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Business Valuation LLC Phone: 304 692 1385 Fax :304 599 7250 Email: bizvaluer@valuellc.com |
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Active and Passive Appreciation
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Valuation Discounts Minimizing the tax bite on transfer of business or partnership interest at retirement, incapacity or death is critical to preservation of your clients' hard-earned wealth. A well-designed and timely executed succession plan can go a long way to ensure that heirs do not have to sell part or all of the business in a fire sale to meet the tax liabilities. A planned gifting of small non-control blocks of your clients' closely held business to family members can minimize the taxable value of these interests, helping your clients to avoid unexpected surprises and making the transition smoother. The following discounts may be available for these transfers. Discount for Lack of Marketability IRS defines fair market value (FMV) as the standard of value for assessing tax liability for estate and gift taxes. FMV is the price at which an asset will change hands between a willing buyer and a willing seller, neither party being under compulsion to buy or sell, and both having reasonable knowledge of relevant facts. Valuation of closely held businesses fails to meet almost all of these criteria. Reliable information is not readily available, transaction costs are high, and willing buyers and sellers are not readily available, This lack of liquidity creates serious problems in marketing small closely held businesses. It has now been accepted by IRS that ownership interests in small closely held businesses are not readily marketable. Several studies providing estimates of marketing discounts for stocks with restricted marketability have been published by the SEC and academic researchers. The average discounts reported in these studies range from 25 percent to 45 percent of the assessed value of the business. The marketability discounts applicable in individual cases depend on a number of factors. The size of applicable discount appears to increase as the businesses get smaller, make less money, and do not change hands frequently. As businesses become larger, have high profits, and are bought and sold regularly, the level of discount decreases. Individual tax situations differ significantly and professional help is needed to determine the best course of action. However, for example, a small business valued at $1 million could be easily transferred to three heirs over 10 years without triggering tax consequences. A 10 percent interest valued at $100,000 FMV can be discounted to $60,000 (a 40 percent discount) for lack of marketability and transferred each year by the owner and spouse as gifts of $20,000 to each of the heirs. If the gifts were being made to the heirs and their spouses, the same transfer could be achieved in five years. Minority or lack of control discounts In general, it is accepted that small non-controlling blocks of business interests have a lower value because of the lack of ability to control the business. Minority stockholders cannot make or enforce decisions regarding operations or distribution of business earnings. As such, a minority interest in a closely-held company can command a lower price than a controlling interest within the same company. These discounts are often determined by studying control premiums paid for companies in acquisitions. The adjusted inverse of a control premium is a minority discount. In case of unrelated minority owners the IRS had accepted the applicability of such discounts. However, until 1993, the IRS had consistently rejected such valuation discounts and related tax savings for transfers to family members. Revenue ruling 93-12 issued by the IRS finally accepted that valuation discounts for small minority shareholdings should be allowed even for transfers of ownership to family members. If certain conditions can be met, the value of minority interests may be significantly discounted for gift- and estate tax purposes -- often by 25 percent or more. For example, if your business appraiser determines that the fair market value of your closely held family business Company is $1 million. In a planned gifting, you may want to transfer 30 percent of your stock to each of your children and keep 40 percent with yourself. Instead of valuing each gift at $300,000 (30 percent of the value of the business), a lowered minority interest valuation may be possible. If a 25 percent discount is allowed on the transfers, more than $80,000 in gift taxes could be saved (assuming a 55 percent gift- and estate tax rate). Tax liability before valuation discounts = $600,000 * 55% = $330,000. Tax liability after a 25% valuation discount = $450,000 * 55% = $247,500. Minority discounts can be an effective way to transfer business interests at a lower tax cost. Key Person/Thin Management Discount Restrictive Agreements
Discounts Careful planning, however, is required to maximize the benefit and avoid the tax traps that can result in disallowing these discounts and trigger penalties. Business Valuation LLC can help to develop valuation models and illustrate the impact of different planning strategies on the estate plans you develop for your clients. contact us. |