Estate Planning for Business Owners

By Eugene T. Maccarrone and Mark S. Warshavsky

In Brief

Keeping It in the Family

There are many issues to be considered when valuing a business for estate planning and related purposes. The fluid status of a taxpayer’s overall family and wealth circumstances, the ever-changing laws affecting estate and gift tax planning, and the inherently dynamic nature of business concerns create planning problems that require special professional attention. The authors highlight the role of business valuation in the wealth preservation process.

The complexity of estate planning increases markedly when the subject of the plan is a business owner. The taxpayer’s business interests can complicate the usual planning considerations in designing a strategy that minimizes estate and gift taxes and maximizes family wealth. This is particularly true when the business relies on the taxpayer’s active participation to maintain its value.

The Family Business and Maintenance of Family Wealth

Considerations regarding the inclusion of business interests in an estate plan may be analyzed in two phases. First are the lifetime concerns of business owners as to how they can best manage the business to maximize its wealth for the benefit of their family. In this phase, present factors affecting the taxpayer’s wealth, including business value, are considered. The following estate planning factors can influence the valuation of business interests:

The second phase addresses estate concerns regarding the ultimate definition of a taxpayer’s wealth, including business interests. These factors include those noted above, as well as additional considerations that arise because of death:

Many of these factors are affected by recent changes to federal estate and gift tax rules. The Economic Growth and Tax Relief Reconciliation Act of 2001 will have far-reaching effects on family wealth planning, with a number of provisions specifically focused on business owners. For example, the 2001 Tax Act repeals the family-owned business deduction in 2004 (deduction of the value of a family-owned business up to $1.3 million, less the federal exemption equivalent amount from the value of a decedent’s estate) and limits, beginning in 2010, the traditional step-up in tax basis of a decedent’s property to the fair market value at death (or at the six-month alternate valuation date). A decedent’s estate will then be permitted to increase the basis of assets transferred only up to a total of $1.3 million, with an additional step-up of $3 million for assets going to a surviving spouse (total to a spouse of $4.3 million). Furthermore, special use valuation reduction for qualified farms and closely held businesses is set to increase to a maximum reduction of $820,000 (indexed for inflation).

Even where the 2001 Act is silent, continuation of past law will affect wealth planning. For example, the six-month alternate valuation date is retained, as are the penalties for tax underpayments attributable to “substantial” and “gross” valuation understatements (20% and 40% of the portions of the understatements, respectively, where the underpayment exceeds $5,000).

The Role of the Business Valuator

The business valuator assists the other estate professionals by performing the analytical work necessary to obtain an appropriate and supportable business valuation for family wealth planning and estate planning purposes. The IRS has escalated its challenges to the valuation of closely held businesses in the estate taxation arena. Without proper analysis and documentation, taxpayers have little chance of successfully disputing an IRS challenge. A taxpayer’s chances are much better where a qualified valuator furnishes a well-prepared report.

There are many possible instances where a business valuator is indispensable in the event of an IRS challenge of the gift or estate valuations, or, for that matter, on the gain or loss computation on the subsequent disposition of the property in question. From a cost-benefit point of view, the cost of engaging a business valuator in the first place is often outweighed by the additional tax, penalties, and appeals costs associated with situations where an IRS challenge must be defended after the fact.

The Business Valuation Process

The first step in the business valuation process is determination of the purpose of the valuation. For example, a business owner may conclude it is time to reward family members involved in the business through a gifting program of company shares. Or, the owner may decide to sell the business to an unrelated third party, which would provide available cash for distribution to family members. Or, the purpose might be to perform a date-of-death or alternative-date valuation for the estate of the deceased person. The purpose could affect the approach taken for the valuation.

The next step in the valuation process is to identify the interest to be valued and the rights associated with it (for example, voting vs. nonvoting or common vs. preferred stock shares of a closely held corporation). The owners, the company’s attorney, and the shareholders’ or other business agreements would provide evidence about the interest to be valued.

Once the purpose has been established and the interest to be valued determined, there are numerous procedures to arrive at the fair market value of a company, including the relevant state law that governs the interest; the impact of any relevant regulatory pronouncements; the calculation of any appropriate valuation discounts; and the proposed composition of the written valuation report.

IRS Revenue Rulings

While there are many authoritative sources for reference when appraising a closely held business, IRS Revenue Ruling 59-60 is the most quoted source in the business valuation field. This 1959 ruling has been widely adopted as the primary authority and resource for the determination of fair market value of business enterprises in virtually all valuation situations. The purpose of Revenue Ruling 59-60 is to outline the general approach to be considered in valuing shares of the capital stock of closely held corporations for estate and gift tax purposes where market quotations are not available. In addition, the ruling discusses some methods and factors that should be examined.

