Viewpoint on Value. Built-in capital gains tax can be a real drag. Knowing value is half the battle

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1 Viewpoint on Value November/December 2009 Built-in capital gains tax can be a real drag Knowing value is half the battle One price doesn t fit all Making sense of valuation discounts SBA tightens business acquisition lending requirements

2 Built-in capital gains tax can be a real drag It s good news when business value grows over time. It s bad news, however, when this appreciation becomes subject to capital gains tax because the company changes hands or its assets are sold off. Capital gains tax obligations can significantly affect value, especially for an established holding company with low cost basis. Tax obligations lurk within Typically, capital gains tax is based on the difference between a company s (or an asset s) selling price and its adjusted cost basis. C corporation shareholders are taxed again on any cash distributions they receive from the company s sale. Even if a sale isn t imminent, investors consider tax obligations when buying and selling business interests. Companies with built-in capital gains tax warrant a discount, because investors could just as easily acquire a similar portfolio of assets without inheriting the previous owner s cost basis. Courts increasingly embrace valuation discounts for built-in capital gains tax. No immediate protection A C corporation can t simply convert to an S corporation to escape corporate-level built-in capital gains tax obligations. First, the IRS limits S corporation ownership. Many companies, such as foreign entities, companies with more than 100 shareholders or those with corporate shareholders, simply don t qualify for the S election. The IRS also requires a minimum holding period for S corporation conversions to avoid corporate-level capital gains tax on sales. (See Stimulus package reduces S conversion holding period, on page 3.) Case law supports discounts Courts increasingly embrace valuation discounts for built-in capital gains tax. It s not as much an issue of whether capital gains tax affects value; rather, it s how to quantify the discount. For example, in Estate of Litchfield, the deceased, Marjorie Litchfield, had minority interests in two family-owned companies that possessed Iowa farmland, marketable securities and other equity investments. These businesses were formed in the 1920s, and their underlying assets had low cost basis. The IRS s and the estate s experts agreed that the combined net asset value of the estate s business interests was $26.4 million. At issue were the valuation discounts, including the discount for built-in capital gains tax. 2

3 Based on historic asset turnover rates and discussions with management about potential future sales, the estate s expert subtracted built-in capital gains tax discounts of 17.4% and 23.6% for the two business interests held by the estate. The expert arrived at these percentages after considering average expected asset holding periods and the time value of money. The U.S. Tax Court accepted the estate s discount for built-in capital gains tax, as well as its discount for lack of control. The estate s marketability discounts which are beyond the scope of this article were substantially reduced, however. New case raises new issues From a built-in capital gains tax perspective, Litchfield is noteworthy on several points. First, the taxpayer didn t demand a dollar-for-dollar value reduction for built-in capital gains tax, which the Tax Court has previously upheld in cases such as Estate of Dunn and Estate of Jelke. Further, the expert didn t combine the discount for built-in capital gains tax with the marketability discount, as upheld in Estate of Davis. Moreover, the family-owned businesses the Litchfield estate held converted to S status a year before Litchfield died. Litchfield represents the first time the Tax Court recognized a built-in capital gains tax discount for a newly converted S corporation. Courts prefer thorough analysis The Tax Court in Litchfield chose the estate s builtin capital gains discount because its expert looked beyond historic data typically relied on by the IRS. As with any subjective valuation adjustment, courts are becoming increasingly sophisticated. They expect valuation experts to understand tax, accounting and finance issues and to support their opinions with solid analysis. The IRS s and the estate s experts agreed that the combined net asset value of the estate s business interests was $26.4 million. Both the IRS and the courts have generally agreed that a discount for built-in capital gains tax on a company s assets may be appropriate when the appraiser values stock using the net asset method. However, they haven t agreed on the proper method for quantifying the discount. Thus, whatever method a valuator uses to quantify the discount must be reasonable and well supported by facts and legal precedent. Stimulus package reduces S conversion holding period In February of this year, the American Recovery and Reinvestment Act of 2009 temporarily reduced the holding period that newly converted S corporations must wait to escape built-in capital gains tax. This required holding period has been reduced from 10 years to seven. If an S corporation (or an asset acquired before the company converted to an S corporation) sells before this holding period expires, the company must estimate its value on the date of S election. Capital gains tax is charged on the appreciation in value that occurred while the company was a C corporation (basically, the difference between the conversion date value and the cost basis). Any gain earned since electing S status (the difference between the conversion date value and the selling price) flows through to owners personal tax returns, and this appreciation in value is taxed only once. The reduced holding period makes it easier to avoid built-in capital gains tax in 2009 and Whether Congress will extend this relief beyond 2010 is uncertain. But for now, valuators must factor in the reduced holding period, especially for newly converted S corporations, when quantifying the effect of built-in capital gains tax on value. 3

