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Business Succession Planning: Know Your Options, Unique Opportunities & Recent Valuation Court Cases
Shaun Duffin, CPA, ABV, ASA, CMA
Senior Managing Consultant
Forensics & Valuation Services
Brief Overview of Business Valuation
• What is business valuation?
• When are valuations needed?
• Who is the audience?
• What standard of value?
• Valuation methodologies
• Valuation discounts
What is Business Valuation?
• Business valuation involves estimating/appraising the value of a business or business interest
• BV analyst is a surrogate for public market
• BV analogous to real estate appraisal
• The need for valuations is most common with hard-to-value assets such as privately held businesses, privately held stock & intangible assets
When are Valuations Needed?
Transaction, Fiduciary or Regulatory Support: • Estate & gift tax planning & compliance • Income tax (IRC 409A, cheap stock/pre-IPO analyses, C-to-S conversions, etc.) • Employee stock ownership plans (ESOPs) • Fairness & solvency opinions
Financial Reporting: • Purchase price allocations • Goodwill impairment testing • Stock option valuations & other fair value measurements
Business Advisory (internal use analyses, “ballpark estimates”, calculations, etc.): • Buy-sell agreements • Potential sale of business/acquisition of business
Litigation Support & Dispute Resolution: • Shareholder disputes • Prenuptial agreements & marital dissolution
Who is the Audience?
• Internal Revenue Service
• Department of Labor
• Securities & Exchange Commission
• Judge or jury
• Independent auditors or audit committee
• Board of Directors
• Fiduciaries
• Shareholders
• Opposing valuation expert
What Standard of Value?
Liquidation Value • “Fire sale” of assets; lowest type of value
Fair Market Value • The price at which an asset would change hands between willing buyer &
willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties being able, as well as willing, to trade & well-informed about asset & the market for asset
• Assumes a financial buyer…no acquirer synergies are considered • This is the typical definition for regulatory purposes, e.g., IRS, DOL, etc.
Strategic Value • Value to strategic buyer, considering add-backs, synergies, etc. • Value is buyer-specific i.e., different buyers will have different perceived
values
Valuation Methodologies
Capitalized Cash Flow
Guideline Public Company
Discounted Cash Flow
Guideline Transactions
• Relies on company projections
• Crystal balls are cloudy
• Assumes constant growth forever
• Difficult to use in recent years
• Public markets are volatile
• Many public companies have struggled; multiples can be crazy
• M&A market has changed
• Multiples from older transactions may not reflect current pricing
Valuation Discounts
• Minority interest
o Also known as discount for lack of control (DLOC)
• Discount for lack of marketability (DLOM)
• Discount for lack of voting rights (DLOVR)
• Key person
• Blockage discount
Overview of Primary Valuation Purposes
• Gift to family
• Estate tax reporting
• Buy-sell agreements
• Employee stock ownership plans
• Charitable contributions
• Shareholder disputes
• Divorce
Gifting to Family
• Annual exclusions
• Dip into lifetime exclusion
• Valuation discounts
• GRATs
• Timing of gifts
• Fair market value standard of value
• Several disclosures required–written report is best
Estate Tax Reporting
• Normally larger interest is being valued
• Lack of control discount may not apply
• Consider alternative valuation date
• Fair market value standard of value
Buy-Sell Agreements
• Important to have, keeps business in the family
• Get valuation firm involved BEFORE agreement is finalized
• Types: o Repurchase by company
o Cross-purchase among owners
o Hybrid (more flexible)
• Define standard of value
• Most disputes are result of unclear language
• Obtain buy-in from shareholders for transactions
Employee Stock Ownership Plans
• One-time sale of minority ownership interest to ESOP o Common when there is desire for some employee ownership, but family or key
executives require controlling ownership o Allows seller to “take chips off the table” & diversify wealth while maintaining
voting control of business
