Journal of Financial Planning: May 2018
Joel T. Redmond, CFA, CFP®, EA, is a senior financial planner and vice president at Key Private Bank where he offers his clients sophisticated financial planning advice and a comprehensive set of strategies to grow and preserve their wealth.
Jeffrey T. Getty, CFP®, AEP®, is the managing director of Key’s Family Wealth Consulting Team. He leads a team of tax attorneys and investment professionals who work with high net worth clients and business owners helping them to design and implement sophisticated wealth strategies.
For most entrepreneurs, the prospect of selling their business to an insider, family member, or third party creates a cataract of emotions. The thrill of a bona fide deal is dampened by the realization that the seller now must navigate a bewildering array of divergent professional and personal agendas, transaction details, and tax and non-tax consequences. How can a seller determine whether it’s too late to use the main pre-sale tax saving strategies existing today to manage the tax consequences? This article will address this question.
A popular pre-sale tax savings strategy for the owners of a closely held business involves gifting shares at a discounted value to family members or trusts for their benefit. Gifting in this manner saves transfer taxes. Simply put, a wealthy shareholder of a closely held business can save significant transfer taxes if he gifts stock today when that stock is appraised for $10 per share, rather than a year from now when the stock may be sold at $100 per share. The estate, in this admittedly extreme case, is “frozen” at a tenth of its future value.
A healthy income statement for a closely held business coupled with a robust industry sector and a competitive bidding process can significantly drive up the price of business interests in the 12 to 24 months prior to the ultimate sale. Having the capacity to transfer stock during the crucial time before the business value increases is an essential component to the “how late is too late” dilemma.
Understanding Fair Market Value
The overriding principle in business valuation cases involving gifts is fair market value (FMV), which is defined by the Supreme Court and elsewhere as the price at which the property would exchange hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell, and both parties possessing reasonable knowledge of the relevant facts.
The seminal Internal Revenue Code ruling on this topic is Revenue Ruling 59-60, and it articulates eight factors to consider (such as the earning capacity of the business and the economic outlook for the particular industry) in the determination of FMV for closely held business interests. In many of these cases, discounts are applied to the FMV of business interests gifted due to a lack of marketability (DLOM) or lack of control (DLOC). For example, the IRS has held that equal minority interests gifted to five siblings qualify for such discounts (see Revenue Ruling 93-12 for details).
A qualified appraiser will look at all facts and circumstances involving a gift of a business interest. Whether the gift is made before or after a letter of intent (LOI) is signed, a qualified appraiser will value each gift discretely, in isolation from all other gifts and ownership considerations. When the donee trust or an individual donee lacks the ability to control management and governance over the business, a DLOC should apply, as long as control level adjustments are made in the valuation process.
Of course, when a purchase agreement has been signed and a closing date has been established, it becomes difficult, if not impossible, for any qualified appraiser to argue that a 20 percent block of a $100 million cash deal is worth much less than $20 million. A hypothetical willing buyer may be very well inclined to pay nearly $20 million for the legal right to receive that amount in a matter of days or weeks. Of course, value itself has different meanings. Fair market value, which refers to value in exchange, is quite different from investment value, which is the value to the acquirer. And other definitions of value exist, depending on the objectives of the buyer and seller.
The Letter of Intent: Line in the Sand?
Many practitioners consider the LOI as a demarcation point at which the shareholder loses the capacity to claim that the DLOM and DLOC apply. Without these discounts, the transfer tax advantages attending pre-sale gifts quickly evaporate. Certainly, the LOI is a convenient, single reference point in establishing the price a potential buyer would offer for the business; but to view the LOI as a cut-off date for valuation discounts would be a gross oversimplification of FMV principles.
It bears emphasizing that LOIs are not legally binding purchase agreements. They do not obligate the potential buyer or potential seller to consummate the deal under immutable terms; a large percentage of potential deals fail to materialize after a LOI is signed. In many other cases, the prospective buyer engages in a due diligence process and discovers financial data or operational risks that make the target company less attractive than originally thought. The buyer’s response is to begin chipping away—sometimes significantly—at the notional purchase price expressed in the original LOI. This chipping away is undoubtedly warranted in some cases, as when the seller has made statements about the business that turn out to be inaccurate. In others, it represents nothing more than a manifestation of nearly every buyer’s desire: to obtain as much value for as little cost as possible.
Again, legal authorities define FMV as referring to the price, expressed in terms of cash equivalents, at which property will exchange hands between a hypothetical willing buyer and a willing seller. Contrast that definition of FMV with many LOIs, and even sales agreements, that fashion the purchase price in a layered arrangement of a cash down payment, a seller’s note, warrants, holdbacks and escrow accounts, earn-outs, and other deferrals and contingencies. Is price value? Is value price? Oscar Wilde himself, who reputedly said, “a cynic is someone who knows the price of everything and the value of nothing,” might have difficulty answering such questions.
Recall that the meaning of FMV is tied to the notion of the hypothetical willing buyer and willing seller, each with a certain degree of indifference about entering into the transaction. That is, the willing buyer and willing seller are not under any particular compulsion to buy or sell, and they are perfectly content to walk away from a deal rather than pay too much or receive too little. Yet, many prospective buyers who sign LOIs are more motivated than our hypothetical buyer. Often, they eagerly envision cost savings and synergies from the acquisition and are quite willing to pay a premium—relative to the textbook definition of FMV—for the seller’s business.