4 Knowing value is half the battle Baby boomers nationwide are considering selling their businesses in preparation for retirement. In fact, according to a survey of 921 businesses conducted by George S. May International, a worldwide management consulting and research firm, 43% of small business owners plan to sell their interests in the next 10 years. Unfortunately, 58% of the businesses surveyed hadn t been appraised by a valuation professional within the last 12 months. So, many of these uninformed sellers could face a rude awakening, especially in today s volatile marketplace. Get to know your intangibles Increasingly, businesses rely on intangible assets, such as patents, copyrights, customer lists and goodwill, to generate value. But valuing these assets is much more subjective than valuing hard assets. And many business owners aren t sure what their intangibles are worth. For instance, many owners are surprised to find that goodwill acquired in a previous transaction has deteriorated (or become impaired ) as a result of the economic downturn. A valuation professional can value such intangible assets separately or allocate the entire company s value to specific assets, including identifiable intangibles and goodwill. And intangible asset valuations are important for infringement cases, licensing arrangements and accounting compliance purposes. Value drivers vs. value drainers Value is an important strategic planning tool. Baby boomer business owners who know the fair market value of their businesses and who understand how to build value will likely receive more when they eventually sell. In addition, informed owners who track valuation trends over time can turn around a distressed company before it spirals out of control. Value is a moving target Most business owners mistakenly believe that they need a formal appraisal only when it s time to sell. But every business owner should know the current value of his or her investment and understand how to build shareholder value. Numerous business scenarios call for valuation expertise. For example, an appraisal is beneficial in ownership disputes or when owners divorce their spouses. Valuation also comes into play when facing bankruptcy, devising an effective exit strategy, drafting a buy-sell agreement, or securing another round of debt or equity financing. To increase value, owners must understand how hypothetical buyers would perceive their business operations. The following are key factors investors look for when valuing a business interest: Profits and cash flow. Investors prefer companies with high profits, positive operating cash flows, and consistent upward growth patterns. Asset management. Potential buyers look for efficient collections and inventory management as well as high property, plant and equipment (PPE) use rates. Reinvestment. Companies poised for future growth always appeal to potential investors. So managers should continually reinvest in PPE and research and development (R&D). If management neglects upkeep 4

5 and distributes excess cash flow, investors may be turned off. Management quality. Strong, decentralized management teams are valuable assets. If a company relies on key people, buyers may require an earnout or ongoing consulting agreements with the sellers as a condition of the sale. Although these characteristics may seem obvious, many owners compromise business value with imprudent business practices. For example, small businesses commonly downplay revenues or exaggerate expenses to minimize taxes. But low taxable income makes a business less attractive to prospective buyers. Sometimes owners may find it hard to relinquish control, thus exposing potential investors to key-person risks. realistically will sell for in today s volatile marketplace. That s because many business owners mistakenly rely on outdated appraisals or oversimplified industry rules of thumb to value their businesses. An objective valuation professional keeps business owners in touch with economic reality and can coach them on ways to minimize risks and maximize selling price when it s time to retire. Closing the gap Often a significant gap exists between what an owner thinks his or her business interest is worth and what it One price doesn t fit all Making sense of valuation discounts Valuation is based on the specific facts and circumstances of a situation. No rule says that all the parts have to add up to equal the whole. If the controlling interest and all the minority interests are valued separately, they may add up to more or less than what could be received if the company were sold as a whole. What type of discount is it? Among the most common valuation discounts are minority interest and lack of marketability discounts. Minority interest discounts reduce an interest s value to reflect its inability to control the company s management and policies. When quantifying this discount, a valuator considers several factors such as levels of control and associated benefits, distribution of the other shares, contractual agreements among the owners, and relevant state laws. Lack of marketability discounts reflect the relative difficulty an investor would have selling an interest. For a controlling interest, this discount is referred to as an illiquidity discount. Factors that affect an interest s marketability include transfer restrictions, dividend-paying policy, financial performance, state laws, size of the block of stock and whether the owner possesses elements of control. Having control is sometimes necessary, often convenient and usually beneficial. What s the degree of control? Having control is sometimes necessary, often convenient and usually beneficial. But interestingly, the 5