• Multiple transactions to eventually achieve 100% ESOP ownership o Size of transactions typically dictated by available bank financing o Common with owners that want to gradually exit business o Common with owners that want to participate in “upside” of business
• Sale of 100% to ESOP o More common than ever o Companies immediately benefit from being income-tax free o Selling shareholders often receive notes as part of their consideration o Seller notes can be attractive investments for sellers
• A valuation is required at least annually
• Fair market value standard
Charitable Contributions
• Basically follow gift & estate
o FMV standard of value
• Sizeable donation
o Accompanied by “qualified appraisal” Not earlier than 60 days prior
Not later than due date of return
o By “qualified appraiser”
Shareholder Disputes
• Reference buy/sell agreement if applicable • State statutes may dictate standard of value & discounts
o Minority shareholder–dissenters’ rights o Fair value as defined by statute (most states) (not FMV) o Triggering events
Merger Sale Exchange/reverse stock split Disposition of significant assets
o Discounts may be excluded o Value of shares immediately before corporate action
• Judicial precedent can also apply
Divorce
• Standard of value is state specific
• Watch double dip if child support is involved o Owner comp adjustments o Goodwill excluded & DLOM
• Goodwill issues in Indiana
o Personal vs. entity o Type of business/practice
• Guaranteed scrutiny from other side
• Cooperation of moneyed spouse can be challenging
Current Opportunities in Estate/Gift Planning
• Tax Relief Act of 2010
• Ways to take advantage
• Time is running out
• Current temperature in Washington
Tax Relief Act of 2010
• After Congress & President Obama struck a deal on the Tax Relief Act of 2010, we entered, arguably, the most pro-taxpayer regime for intergenerational wealth transfer we have ever seen
o New law raised exemptions for both the estate and lifetime gift tax, while lowering the estate tax rate
o Lifetime gift tax exemption jumps from $1 million to $5 million ($10 million for a married couple)
o Further, the gift tax exemption is now “portable”, just like the estate tax exemption. In other words, when an individual dies, any gift or estate tax exemption that the deceased did not use may be used by the surviving spouse, in addition to the spouse’s own exemptions
Tax Relief Act of 2010
• Estate tax will be 35% with the first $5 million exempt (identical to gift tax)
• Generation-skipping transfer taxes increased from $3.5 million to $5 million with a top tax rate of 35%
Ways to Take Advantage
• Outright gifts
o May not be the right time for recipients or parents, e.g., age, control, etc.
• Sale to Irrevocable Grantor Trust
o Popular for assets where significant appreciation is expected in value
o Typically designed to be “intentionally defective”, making your sale of assets to the trust non-taxable (i.e., treated as though you are selling the assets to yourself)
o Income in the trust is treated as though the individual earned it
o A trust can purchase additional assets on an installment basis up to nine times the value of the gift
Now $45 million (i.e., $5 million times nine), or $90 million per couple versus $9 million
Done without triggering gift taxes
Ways to Take Advantage
• Dynasty Trust
o Provides for gifts to grandkids, great-grandkids or great-great-grandkids
o Effectively eliminates one or more generations of wealth transfer taxes
o Children can receive income from the trust; although, assets in the trust are usually for more distant heirs
o Other than applicable GST tax, no other gift or estate tax is owed
o Can be structured as an irrevocable trust to further leverage the amount of assets that can pass to heirs tax free
o Increased exemptions of $5 million ($10 million for couples) allows for more value to be transferred now
Ways to Take Advantage
• Life Insurance Trust
o All or portion of lifetime gift exemption can be used to create an irrevocable life insurance trust (ILIT)
o Trust uses those funds to purchase life insurance policy that benefits heirs without exposure to gift, estate or income taxes
o Policy must be fully funded from the start Single, lump-sum premium is typical
Second-to-die policy can usually increase coverage
o Can be made into dynasty trust
o Increase in exemption allows the parents to buy larger policy without triggering gift tax
Time is Running Out!
