Family Business Values and Timely Ownership Transfer
The timing and magnitude of estate tax relief has vastly complicating financial, business and succession planning. Many more family businesses and investment assets will escape estate taxation as, over time, exemption amounts rise and tax rates decline. In 2010, the unified credit will become unlimited (because tax rates will fall to zero). The next year, the system will revert to pre-reform levels and rates. That's the way things stand now. This regime will be changed, but nobody knows when and how.
This situation has caused many families to postpone dealing with these vital planning issues on the basis that for the next few years their estate tax exposures will decline. This is understandable, but the underlying need to plan will not go away! More importantly, estate tax relief empowers families to make major decisions about business and investment asset values, as well as their ownership allocation among heirs, based on criteria they - not the IRS, the courts, the law, or the markets - define. This raises a host of new valuation and ownership transfer issues because, in estate tax-exempt situations, many traditional assumptions, based on tax law and market foundations, do not automatically apply.
In a tax-exempt estate, for example:
o There will be no IRS audit exposure (except to demonstrate that estates are tax-free); indeed, no other adverse scrutiny, except from heirs.
o The fair market value standard (value to any willing buyer and seller), will no longer necessarily apply. The family will decide what standard of value is fair, and each family may define fairness differently.
o Discounts for lack of control and lack of marketability, a key estate-tax reduction benefit, will not necessarily be relevant.
o The entire concept of what is "fair", "reasonable" and "equitable" will be a family decision.
o Families in otherwise identical circumstances will have the power to resolve these issues based on whatever criteria they deem most important. The criteria themselves will be variable, and may include non-economic as well as economic considerations.
o This will vastly increase the potential for family disputes over valuation issues. The courts may be unable or unwilling to resolve them.
o This will create new challenges for professionals who help families plan their estates.
o It will make informed, open and full communication among family members as well as their advisors even more important.
A Case Study
This hypothetical situation illustrates the preceding points and reveals some of the ticking time bombs inherent in tax-exempt estate appraisals.
A client has a $3 million estate (assume it is below the tax threshold) consisting of $2 million of marketable securities in a family limited partnership (FLP) and a profitable, going concern business with an appraised fair market value of $1 million. The business is in a consolidating industry; it is reasonable to expect that it could be sold to a strategic (not a fair market financial) buyer for $1.5 million. The business, although viable, has volatile earnings and is somewhat leveraged. There are two heirs: a daughter who competently manages the business and is paid fair market compensation, and a son who has no desire to enter the business, is in another profession which pays him less than the daughter earns, but who has more secure earnings prospects. The daughter has a strong marriage and two children who will soon be entering college. She enjoys her career and has no desire or need to sell the business (as the buyer would not require her services; she would be out of a job she loves and for which she is well-paid). The son is a confirmed bachelor with no children.
Among the valuation and allocation issues raised in this scenario are
:
1. Should the business be valued at the fair market ($1 million) or strategic value ($1.5 million)?
2. Since the daughter is at risk for the business in terms of her income as well as the equity (were she to receive all of it), should the son be entitled to any participation in a sale?
3. How should the grandchildren be treated? Should the daughter receive more assets because she has higher living expenses, including college tuition?
4. If the daughter inherits the business, she will have to personally guarantee the bank loans. Should she receive additional assets or compensation in exchange for assuming this risk?
5. How should the FLP interests be allocated? Who should be the general partner (after the parents are no longer around)? What about valuation discounts for limited interests?
6. What about the disparity between the son's and the daughter's earning prospects? Should there be compensation to equalize them?
7. Should the son be at risk (of both gain and loss) for the value of the business of which he is not a part?
These are but a few of the issues raised in this relatively simple case. There are many possible answers to each issue. The key point is that the family must make these decisions based on their own criteria. Their advisors can provide information, but cannot independently determine what is "fair, reasonable and equitable".
A traditional fair market value appraisal of the business, although informative, may not be relevant if the family decides that strategic value should apply. And the relevance of discounts for lack of control and lack of marketability for the FLP interests is another open issue. This is in stark contrast to taxable estates, in which fair market value and the indicated discounts are routine.
There are no easy answers!
This places a higher burden of responsibility on the family as well as its advisors, including the business appraiser, to identify, think through and help resolve these controversial issues. Keen analytical skills, diplomacy, sensitivity, an open mind, and a pro-active disposition are some of the skills that successful advisors will need when advising tax-exempt estates.