax. This amount is at an historic high. For example, in 2009 you could give $13,000 to your son, another $13,000 to your daughter, and $13,000 more to each of their spouses without having to pay taxes on the gifts. Your spouse can also give $13,000 per year to each person. You can use one valuation to support a gift in 2009 and a second gift in 2010 if the second gift is within a reasonable time of the valuation date and the valuation is not stale. The annual exclusion level has not been disclosed yet for 2010, but it will likely be at least $13,000. For instance, gifting $26,000 between you and your spouse in December 2009 and then gifting another $26,000 in January 2010 allows you to gift $52,000 over a short period of time, reducing administrative expense by using one valuation for two gift filings, and yet still not eating into your life time exemption. Say your company was valued at $2,000,000 one year ago, but now it is value as $1,000,000. The $52,000 gifted interest in the company was 2.6%, but now it is 5.2%. You are transferring more company interest under the gift exclusion limits.
You are able to gift more than the annual exclusion limit, but it will reduce your lifetime gift exclusion of $1,000,000. For larger estates, the gift tax may not be completely avoidable, but like smaller estates, the current market conditions can provide a great opportunity to transfer a larger portion of the family business at one time and pay less tax on the transfer.
Prudent gifting practice requires that a gift tax return and valuation of the interest gifted be prepared regardless of the size of gift. Filing a gift tax return and having a supporting valuation starts the clock running for the safe harbor rule. The safe harbor rule states that once you file the gift tax return, and assuming all valuations are adequately disclosed, the IRS has three years to question the value of the assets being gifted.
In gifting scenarios that are for the purpose of transferring ownership to the next generation, it is the general strategy to gift a minority position to each person receiving the gift. The gifting of minority interests allows for discounts for lack of control and additional discounts for lack of marketability to be taken against the pro-rata value. The goal is to prepare an IRS acceptable valuation while showing the lowest possible value for the gifted interests. The valuation of the business interest being gifted is a critical element in reducing IRS exposure, reducing any gift tax and maximizing your gifted interests as a percentage of the whole company.
By IRS rules, the business valuation may be determined by an objective appraiser qualified to appraise the business as shown by the appraiser’s background, experience and education. The appraisal report must then meet further content specifications contained in the tax regulations, including the identification of information utilized in sufficient detail to allow the reader (IRS) to replicate the appraisal analysis and value conclusion. The IRS is increasingly scrutinizing valuations for gift and estate tax purposes. Therefore, the preparation and disclosure to the IRS of a formal business valuation is critical to establish the value of the interests to be transferred for federal transfer tax purposes.
There are many strategies for transferring family owned businesses and assets to the next generation. Proper valuation of the assets is always a key factor in the success of the strategy. Using gifts in an overall estate plan can get complicated, and you should consider using the services of a qualified estate and tax professional to assist you with your overall strategy.
When an industry is seeing historical changes or transitions in an economy resulting in tighter regulations and monitoring, reliance on accurate and timely information becomes key. AccuVal has experience in 100 industries and can provide the information necessary to support any financial transaction. Read more about how AccuVal can help you to take control of your tax liability in this economically challenging time.