• Current law is scheduled to expire at the end of 2012
• Although it is unsure what new laws will be introduced, based on current sentiment, new laws will not be as beneficial as current laws
• With mounting deficit pressure in Washington, it could be a long time, if ever, before we see as taxpayer-friendly provisions again
• Current uncertainty in Washington provides sufficient support for acting now before it is too late
Current Temperature in Washington
• What are Congress’ estate tax options in 2012? o Do nothing. First option is for Congress to do nothing & allow the current provisions to expire as
scheduled to do on December 31, 2012. If this happens, then $1,000,000 estate tax exemption & 55% estate tax rate will kick in on January 1, 2013
o Extend the current provisions. Second option is for Congress to extend current provisions for 2013 & beyond. This would mean that estate tax exemption would be indexed for inflation above $5,120,000 exemption that has gone into effect in 2012 & estate tax rate would remain at 35%
o Pass a compromise bill. Third option is for Congress to pass some form of estate tax compromise which will lower estate tax exemption and increase estate tax rate to something more in line with 2009 numbers of $3,500,000 and 45%. This may also include repeal of portability of estate tax exemption between spouses which is in effect for 2011 and 2012 tax years
o Repeal the estate tax. Fourth option is for Congress to completely repeal federal estate tax. This is a real possibility since Republicans are in control of the House and substantial number of congressional Republicans favor full repeal of estate tax. Couple this with significant number of bills that were circulated in the House in 2011 that called for full repeal, with one bill being bipartisan & having 193 co-sponsors, & possibility of repeal has never been greater
o Throw in a wild card. Fifth option is for Congress to do something new & different that is not listed above. This is the "your guess is as good as mine" option
Current Temperature in Washington
• There were rumblings that current exemptions could be reduced prior to year-end 2012
o Still possibility that exemptions could be retroactively reduced
o Appears unlikely at this time
• Congressional Budget Office (CBO) found that extending estate tax reduction in effect for 2011 & 2012 would cost $432 billion over the following decade
• Almost certainty that legislation after 2012 will be less favorable
• If no action is taken, exemptions revert to $1 million with 55% top tax rate
Current Temperature in Washington
• Currently, there is a push for the Sensible Estate Tax Act, H.R. 3467, which would restore estate tax to Clinton-era levels (indexed to inflation in the future)
• Bill provides $1.3 million tax-free exemption ($2.6 million for married couples), with graduated rates up to a maximum marginal rate of 55 percent
• This exemption would shield about 99 percent of Americans from the tax & would continue to be adjusted for inflation in the future
• Sensible Estate Tax Act would also make important reforms that reunify gift and estate tax exclusions, make permanent portability of the exemption for spouses, restore state credit to provide critical revenue for states without increasing taxes, among a number of other reforms
Recent Court Cases
• Caveney v. Caveney, 2012 Mass.
• Development Specialists, Inc. v. Weiser Realty Advisors, LLC, 2012 U.S. Dist. LEXIS 8666
• BC Technical, Inc. v. Ensil International, Inc., 2012 U.S. App. Unpub. LEXIS 2294
• Sann v. Mastrian, 2012 U.S. Dist. LEXIS 9107
• Marriage of Rodenbeck, 2011 Ore. App. LEXIS 1500
• Estate of Liljestrand v. Commissioner, T.C. Memo 2001-259; 2011 Tax Ct. Memo LEXIS 251
Recent Court Cases
• Caveney v. Caveney, 2012 Mass.
o Court primarily relies on Bernier v. Bernier, 2007 Mass.
Fair Value Standard in Massachusetts for divorce excludes any discounts
Supreme Court held “that the value of a closely held corporation should not be ‘unfairly deflated’ by marketability discount, absent extraordinary circumstances such as evidence that the company was about to be sold or converted to cash”
o Court agrees with Bernier & states “none of the wife’s businesses were about to be sold or converted to cash.” In these circumstances, “liquidity, a hallmark of the marketability discount, is of little consequence,” & to apply DLOM would “unfairly deflate” value
o Further, although Bernier did not squarely address application of minority discount, the decision, “through dictum, made clear that such a discount should not be applied absent extraordinary circumstances”
o Asset approach in valuing was allowed by court, with no discounts applied
o Key Takeaway: Fair Value with no discounts is standard of value in divorce in Massachusetts
Recent Court Cases
• Development Specialists, Inc. v. Weiser Realty Advisors, LLC, 2012 U.S. Dist. LEXIS 8666
o Primary issue is about appraisal malpractice
o Defendant’s appraiser complies with Uniform Standards of Professional Appraisal Practice (USPAP)
o Plaintiff’s expert cites Revenue Ruling 59-60; however, does not follow USPAP or any other professional standards
o In considering defendants’ Daubert motion to exclude plaintiff’s expert & her reports, the court states, “Accordingly, her total failure to engage those standards (i.e., professional business valuation standards)…makers her approach particularly unreasonable”
o Further, her valuation techniques “ran afoul” of Daubert test for reliability
o Plaintiff’s expert & her reports were excluded
o Key Takeaway: Use qualified/credible appraiser that follows USPAP or other professional standard
Recent Court Cases
• BC Technical, Inc. v. Ensil International, Inc., 2012 U.S. App. Unpub. LEXIS 2294
o Primary question, can you prove lost profits with only five months of sales data?
