Lower Valuations May Be A Silver Lining In The Dark Economic Clouds
We’ve all read the headlines and felt the impact of the worst recession
since the Great Depression. With this protracted downturn in the
economy, many businesses have experienced a significant reduction
in both revenues and net income. There doesn’t appear to be a consensus
as to when a sustained recovery can be expected.
One of the ways that a business owner can take advantage of this
downturn is to do some succession planning that utilizes lower company
values caused by decreased revenues and earnings. By gifting or
selling non-controlling blocks of stock, you can also combine a
lower starting value with discounts for lack of control and lack
of marketability discounts (more on this later).
This planning strategy assumes that:
- You are at a point in life where you want to transfer shares
of the company to your children (or others)
- You are at a point financially where gifting shares is an option,
or you are willing to take a lower value for your shares in a
For those who need to maximize the value of the business in a transfer
in order to meet retirement goals, this planning opportunity is
not for you.
Turning Lower Earnings in Your Favor
In many cases, if a business suffers lower earnings over a sustained
period of time, the value of that business would be lower than before
it experienced those losses, and hopefully, lower than it will be
after the downturn is over. There are exceptions to this of course,
and a valuation of the business is an essential component of this
Assuming the value of the business is at a low level, you will
be able to gift or sell the business to your children at a lower
value than if you did so in a more favorable economic climate.
The benefit of transferring the business at a lower value is that
if the transfer is in the form of a gift, you use less of your federal
gift tax exclusion (which is $1 million per person). If the parents
want to sell the shares, a lower value will allow the children to
buy more shares.
An illustration will help clarify this concept. We’ll work with
the following assumptions:
- Your business is worth $2 million today, but was worth $2.5
million three years ago
- You are a 100 percent owner of the shares of your company, and
wish to transfer up to 49 percent of your shares to either your
children or others
- As long as you retain 51 percent of the company’s shares, you
will retain control of the company
- You are married and have not used up any of your $2 million
gift tax exclusion ($1 million per person)
- There is no shareholder agreement that allows minority shareholders
to force the company to purchase minority shares
If you were to give 100 percent of your business away today, you
could do so without paying any gift taxes, since the value of the
business equals your remaining gift tax exclusions (assuming you
are married). If you had given the company away when it was worth
$2.5 million, you would have had to pay a large gift tax on the
amount over the $2 million exclusion. The current gift tax rate
is 35 percent, amounting to a tax of $175,000 that would be saved
in this scenario. Without Congressional intervention, the gift tax
rate goes to 55 percent in 2011 and beyond.
Selling a Minority Interest
While this savings is impressive, you can leverage your transfer
of shares even further if you gift or sell a minority block of shares.
In general (there are exceptions to this and as noted, a business
valuation is needed), a minority interest in a closely-held business
is worth significantly less than if it were a controlling block.
This is due to two factors: A lack of ability to control the operations
of the company, and the lack of a market for the shares. These two
factors can reduce the value of a share of stock significantly.
For discussion purposes, we will assume a combined discount of 30
percent is appropriate.
Assuming you transfer a 20 percent interest in the company when
the 100 percent interest is $2 million, the pro-rata value of that
interest is $400,000 ($2 million times 20 percent). You then apply
a discount of 30 percent to that interest and you end up with a
net value for the 20 percent interest of $280,000 ($400,000 times
In this scenario, the savings by gifting the 20 percent at a time
when the value of the business was depressed due to the poor economic
conditions is $220,000. A 20 percent interest in a $2.5 million
business equals $500,000 before discounts. A 20 percent interest
in a $2 million business equals $400,000. This is a $100,000 savings
due to the lower beginning value.
Next, you are allowed to transfer the 20 percent interest for $280,000,
rather than the $400,000, due to the 30 percent discounts discussed
earlier. This is a savings of $120,000. Therefore, the total savings
is $220,000 on what would have been a $500,000 pro-rata value just
a few years before. This is a 44 percent reduction in value from
its high a few years ago — a dramatic savings by any measure.
Start with a Formal Business Valuation
As illustrated, there are opportunities to transfer a closely-held
business at reduced values when the economy is weak. The discount
amounts used in this article are hypothetical and cannot be relied
upon for your specific situation. You need a formal business valuation
to properly value the business and the transferred interests.
If your personal situation fits the scenarios described above,
you may be able to turn those dark economic clouds into serious