The Estate and Gift Tax Avoidance Valuation Process
By Loyd Rawls
The ability to convert an asset into cash supports the age-old axiom, "It is only worth what somebody will pay for it." Although your goal is not to sell your business, a realistic appraisal must address marketability, which is the ability to convert an interest into cash. As you are aware, no one makes a market in privately-owned business with a worth based solely upon all that you know about your business' potential. As a result, the true market value of your business cannot be readily determined. In order to actually sell it, you will have to put the business on the market and, through whatever steps necessary, locate a buyer and try to convey to him or her your unique understanding of profit potential. Because of the perceived risks and costs of buying a private business, you would receive less than what the business is really worth from a pure return on equity or capitalization of earnings perspective. For estate tax purposes, you should be eligible for lack of marketability discounts of approximately 25% of the fair market value. Furthermore, within a family environment, marketability discounts are affirmed by the normal and customary stock transfer restriction agreements. The same documents that give parents peace of mind that family stock will not be lost in the event of a divorce also provide further substance to lack of marketability discounts.
Similarly, effectively addressing technical control of a family business can also generate valuation discounts. An effective appraisal of stock or partnership interests must consider if the total or partial ownership interest has the power to convert the interest into cash. Generally, any voting percentage ownership in excess of 50% represents control of the entity. A 50% voting percentage does not provide control, but does provide a protective "dead lock." Any ownership under 50% is considered a minority with no control or deadlock ability. The bedrock of the concept of valuation discounts is that a deadlock or minority ownership interest is worth less than a controlling interest. Assuming a business is worth $X, a majority interest might be 75%, which is usually valued at 75% of $X. However, a minority interest of 40% is usually valued at 40% of $X, less a minority discount of approximately 25%.
The most powerful estate tax avoidance practice of a family business owner is to always give minorities and never die with majority. A gift of a minority interest should have substantiation for both a 25% lack of marketability discount in value and a 25% lack of control discount in value. Assuming lifetime gifts or sales by parents leave a minority ownership interest in the surviving parent's estate, the same double discount should be available to the estate. This amounts to a reduction in the taxable value of 30% to 40%. In the realm of multi-million dollar businesses, a 35% discount will avoid big time estate tax.
It should be noted that the IRS is not taking lightly the reversal of Chapter 14 of the Internal Revenue Code to empower valuation discounts for estate tax and gift tax purposes. Therefore, the IRC continues the challenge of what they deem as "abusive discounts," which are perceived devices for estate conveyance. Furthermore, they continue to pursue legislative relief that would specifically restrict or eliminate valuation discounts. Therefore, you must proceed in this area only under the counsel and leadership of experienced technical advisors.
Control Contraction Via Recapitalization
With businesses worth many millions of dollars, it is difficult to gift sufficient minority interests to leave a minority interest in the estate. As an example, if the business is worth $10,000,000, under the classic stock structure, over $5,000,000 of stock would have to be gifted in order to leave a minority in the estate. Unfortunately the combined lifetime gift tax credit is not sufficient to gift $5,000,000. There may also be insufficient time to gift the balance under the annual $10,000 exemption.
A technique for facilitating the gift or transfer of a minority stock position is a recapitalization of the corporate stock structure. The most common purpose for recapitalizing the stock in a succession planning environment is to contract the voting rights of the stock into a relatively small percentage of the outstanding stock. This form of recapitalization is accomplished by authorizing additional non-voting stock and declaring a non-voting stock dividend on existing stock.
Example:
As an example, a corporation could have a value of $3,000,000 with 1,000 shares of issued voting stock representing 100% of the corporation's capital. If a nine share non-voting stock dividend is declared on the 1,000 voting shares, the capitalization is expanded to 10,000 shares. Now the 1,000 shares of voting stock represent only 10%, or $300,000, of the corporate capital but 100% of the corporate voting control. When the goal is to obtain a minority position to lower the estate tax valuation, a recapitalization such as this example, which contracts the voting component of the stock, reduces the amount and the value of stock that must be transferred in order to achieve a minority position and realize valuation discounts.
Based upon our assumed $3,000,000 business valuation, prior to the recap, over $1,500,000 of stock would have to be transferred to children before the last parent to die could claim a minority valuation discount. After a recapitalization, wherein the voting stock has been diluted to 10%, the voting capital would be valued at $300,000 plus an appropriate control premium. If the appraisal cited the pricing differential between voting and non-voting shares on the public stock exchanges, the control premium would probably be determined to be 10%. Therefore, the total value of the voting stock would be $330,000. A minority could be achieved with transfers of just over $165,000 worth of voting stock. After the recap, annual exemption gifting of $20,000 per child would have a much greater impact on creating a minority position for the surviving spouse. The gift tax credit equivalent would cover the total block of voting stock.
The above is a gross simplification of the mechanics of contracting the voting element of business capitalization to facilitate achieving minority discounts. Regardless of the technical complications, the most difficult aspect of achieving minority valuation discount is relinquishing control. This is not a comfortable position for entrepreneurs whose past success has, in some measure, been the result of the tight hand they have held over business operations. It is admittedly difficult to give up control of a business because of emotional and security reasons. There is a right time from each of these perspectives. Ideally, this time is prior to death to enable a reduction in estate taxes. However, when to give up control is an individual conclusion that merits your highest quality consideration to keep a proper balance between peace of mind and financial peace of mind.
Loyd H. Rawls, CLU, ChFC, MSFS, of The Rawls Company in Orlando, Fla., has specialized in family estate and succession planning for closely held family owned businesses since 1973. lrawls@dealeronline.com