o Defendant attempts to challenge expert’s damages conclusions under Daubert & fails
o Court states that utilizing historical sales of “only” five months (instead of longer period) makes testimony vulnerable; however, there was sufficient evidentiary support to pass admissibility threshold
o Key Takeaway: Limiting timeframe for historical data can make testimony vulnerable, however, may not hinder testimony
Recent Court Cases
• Sann v. Mastrian, 2012 U.S. Dist. LEXIS 9107
o Plaintiff first sues his business attorney for malpractice for failing to advise him that his company could choose S Corp status over C Corp status & failed to provide any form of shareholder dispute resolution in the formation of company
o Plaintiff then sues his trial attorney for malpractice for failing to meet deadline for disclosing his expert’s damages report
o In second malpractice suit, plaintiff attempts to prove what his damages would have been (but for dismissal of first suit)
o CPA expert utilized an income approach, which defendant contended was unreliable because it was based on “false” assumption that “the company had a buyer …who would have purchased it for the determined amount”
o Key Takeaways: Court found defendant’s assertion meritless & misplaced, allowing value from income approach. Court did, however, reject plaintiff’s assertion of tax-impact damages for being formed as C Corp instead of an S Corp as purported tax liability was not likely to occur, i.e., upon hypothetical sale of the business
Recent Court Cases
• Marriage of Rodenbeck, 2011 Ore. App. LEXIS 1500
o Case centers on valuation of 50% interest in company for divorce
o Court determines that in valuing the entity, “off-the-cuff” forecasts by an avowed “non-expert” (i.e., the husband) are not reliable and that the most persuasive valuation of company relied on historical earnings
o Husband’s expert reduced value for tax burden owed by the husband. Court did not agree with this assertion stating “we readily conclude that it is not just & proper to reduce the wife’s share” of business’ value to account for husband’s tax burden. If husband had borrowed money to make payments, it would not be fair to charge wife with the interest rate he would have to pay
o Key Takeaways: Forecasts can be viewed negatively by courts, typically relying on historical earnings. Further, tax burden incurred should not be used to reduce value for other party
Recent Court Cases
• Estate of Liljestrand v. Commissioner, T.C. Memo 2001-259; 2011 Tax Ct. Memo LEXIS 251
o Another ‘bad facts’ FLP case emphasizing poor planning & operations
o A doctor formed revocable trust to hold various real estate property, naming his eldest son as trustee & also paying him to manage the property
o FLP was formed for estate planning, originally funded with trust-owned properties
o Multiple bad facts with FLP
In transferring interests, appraisal of FLP was ignored with transfers made at other values (unclear as to how these values were determined)
Parties ignored formalities of FLP and its operations, e.g., not using separate bank accounts, reporting real estate income on father’s personal tax returns, etc.
FLP made disproportionate distributions larger than those provided by partnership agreement to pay father’s living expenses, debts & gifts to grandchildren (father contributed all but his personal residence into FLP)
o IRS assessed $2.6 million deficiency, based on including entire fair market value of father’s real estate holdings
Recent Court Cases
o To qualify FLP transfers as bona fide sales for full & adequate consideration, estate claimed FLP had three legitimate, nontax business purposes
Ensured son’s continued employment. IRS contends FLP simply changed nature of trust’s holdings, from directly owning real property to owning FLP interests
Protect FLP assets from partition. Most properties were located outside of state (Hawaii), beyond reach of Hawaiian trust laws. Further, father’s estate planning attorney never researched application of trust laws in those other states. “The lack of such basic legal research is telling as to the significance of *the threat of+ partition in the decision to form” the FLP, court observed. In any event, Hawaiian partition laws would not have applied to trust-owned properties & father had left his personal residence to children as joint tenants, without any apparent “fear of partition” or any evidence that they wanted to partition FLP properties. Thus “threat of litigation” did not serve a legitimate business purpose, court held
Protection from creditors. Likewise, court was skeptical that father formed FLP to protect assets from creditors, since estate failed to name a single potential claim or even establish pattern of activity by partners that could expose them to liability
o Key Takeaways: Do not ignore appraisal of FLP or formalities to formation of FLP & its operations. Do not forget about “small stuff”
BKD Forensics Institute Upcoming Schedule
• Splitting the Money: Financial Issues in Divorce o Wednesday, May 2, 2012
o 11:30 a.m. – 12:30 p.m. CST
o Presented by Angela Morelock, CPA, CFE, CFF, ABV, CrFA
• FCPA Investigations: Tools to Help Put the Evidence Puzzle Together
o Wednesday, May 9, 2012
o 11:30 a.m. – 12:30 p.m. CST
o Presented by Julia Mast, CPA, CFE
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Slides & Webinar Archive
• Today’s presentation slides are available at bkd.com/fi. A recorded copy of the webinar will be available at the same location at the conclusion of webinar series
• If you have any questions, please contact Jared Welch @ [email protected]
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