The Valuation Of A Closely Held Business And Its Importance

By: Randall A. Denha, J.D., LL.M.

It’s November – again. As usual, many business owners are looking forward to making the final push for a successful year. Others, nearing retirement, and who may be contemplating the arrival of another winter, are considering whether it is time for a move to a warmer climate.

It may also occur to some of these that it was time they planned for the transfer of their business interests or investment assets. Most of them have already been making so-called “annual exclusion gifts” to various family members. They may recall their advisers having told them about the greatly increased federal estate and gift tax exemption, and they may even remember that this benefit is scheduled to expire after December 31, 2025, if it is not eliminated sooner.

With these thoughts in mind, a number of these business owners will visit their advisers to discuss the available estate and gift planning options, especially with respect to equity interests in their business. The advisers will likely tell them about outright gifts and gifts in trust, about installment sales and sales to grantor trusts, about GRATs, and about the importance of having a shareholders’ agreement or a partnership/operating agreement in place prior to making such transfers.

Hopefully, the business owner will also be alerted to the possibility that regulations which were proposed by the IRS in 2016 – but withdrawn in 2017 – may be reintroduced after 2020; in that case, they could present a significant impediment to the tax efficient gift or testamentary transfer of interests in a closely held business.

The business owner is also likely to hear about the importance of retaining a knowledgeable and experienced appraiser, and of having a well-reasoned appraisal report to support any transfer of their business interests, whether by gift or by sale.

Business owners who are looking ahead to estate planning would be smart to obtain a business valuation as part of the process. Whether you, as a business owner, plan to sell or gift a business to your heirs, the business likely represents the most valuable asset in your estate. If its value pushes the estate above federal and state exclusion levels, your heirs could be stuck with a large tax bill. But there are many ways to create an estate plan that allows for paying estate taxes, or avoiding them altogether.

One of the strategies for reducing potential estate taxes is by gifting some or all a company’s ownership from the business owner to their children or a family member during their lifetime.  By gifting ownership, business appraisers can utilize discounts to reduce the value of the business. The following are some of the more popular discounts available for use when determining values for gifting purposes.

Marketability Discounts

A marketability discount is a discount allowed for reducing the value of the business due to lack of “marketability.” If the company is a closely-held business, finding the right buyer may take a substantial amount of time and effort, therefore the value of the business can be reduced for these factors. Unlike publicly traded stocks, which can be easily bought and sold on a whim, a family-run business is not as quick and easy to buy and sell.

Minority Discounts

A minority discount is available when only a small percentage of a company is transferred. For example, if a dad owns 100% of the company, and transfers 10% to his son, then the small percentage is not as valuable to the son because of lack of control. If the son only owns 10% of the company, he may not have any ability to vote on important issues or make executive decisions.  As such, a minority discount is allowed since the son is not really enjoying a relatively equal 10% share of the pie.

Key Person Discount

A key person discount is a discount used to take into consideration personal goodwill. A company that is heavily dependent on the reputation and skill of the owner is probably not worth as much in the hands of another person. Although, the owner can certainly transition their work, inevitably, some customers may not be loyal to the new owner.

The advantage of using discounts is best explained with an example.

Let’s say Mr. Money owns 100% of the shares in an S-Corporation, Prosper, LLC. An initial business valuation is performed, as a baseline, and determines that 100% ownership of the business is worth $10M. However, Mr. Money wants to gift ownership of the company to his son, Noah, but he is not ready to give up control of the business at this time, so he decides to gift 40% to Noah initially. Based on the baseline value of $10M, the value would appear to be $4 million for the 40% interest. But, due to the fact that Noah will not be in control and the stock lacks liquidity, a business appraiser would discount the 40% interest. Assuming the appraiser determines a 35% combined discount is appropriate, the interest would only be worth $2.6 million for gift tax purposes.

When the 40% interest in the business is transferred to Noah, Mr. Money will be required to file a gift tax return. The value listed on the gift tax return will only be $2.6M, thereby reducing Mr. Money’s lifetime exemption by this amount, instead of the original value of $4M.  On the other hand, if Mr. Money dies while still owning the company, the $4M value will likely be used for estate tax reporting purposes. Assuming Mr. Money has other assets that push him over the estate tax exemption, the $1.4M discount from the gift to Noah has the potential to produce a savings of up to 40% in estate taxes, or $560,000.

Furthermore, provided that a gift is adequately disclosed on the gift tax return, the three-year statute of limitations clock begins to tick. Business appraisers have a checklist of the required disclosures and documentation required by the IRS to support the valuation of the business. After the three years have passed, the IRS generally cannot open the gift tax return for audit and challenge the value of the gift.

Federal and state exclusions

Under our current estate tax regime, for many business owners the value of a business is not as important as it used to be, due to the $11.4 million exclusion for federal estate tax calculations. For a married couple, the exclusion could reach $22.8 million. At this time, he the state of Michigan does not have any state estate tax to contend with.

