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October 28, 2016

The Value of a Discount

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I’m going to let you in on a little secret, that’s not much of a secret: estate planning attorneys have been effectively reducing the value of family businesses for years. Now, before you make a joke about lawyers’ fees, let me explain.

Generally speaking, business owners are looking to maximize the value of their stock, particularly if they are looking to sell. However, in the case of inter-family sale, or in the case of the older generation desiring to gift stock to the younger generation, family business owners are instead often looking to reduce the value of their stock in order to make the gift or sale most tax efficient.

Closely-held businesses, such as family businesses, typically have shareholder restrictions in place so that shares, stocks or units of memberships, LLC membership interests, cannot be freely exchanged or sold to someone outside the original ownership group. Those are commonly known as transfer restrictions. These transfer restrictions create a “lack of marketability,” meaning that because the stock cannot be freely exchanged, its value is less. In the context of valuing a business, this is known as a valuation discount and for years, estate planners have used this strategy effectively to provide better tax outcomes for their clients.

The Internal Revenue Service has repeatedly attempted to argue against these valuation discounts in court but has been largely unsuccessful when the planning was done correctly. Certainly there have been cases where the “plan pushed the limits,” so to speak and the IRS may have won a bit. However, the IRS has proposed new regulations (i.e. regulatory authority that interprets statutes), which would allow the IRS to bypass the court arguments and preemptively remove the ability to utilize these valuation discounts. These proposed regulations will go to a public hearing on December 1st of this year. If adopted, the regulations could go into effect in as little as thirty days.

Family business owners that have estate tax concerns (i.e. the estate is over $ 5,450,000 per person or $10,900,000 for a married couple) should pay close attention to the outcome of the public hearing. Thus, if a family is considering the sale, gift, or otherwise transfer of membership units to another generation and the business valuation would benefit from the lack of marketability discount, time might be of the essence to complete that transfer.

With that said, before anyone transfers a portion of their business, and especially in a situation in which the transfer needs to take place quickly, you must first evaluate whether the transfer makes sense. Much like shopping on Black Friday, it is important to recognize the benefit of a “Helping people leave a legacy for their loved ones, not solely in terms of financial means, but also with a reflection of the values and the beliefs that can be shared for generations to come.” Page 2 discount, but not without first asking: does it make sense to take advantage of this discount or not? For instance, depending on how the transaction is structured, one could capitalize on the valuation discount and create a great tax advantage in gifting to multiple people (e.g., all your children), but you must first stop to consider whether it is in the best interest of the business, the family, and each of your children, for all of the children to own a portion of stock. I reflect on the many families I have met where there is sporadic ownership of shares in a variety of children, some of who are in the business, some who are not. Typically there is no exit planning or really poor planning. Some of this kids want to be cashed out of the entity, some are feeling it’s unfair that they are working in the business or on the farm, building the value and the ones not in the business get to reap the benefit of an increased share value. When I visit with them on how this occurred many times I hear “We don’t know, we were just trying to reduce our estate so we gave shares away each year.” That’s what I call “hot potato planning,” get it off of mom and dad’s balance sheet and on to the kid’s balance sheet. That’s fine if it’s cash, not so fine if you have an operating business without a good exit strategy.

So before any transfer takes place, I caution people to make sure they know the whole layout of their estate plan and business succession plan. Make sure that the operating agreement, shareholder agreement, or other restriction agreement, says what you want it to say before you make any transfers. It’s easy to react to new rules, but working with a good, proactive planner will allow you to have a solid picture of how your whole plan lays out and what the best strategies are going forward. Then, with that information in mind, you can make sure that your exit strategy is solid before you gift or sell any of the ownership units.

It would be wise to start meeting now to ensure that you’ve taken a closer look at your succession plan. If utilizing valuation discounts will have a significant impact on transferring your stock or ownership interest, you need to be prepared. Thirty days is not much time. You don’t want to be playing “hot potato” with your family or your business. And be assured that all qualified estate planning attorneys are going to have their calendars filled if these regulations get approved.

Carolyn Thompson Headshot       Carolyn Thompson, JD, Founder of Thompson Law, P.C.

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