An interest in a business must be valued for tax purposes before it can be transferred to another family member. The standard is fair market value, the price a willing buyer would pay a willing seller with neither being under any compulsion to deal and both having reasonable knowledge of the relevant facts.
Although, this standard and this definition had been around forever and the IRS nearly a half century ago provided guidance in how it should be applied in value and closely held business interest, serious valuation tax disputes regarding business interest routinely erupt. These disputes teach 3 important lessons.
First, secure the services of a professional appraiser, a real expert. Value in a closely held business interest requires judgment calls that must be made by a pro.
Second, get the best appraiser available. If a dispute breaks off, the quality reputation and competence of the appraiser may be the ultimate deciding factor. The tax court has consistently refused to accept an appraisal on its face. It is followed and practiced of carefully examining the underlying details and assumptions and the quality of the appraiser’s analysis. A quality appraisal by a competent appraiser may shift the ultimate burden of proof to the government or result in a complete victory.
And the now sort of famous case of Buffalo tool and die manufacturing company decided in 1980, the tax court refused to split the difference in a valuation dispute opting instead to declare a winner based upon the comparative assessment of the credibility of the experts on each side. With full knowledge of this winner-take-all approach which has been followed in other key cases, an IRS agent must carefully size up the company’s appraiser in assessing the value of starting any fight.
Finally, never get too aggressive on value. It can put in play costly penalties that may be as high as 20% and in some cases, as high as 40%. In every situation involving a closely held family business, valuation discounts become the name of the game and an essential role in the plan design. In a very real sense, they are the ultimate disappearing act because big transfer taxes are saved as the values are discounted and plummet. Usually, there’s a dual goal in planning for these valuation discounts.
First, all stock transfers by the parents during life should be structures to qualify for the largest possible discounts. Discounts reduce the value of the stock transferred which in turn reduces gift taxes or permits a greater leveraging of the 2 big gift tax freebies. That $13,000 any person can give to any other person each year free of any tax, often called the annual exclusion and sometimes the annual free amount and the gift tax unified credits sometimes called the “lifetime free amount” which allows a person to gift, free of any gift taxes, an additional million dollars during life.
In our case for example, Steve and Betty will be able to transfer to Dave over time and gift tax-free a larger percentage of the company’s stock if the value of the shares transferred is heavily discounted.
The second goal of the discounting is to ensure that any stock remaining in the parent’s estate at their death qualifies for the maximum discounts in order to minimize any estate tax burden attributable to the stock.
The two most significant discounts associated with an interest in a family business are the minority interest, lack of control discount, and the lack of marketability discount. The minority interest discount recognizes that a willing buyer will not pay as much for a minority interest. There’s just no control. The lack of marketability discount reflects the reality that a willing buyer will pay less for an interest in a closely held business if there is no ready market for future buyers of the interest.
Usually, both of these discounts are applied in valuing the transferred interest. The size of the discounts is determined by appraisal. Often the two discounts total as much as 35% to 40%. These discounts may have a powerful impact in the design of any transition plan.
The other good news here is that there are no family attribution rules applied in determining the amount of these discounts. The fact that all the business interest stay in the family will not eliminate or reduce the discounts. Even the separate property interest of spouses is not aggregated for valuation purposes.
In one case where 100% business owner transferred his entire ownership to 11 different family members, the service recognized that each gift could qualify for a minority interest and lack of marketability discount. Absence of such discounts, each family member would have received a business interest valued at 1/9 of the total value simply by breaking the ownership interest into minority pieces, the discounts reduce the value of each gift to less than 6% of the total. For tax valuation purposes, this math can be awesome, downright exciting; 100/11 equals something less than six.
In the planning process, care must be taken to avoid a few traps. The first is the step transaction doctrine that can sometimes mess up transactions between family members who are trying to qualify for minority and lack of marketability discounters. If, for example, Steve and Betty transfer a minority interest in the corporation to Dave, and then have the corporation purchase from them the balance of their stock, the step transaction doctrine will kick in to deny any valuation discounts on the transfer to Dave. A linking of the two transactions kills the discount because Dave ends up owning a controlling interest in the company after the redemption. He never owns a minority interest.
The second trap surfaces whenever voting control is transferred to a family member. The flipside to the discount game is a control premium often as much as 35%. This must be considered when voting control is transferred to another family member. This results in a higher valuation and more taxes. The math can be just as weird but in the wrong direction. When voting control is ultimately transferred and a valuation premium kicks in for tax purposes, the planning challenge is to make certain that the control premium attaches to the absolute smallest equity interest possible.