By Tom Decosimo
TRANSITION TAX PLANNING
Estate taxes are complicated, but generally, once the value of an estate exceeds $5 million, an individual can count on paying an approximate 50% federal and state estate tax rate (no wonder some people call them death taxes). One of the key benefits of strategic transition planning is a reduction in the total taxes that must be paid to transfer the proceeds from a sale of a business to the next generation.
Estate taxes are calculated based on the fair market value of the assets in the estate at the time of death. Similarly, gift taxes are based on the fair market value of the gifted assets at the time of the gift. Appraisers recognize three levels of value based on the degree of control and marketability associated with the interest. The fair market value of the business as a whole when sold outright is calculated at the controlling interest level of value. The fair market value on a controlling interest basis includes the benefit of the ability to control the operating, financial, and strategic decisions of the business.
Business owners typically do not gift the entire business all at once; rather, gifts are made of minority interests in the stock of the company. These minority interests cannot make (and often cannot even influence) the operating, strategic, and financial decisions of the business, and unlike shares of publicly traded securities, they cannot be sold on a liquid public stock market. The fair market value of an illiquid interest in a private company is calculated at the nonmarketable minority interest level of value, and the result is likely to be significantly less than the pro rata value of the business in total if sold outright.
The definition of fair market value is based on a willing buyer, willing seller framework in which no unusual motivation to buy or sell is assumed. In the real world, however, transactions take place at investment value – the value to a particular buyer and a particular seller. Investment value can be higher than fair market value, even when FMV is determined on a controlling interest basis. Differences between fair market value and investment value might arise as a result of cash flow enhancements contemplated by the buyer such as expense reductions or cross-selling opportunities. Other possible differences include a particular buyer’s unique ability to decrease the risk of the business, a unique perception of the growth prospects of the business, or simply an unusual willingness to overpay for a particular deal.
One of our clients recently set up a family limited partnership into which she gifted minority shares of her privately held business. The fair market value of these gifts was substantially less than the pro rata fair market value of the company as a whole, so gift tax calculations were based on a substantially lower base than they would have been had the owner waited until the business sold outright.
For the several years during which the gifts were made, our client paid gift taxes based on the fair market value of the gifted interests on a nonmarketable minority interest basis. When the business eventually sold on a controlling interest basis, our client was fortunate enough (due at least in part to our efforts) to sell at an investment value that reflected significant synergies. The family limited partnership received deal proceeds based on its pro rata share of the investment value of the business in total. Had our client waited until her business sold (or her death) to distribute the proceeds to her children, the proceeds would have been reduced by gift (or estate) taxes based on the transaction value.
Obviously, the above example is greatly simplified. We assume the client has assets other than the business that result in 100% of the value of the business being taxable. We also assume that the proceeds from the sale are after tax. Excusing this oversimplification of the relevant tax rules, the example highlights the advantage of paying taxes based on the fair market value of a minority interest in the company rather than on the investment value of a controlling interest in the business.
WE CAN HELP
Just as we assisted the client in the mentioned example, we have over 40 years of experience providing estate tax planning, business valuation, and sell-side advisory services that we can put to use for those owners contemplating transitioning their business to future generations. We’ve seen the savings that result from simple planning. We’ve also seen the outcome on liquidity and other issues that failing to plan leaves for the next generation. Please contact Tom Decosimo to discuss how strategic transition planning can help you reduce the tax burden on the transfer of your business.
Tom Decosimo, CPA•ABV, ASA | Principal