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 sale

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 plan.

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 70 percent).

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 savings.