Thus, the purchase price and other forms of remuneration expressed in a single LOI are not particularly correlated to the overriding principles at the core definition of FMV. In this sense, the LOI is a red herring as to issues affecting pre-sale tax planning. The primary issue is always: what is the FMV of the business interest? The secondary issue is: to what extent do the DLOM and DLOC apply?
Revenue Ruling 59-60 recognizes that the valuation of securities is, in essence, an attempt to predict the future and must be based on the facts available at the required date of appraisal. Appraisers will confront wide differences of opinion and recognize that valuation is not an exact science.
Subsequent Events
The LOI is not particularly determinative with respect to the process a qualified appraiser will go through and the conclusion of value he or she will reach. A single, prospective buyer’s LOI does not constitute a readily available market for a business, and given the fact that many potential deals fall through after the LOI stage, a DLOM is quite germane on or even after this point in time. Further, LOIs typically involve potential purchases of controlling interests in a business, and given Revenue Rule 93-12’s abdication of the family attribution rule, a qualified appraisal can certainly incorporate DLOC at this point when discrete gifts of minority interest are involved.
Where a taxpayer (and an appraiser) might get tripped up as far as the timing and sequence of events occurs with the doctrine of subsequent events. The timing of the gift, the sale, and the appraisal are all important considerations.
Imagine the following scenario. After discussions with his advisers in January, a taxpayer decides to engage a qualified appraiser and transfers stock to a trust for his children based on preliminary indications that the stock’s FMV for transfer tax purposes is $10 per share. The taxpayer then engages an investment banking firm, and by December the entire business is sold to a private equity firm for $130 per share. The appraiser finally completes a comprehensive appraisal report in April of the following year (in time for tax returns) for the gift made 16 months prior. To what extent, if at all, should the appraiser’s valuation report consider data about the December sale? “Subsequent events” by any other name may be the elephant in the room to the IRS; they are hard to ignore.
The AICPA Standards for Valuation Services require valuation specialists to account for events that occur subsequent to the valuation date only when these events are “knowable or foreseeable.” Hearken back to Revenue Ruling 59-60 and its promulgation that valuations of securities are prophecies of the future and based on information that is reasonably knowable as of the valuation date.
The key is what a reasonably informed person would have knowledge of as of the appraisal’s effective date. Information unavailable or unknown on the date of valuation is not probative to the appraiser or his concluding opinion of value. Because most real-world transaction prices are materially different from FMV, an experienced appraiser should be able to make any necessary price adjustments, provided the reasons for doing so are clearly laid out; this typically involves adjusting the agreed-upon price to FMV or dismissing the price altogether.
In Estate of Ridgely v. U.S. (101 T.C. 412 (T.C. 1993)), the U.S. Tax Court used the “known or foreseeable” criteria to find that “evidence of a sale taking place after a valuation date has probative force bearing on the value as of the earlier critical date—where there has been no material change in conditions or circumstances in the interim.” In 1993, the Tax Court went even further to find that subsequent transactions are sometimes credible evidence as to FMV, even if the transactions are not foreseen or contemplated as of the valuation date (see Jung v. Commissioner).
The Tax Court has been trending toward giving more evidentiary weight to subsequent events and subsequent sales prices, particularly when the sale occurs within a reasonable time after the valuation date. This is a matter of evidence, and FMV is a matter of myriad relevant facts and circumstances. Certainly, the more time between the valuation date and the subsequent transaction, the less weight and relevance the sale price will have with respect to the appraised value.
The Tax Court recognizes that appropriate adjustments must be made to consider the differences (in the economy, capital markets, industry, and the specific business in question) between the valuation date and the later-occurring event. While the Jung v. Commissioner case dealt with a sale occurring about two years after the valuation date, most practitioners are wary of the relevance of any data arising from events more than one year after the valuation date.
Although a protracted chronology and a disjointed decision path stretching between the valuation date (date of gift) and the subsequent sale suggest strong facts and circumstances supporting the tax advantages of pre-sale gifts, a strong, well-reasoned, and well-researched appraisal is equally important. No case law has found that the DLOM and DLOC do not apply to a gift of a non-controlling block of shares of a closely held company simply because the company was sold nine months later to a strategic buyer. At least until an iron-clad purchase agreement is in place, the securities subject to the valuation appraisal represent a minority interest for which there is no readily available market.
Conclusion
Entrepreneurs come in all types. Some are bold, some are methodical. Some are conventional, others make careers of rocking the boat. Some wear t-shirts and flip-flops, some wear expensive suits, but they typically have one thing in common: they tend to be people of action. After all, it was this propinquity for making calculated but quick decisions, seizing opportunities, and being the first one to the land-grab that got them where they are today—at least, so the conventional wisdom says. Yet the bewildering array of emotions, transaction details, and tax and non-tax consequences involved in any business transition can strike uncertainty, if not fear, into the most entrepreneurial heart.
The remedy for these conditions includes having the best answer to one of the most important questions: how late is too late? Is the opportunity for tax management strategies over when a LOI is signed? Not necessarily, depending on the facts and circumstances. An advisory perspective from someone with deep expertise in this arena is invaluable in this process.