- Category: Industry News
- Created: Wednesday, 20 May 2020 17:38
- Written by Craig Castelli
By David Ogurek, CVA
When this unforeseen global pandemic began a few months ago, countless questions swirled inside the heads of many business owners, beginning with “What do I do now?”. Others followed like, “How will I pay my bills?” or “What will happen to my employees?”. Fortunately, several programs were created to help business owners answer those questions. As plans begin across the country to reopen many businesses, more questions will arise like, “How will I get my business back to where it was before?”, and, more importantly, “What is my business worth now?”.
Unfortunately, for many business owners, their company will be worth less than it was just a few months ago. While a lower fair market value may affect the potential sale of a business to an outside buyer, there can be a significant benefit to a reduced fair market value: lower gift taxes when transferring interest in a business to a family member.
Lower gift taxes are particularly attractive to family-owned businesses looking to transfer wealth to the next generation. Under the present laws and regulations, when a family business owner transfers an interest in his or her business to another family member, the value of the transfer is recorded at fair market value. That fair market value is further reduced by certain discounts, namely Discount for Lack of Marketability (DLOM) and Discount for Lack of Control (DLOC), when transferring a minority interest in a business.
While the DLOC still applies while assessing the value of the minority interest in a business with regard to a shareholder’s rights (voting, hiring, policy setting, dividend declaring, etc.), it will not need to be inflated due to the effects of the global pandemic. On the other hand, the DLOM will be greatly affected.
According to the National Association of Certified Valuators & Analysts (NACVA), lack of marketability is defined as the absence of a ready or existing market for the sale or purchase of the securities being valued. Due to the atypical market conditions created by the Covid-19 global pandemic, many buyers will be reluctant to invest in illiquid securities in the near future. Also, due to the current restrictions in place for non-essential businesses, many buyers have not been able to conduct due diligence on their acquisition targets, thus slowing down the acquisition market. These two reasons, coupled with several macroeconomic conditions, will tend to cause valuators to use a higher DLOM.
Let us look at an example of how a lower fair market value and higher DLOM can affect the gift tax paid on the transfer of minority interest. Mr. Smith owns a business that is worth $50 million, based on a January 31, 2020 valuation date, and wants to transfer 40%, or $20 million, to his daughter. Assuming a DLOM of 25%1 and a DLOC of 20%2, the minority interest has a value of $12 million:
The lifetime gift tax exemption is $11.58M, so assuming he has not made any prior gifts, $420,000 would be taxable. According to the Gift Tax Table for 2020, the tax on that $420,000 is $128,600.
Six months later, Mr. Smith’s $50M business is now worth $40M. Assuming a higher DLOM of 40% and a DLOC constant at 20%, the minority interest now has a value of $7.68M:
Since the $7.68M falls below the lifetime gift tax exemption of $11.58M, no tax is due, saving Mr. Smith $128,600. Further, Mr. Smith will not have exceeded the lifetime gift tax exemption and will be able to gift another $3.9M tax-free in his lifetime3. As you can see, timing, the market, and economic conditions play significant roles in the value of a business!
It would benefit all business owners to have their business valued during this unprecedented time, whether it be for gift tax planning, or for any other reason. The team at Caber Hill Advisors has conducted valuations for hundreds of companies and we would be happy to assist your business plan for the future.