Revenue Ruling 59-60 defines fair market value as the standard of value for federal estate and gift tax purposes. Section 20.2031-1(b) of the ruling defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

The ruling also states that all available data should be considered when analyzing a company being valued. A business cannot be valued solely on financial performance without regard to the company’s marketplace or industry outlook. The ruling identifies the following factors that should be examined:

In the final analysis, there is no established procedure for combining the various factors into a prescribed formula that can appropriately determine the fair market value of every business. The theme that resonates throughout the ruling is the need to balance common sense, informed judgment, and reasonableness when weighing these factors in order to arrive at a value for gift or estate tax purposes.

Another important decision that has shaped the business valuation process is Revenue Ruling 93-12, issued in January 1993, which discusses the use of minority interest discounts when a shareholder group is related. The ruling states that a minority discount would be allowed in a gift or estate transfer even though members of the same family as the donor own the minority interest being transferred. Prior to this ruling, if a donor transferred shares in a corporation to other family members, the factor of corporate control by the family may have precluded a minority interest discount.

Discounts

The business valuation process should also take into account all appropriate discounts available to decrease the value of the company’s stock. Thevaluation discount is the reduction in value from the initial fair market value calculation that reflects the economic reality of what a willing buyer would pay for the specified business interest. Section 3.01 of Revenue Ruling 59-60 states that the valuation process is not an exact science. Much of the value of a closely held entity could lie in difficult-to-quantify factors where discounts may apply. Two of the more utilized discounts applied to the value of the business, depending upon the circumstances of the entity, are lack of control (or minority interest) and lack of marketability.

Minority discounts. A minority discount reflects the reduced control over the decision making and daily operations of the business possessed by a noncontrolling owner. The extent of the discount depends upon the size of the interest being appraised, as well as the factors that affect control. In assessing the size of a discount for lack of control, a variety of factors come into consideration, including the nature of the business, the size of the other outstanding interests, the size of the minority interest, and the voting rights.

The interest to be valued may vary from a small percentage of ownership to 100% control. This determination becomes an extremely important point in the valuation process. As an example, an individual with a 20% interest in an entity would have a value of less than 20% (the minority interest discount) of the entire company because this shareholder has almost no rights with regard to the operations of the business.

Determining the effect of a minority discount is often not straightforward. For example, a 2% interest may have no minority discount if there are two other 49% shareholders. In this case, whichever of the two 49% shareholders acquires the 2% interest would then have 51% and effective control of the company. In addition, the value of the swing vote increases with disharmony between the other two shareholders. Thus, in this example, a premium might even be added to the value of the 2% interest.

In other situations, a 49% shareholder may or may not have effective control, depending on the composition of the other shareholders in the company. A 49% block of stock may have little or no control if the remaining shareholder has a 51% interest. Nevertheless, the 49% shareholder may have effective control of the company if there are many other shareholders, which would fragment the remaining block of outstanding shares of stock.

Crucial factors in establishing minority interest discounts are the assortment of rights possessed by the holder of the interest and the ability to exercise those rights. Such rights are based on a combination of applicable state law, the owners’ agreement, and other rights and restrictions agreed to by the parties. The extent to which the various elements of control do or do not exist in the particular situation affects the impact of each element on the value of control.

Control is an important benefit of ownership, particularly in a closely held business. There is no scientific way, however, to convert these qualitative considerations to a quantitative measure of the difference in value between a controlling interest in a corporation and a noncontrolling interest in the same entity. There is usually less perceived risk in an investment when the investor can control the company’s courses of action. Accordingly, a controlling interest in a closely held business should generally command a higher price than a minority interest.

Marketability discounts. Marketability discounts occur because the liquidity of the interest being valued, or how quickly and assuredly the interest can be converted to cash, may be subject to time delays and risks associated with the sale of a closely held company. In essence, the market commands a premium for a liquidity situation and assesses a discount for the lack of it. When prudent and well-informed investors accept an illiquid investment, they do so only when the purchase price is sufficiently low to increase the rate of return to a level commensurate with the risk associated with the investment.

Thus, an adjustment for lack of marketability is intended to compensate the company being valued for the difference in liquidity that arises because publicly traded shares can be converted to cash—i.e., sold—almost instantly, whereas privately held shares cannot. Moreover, privately held shares often are subject to onerous restrictions in owners’ agreements. Financial theory and actual market observation demonstrate the value of liquidity.

Another consideration when determining the size of the marketability discount concerns the costs associated with closing the sale of a closely held business. Such costs are attributable to the brokerage, legal, accounting, and valuation services necessary to register a closely held company so that its shares can be sold on an exchange or to negotiate the sale of the controlling interest so that it can be sold in a private transaction.

Finally, general business factors may increase the discount for lack of marketability:

The Written Report

The valuation report should contain, at a minimum, the following information:

Objectivity and Independence

The business valuation analysis process can be critical to the operation of an estate plan or business succession. It is imperative that the individual performing the valuation have credibility in the eyes of the IRS and the courts. The business valuator should never be viewed by them as an advocate for the taxpayer. Conclusions should be objective, based on the methodology selected, and supported by all of the relevant facts and the analysis of the data available. The ultimate goal—to estimate the fair market value of the determined interest in the closely held business—must remain the main focus.