Thus, if your estate, including the value of your business, is less than the exclusion amount you might not have to worry about minimizing federal estate taxes. But if the value of your business could put you above that threshold, you do have federal estate taxes to be concerned about.

Planning ahead to pay estate taxes

Let’s suppose you are in the category where estate taxes are a concern. Knowing the value of your business can help you to determine what your estate taxes might be and how to plan ahead to pay the taxes, or avoid them.

Your estate must be liquid enough to pay the taxes if you do nothing to avoid them. If you plan to leave your business to family members, you don’t want to burden them with paying estate taxes to the extent that their personal lifestyles or the business may suffer. Knowing the value will help you estimate the estate taxes and plan for payment. Strategies for paying estate taxes can include using other assets or acquiring life insurance. But do you really want to give the federal and state government all that money if there are ways to avoid it?

Knowing the value of the business can help you and your advisors plan to reduce the estate by giving away a portion of the business, or some other assets of a like value, while the owner is alive.

Gifting a portion of the business

If the plan is for the business to remain in the family, gifting a portion of the business while the owner is alive might be the appropriate course of action. Depending on the value, this would usually not require the owner to give up control. It is also likely to be an asset that will appreciate over future years, making it more appropriate to give than cash, for example, in keeping the estate from becoming taxable as years pass. If there is no plan to keep the business in the family, and there is an apparent estate tax problem due to the value of the business, knowing the value can help to determine what other assets might be given to family members to reduce the size of the taxable estate. Other investments, real estate, collectibles, etc., might be given to family members, while the business is retained.

Life insurance

If the estate cannot be reduced enough to avoid the estate tax by giving away other assets, then life insurance might be a solution (assuming reasonably good health of the owner). Knowing the value of the business helps to know how much life insurance might be necessary. Ownership of the life insurance can be established in such a manner that the insurance itself does not become an asset of the estate.

Using IRS-approved valuation method

A business valuation for estate planning purposes should be performed in the same manner as a valuation for estate tax purposes, since the value arrived at for planning purposes needs to be the same as that for tax purposes or it would not be meaningful for planning. This means that it should be performed by a “qualified” appraiser using a method that the IRS would approve for estate tax purposes.

Methodologies should include adherence to applicable Internal Revenue Rulings and Procedures. Such compliance would be important if the valuation were to become part of the supporting documentation attached to a gift tax return resulting from the planning process. The value arrived at would be “Fair Market Value” and would likely be subjected to a discount for lack of marketability and, for potential gift tax purposes, to a discount for lack of control (or “minority interest”) as described above.

Business Valuations Post-Mortem

After the passing of a business owner, there are two considerations for business appraisers. The first is valuing the business for purposes of reporting and paying estate taxes and the second is valuing a business for purposes of the step up in basis. In my experience, the second consideration is the more important of the two, considering the increase of the estate tax exemption. When an individual passes away and the assets are transferred to their heirs, the heirs acquire a brand-new basis in the asset. The assets are valued as of the date of death and the value becomes the heir’s basis. This is the step-up (to fair market value) in basis.  If the beneficiary decides to sell the asset, they may not realize much or any gain on the sale and therefore pay minimal or no income tax. Alternatively, if the assets were transferred to the beneficiary as a gift before death, the donor’s basis generally becomes the donee’s basis. In this case, if the asset is later sold, there may be significant gains subject to income tax.

If the value of the business, along with the taxpayer’s other assets, is well below the estate tax exemption, there may not be a need to gift ownership during the taxpayer’s lifetime. The value of the business, as determined upon death, may be more beneficial to the heirs because of the step up in basis. Effectively, reducing income tax in the hands of the beneficiary becomes the main goal in this situation. With the current exemption rich landscape for taxpayers, many people may be better passing away with the asset than gifting the same during life.

On the contrary, if the taxpayer’s business and other assets are near or above the estate tax exemption, then gifting before death could be beneficial to reduce estate taxes. Gifting before death allows the use of some of the discounts mentioned above and an overall reduction of estate taxes. One concern of making such lifetime gifts prior to the sunset of the increased exemption amounts is whether the IRS would try to “clawback” such gifts into someone’s taxable estate when he or she later died, if the amount of such person’s lifetime gifts exceeded the exemption amount at the time of that person’s death. Now we know that the answer is that there would be no clawback.

In fact, and as a side note, the IRS clarified late last year in IR-2018-229 that the increased gift and estate tax exemption would not adversely impact estates post-2025. To explain this, supposed an individual dies in 2026 and this person gifted assets of $10M between 2018 and 2025, but the estate tax exemption reverted back to $5.5M. The estate is permitted to use $10M as the exemption instead of $5.5M, and not be penalized by the large gifts made during the time frame that the estate exemption was much higher.