6 Discounts take many forms Although smaller and less common, the key person discount is a valuation discount applicable to companies that rely heavily on one person. Even less common are blockage discounts, which extend to large blocks of publicly held stock to reflect the stock s reduced price if a large block were to suddenly flood the market. Finally, nonvoting discounts (usually of less than 5%) are applied to interests that lack the ability to vote on key decisions. amount of stock an owner holds can affect value. One factor that valuators consider in valuing the stock of a closely held corporation for which no bid and ask prices are available is the degree of control represented by a block of stock. The percentage considered to constitute control can vary, but for our purposes, let s say that control is 51% of the stock of a family-held corporation. Courts recognize control level of value based on the principle that the per-share value of a minority interest is less than that of a controlling interest. But just because a minority interest is valued at a discount 30%, for example doesn t mean that the controlling interest will be valued at a corresponding control premium. deduction trust for the benefit of the surviving spouse. That controlling interest might be valued at a control level of value on the death of the surviving spouse. But if the founder transfers a portion of the company interest out of the trust to his wife, who then gifts the interest to his descendants, the trust retains no more than 49% interest in the business. This would reduce estate taxes. But this situation holds a potential trap. When a surviving spouse dies, the IRS will determine if the spouse held any interest personally and then might aggregate the spouse s individual and trust holdings. While this aggregation might not occur, it should be considered when setting up an estate plan. Why do discounts matter? The IRS often attempts to attack valuation discounts. Why? In addition to being widely variable in their reasonable ranges, unsupported discount assertions are obvious targets. It s important to remember that different ownership percentages of privately held corporations have different effects on value, depending on the circumstances. A qualified appraiser can find well-supported discounts that will withstand IRS scrutiny. How do discounts work in the real world? Assume Sue Jones has a company that s valued at $1 million. Through a gifting program she transfers 49% of the company to her children, leaving her with 51% and actual control. In her estate, the asset would be valued at close to $510,000. On the other hand, if she gifted an additional 2% of the company to her children, leaving her with 49%, the asset would be valued in her estate at perhaps only $367,500 (assuming a 25% minority interest discount). For valuation purposes, ownership isn t attributed among family members, so this step would likely reduce estate taxes by more than $70,000. Or consider a marital deduction trust. In a typical situation, a family business s founder has died and left controlling interest of the business in a marital 6

7 SBA tightens business acquisition lending requirements Lenders are holding onto their purse strings more tightly these days. But Small Business Administration (SBA) loans which are guaranteed by the federal government remain a viable alternative for small businesses having difficulty financing a transaction. As an added bonus, SBA borrowers also receive preferential interest rates and extended repayment terms. But under pressure from Congress to rein in lenient lending practices, the SBA has stepped up its requirements for business acquisition loans. Independent appraisals Effective March 1, 2009, SBA Standard Operating Procedure (SOP) (A) requires business acquisition (or change of ownership ) loan applicants to submit an independent business appraisal for all loans greater than $250,000 (excluding the appraised value of real estate and equipment). The SBA also requires independent business appraisals for business acquisitions involving related parties. Qualified appraisers Independent appraisals must be performed by a qualified source, which SOP (A) defines as someone who regularly receives compensation for business valuations and is accredited by a recognized valuation organization. Specific appraisal designations the SBA endorses include: Accredited Senior Appraiser (ASA) accredited through the American Society of Appraisers, Certified Business Appraiser (CBA) accredited through the Institute of Business Appraisers, Accredited in Business Valuation (ABV) accredited through the American Institute of Certified Public Accountants, and Certified Valuation Analyst (CVA) accredited through the National Association of Certified Valuation Analysts. Also acceptable as a qualified source are licensed certified public accountants (CPAs) who follow the AICPA s Statement on Standards for Valuation Services. Goodwill limits Business valuations prepared for SBA loans must allocate value to the underlying assets of the acquired business, including land, building, equipment, intangibles and goodwill. Goodwill equals the selling price minus the value of tangible assets and identifiable intangibles. As a result of the recent turmoil in the banking and real estate mortgage sectors of the economy as well as the current recession, the SBA has placed restrictions on loans based on a company s goodwill. As of the writing of this article, the SBA limits the amount of goodwill financed to 50% of the loan up to a maximum of $250,000. The SBA also encourages lenders to explore subordinated seller financing for transactions involving goodwill. Staying up-to-date Because lenders and business brokers have criticized the goodwill limits, the SBA is reconsidering its restrictions and may make exceptions on a case-bycase basis until a final decision is made. A qualified appraiser can update business owners on the latest developments and provide appraisals consistent with the most current SBA rules. This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations VVnd09 7