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More Money to You and Less to the IRS

Business succession planning and transfer values must be based on a professional appraisal. Not only does the business owner need a professional valuation to determine the parameters of any transfer, but she will also need it to defend any strategy and valuation used should it be challenged by the IRS.

What is The Elusive Fair Market Value?

Essentially, the value of a business is what someone else is willing to pay for it.  If an owner sells to key managers or employees, the general rule that the value is determined by the Fair Market Value which is defined as “the price at which property changes hands between a willing buyer and a willing seller when each is under no pressure to act and both have reasonable knowledge of the relevant facts.” In determining value, the parties must give consideration to subjective facts in the businesses market place as well as to the individual.

If an owner is planning on transferring the company to family members, he or she is generally not trying to maximize the price of the company. When the sale is to family members, the parties will use the lowest value that will be acceptable to the IRS without triggering a gift tax.

3 Methods to Value Your Business

When appraising a company, a valuator generally uses one or more of the following approaches:

  • Asset Approach – Looks at the market value of the assets on the balance sheet including a value for goodwill to the extent it will benefit the new owner.
  • Market Approach – Compares a business to recent sale prices of similar companies in same industry and operating under similar conditions.
  • Income Approach – Looks at the income the business can produce.

Discounts- What They Mean for the Value of Your Business

For Succession Planning an Appraisal is a Must

Which approach is used depends on the type of business, and the purpose of the valuation.  Note that proposed IRS regulations could eliminate these discounts by the time this book is published. Check current regulations before relying on these discounts.  As most businesses don’t fit neatly into any category, a valuation may utilize two or more these approaches.  The appraiser may apply a premium or discount to the value of an asset.  A controlling share may be valued at a premium, while a minority interest will be discounted. Shares for which there is no ready market will carry a “lack of marketability” discount. Shares which represent a minority interest will carry a “lack of control discount.” Discounts can also be taken for a blockage or for a built in capital gains.  Thus, if the gift is a minority interest in a closely-held entity for which there is no ready market, the courts and the IRS have recognized that these discounts may be used to value the interest.

Generally, a primary goal of succession planning is to transfer business interest to a family member by removing the asset value from the owner’s estate, and to freeze the asset value prior to death, thus, transferring any subsequent appreciation in the business asset value estate tax free. Owners transferring closely held businesses take lack of control and lack of marketability discounts on the business value. As long as the business is a legitimate active business the IRS usually limits its challenges to the amount of the discounts.

Although the law was written to limit the use of discounts in the closely held family business situation, the discounts are routinely taken as part of succession planning.  The IRS recently announced that it would be issuing regulations that may limit minority interest and lack of marketability discounts when valuing certain family-owned businesses.  Until the new regulations are issued and can be analyzed, the estate strategies and freeze options should continue to be used. Freeze strategies such as zeroed-out GRATs and grantor trusts remain valuable vehicles for leveraging gifts of close business interests. Also, it is likely that more use will be made of sale to Defective Grantor Trusts, gifts of partial interest in real estate, installment sales of property, and the use of self cancelling promissory notes. If the regulations become final on valuation discounts, expect estate planners to become more creative in using other tools available to reduce the tax burden.

Whatever the tax consequences of the transfer of a business interest to a family member, the transaction must still make economic and personal goal sense and correspond to the owner’s, other stakeholder’s, and family member’s goals.The ultimate planning goal is to maximize the after tax net value to the business owner and his or her heirs. This requires complex planning for multiple consequences.

Get a Fast Start on Your Estate and Business Succession Plan

Russ Pike is an engaging speaker, author, and passionate estate and elder law attorney. Russ is known for understanding his client’s needs and explaining complex areas of the law in a way that non-lawyers understand. Russ helps his clients by providing strategies and plans that will not only minimize taxes and protect assets, but will also ensure that wealth is transferred to the person intended. Russ works closely with families to minimize the occurrence of those situations you have heard about where family members are at each others’ throats over their inheritance. Russ is the author of two books, “Estate Planning for the Not Yet Wealthy” and “I Wasn’t Ready Yet! Survivor’s Guide to Handling a Loved One’s Estate.”

If you would like to learn more about the planning options available to you, pick up the phone and give Russ a call at 503-888-0952 to schedule a free consultation. During the consultation, which usually cost $295, you will have all your questions answered and receive at least one actionable strategy that you can implement.