Kids fighting for teddy bear

The Rewards of Not Planning

MostKids fighting for teddy bear professionals working with small businesses have stories they hear from clients about bad situations that could have been avoided.  Here are two that we’ve heard from our clients:

A substantial New York-based electrical contractor had two 50% partners.  They started and grew the business over the years from scratch.  Each has a lifestyle they never imagined could happen.  At age 55, one partner passed away from previously undetected heart failure, and that’s when the troubles began.  The partners had only an oral agreement that if one should pass away, the other would buy him out at book value.

The widow had buried her life partner and realized her main source of income was gone.  She contacted her deceased husband’s partner for advice. He told her about the agreement he had with her husband. He let her know the amount of money he would be paying her.  The widow told her children of the conversation.  They balk at the amount involved.  Enter the lawyers.  The case still continues into year three.

Had the partners had a formal written and reasonable buy-sell agreement, this situation would never have happened.  What constitutes a reasonable agreement depends on the company.  Book value for a contractor is typically not a good indicator of company value.  Engaging experts to determine a fair and unbiased value may have costs associated, but the surviving partner in this story has told me he regrets not having taken this step years before.

In the second situation, a Massachusetts boutique printing company started by parents employed their two adult children.  All were very well paid.  The son ran the company full time, the daughter contributed on a part-time basis.

After some time, the son convinced Mom and Dad to transfer 100% ownership to him, leaving Daughter out completely.  He then proceeded to remove her position, eliminating a $400,000 salary. Here, too, the lawyers enter and the case continues at high expense.  And it gets even uglier: As a result of feeling betrayed, the Daughter has forbidden her parents from seeing their grandchildren.

How did this happen, you might ask? The son told me he is still angry his sister took his teddy bear away when they were children.

A succession plan must be fair, as difficult as that process can be.  Request our booklet Business Transition Planning: Maximize Your Legacy to see how this process can work best for you.

Buy-Sell Agreements – Do You Really Need One?

In a business owned by more than one partner, the need for a buy-sell agreement may seem remote, especially while the business is still young and growing. Understandably, the owners are focused on the urgent and important matters of running and growing the business. Investing time into planning for the future exit of a partner seems like a distraction. Drafting legal documents requires an attorney, and that costs money.

As the business matures, the need for this document that defines the orderly transition of the business becomes more acute, but is often still neglected. The result is a nagging worry about what would happen if a partner became ill or decided to retire.

The sooner a buy-sell agreement is created, the more peace of mind the partners and their families will enjoy. Dealing with an unplanned exit situation will stress and cause conflict among even the friendliest of partners.

A well-planned buy-sell agreement can help avoid those pains. And, while the buy-sell agreement puts a legal framework around the transition process, the heart of the matter – and, the likely bone of contention — is the value of the business.

In some cases, the agreement stipulates a fixed dollar price. The partners adjust the price on a regular basis as the business expands or contracts. However, when the moment arrives, the heir of a deceased partner or the exiting partner hi/herself may claim this price does not accurately represent the true value of the business. The next step often involves lawyers.

A second approach to valuation involves the use of a formula or set of formulas that are based on revenue, EBITDA or some other definable metric. Valuation experts may be consulted to help produce these formulas. However, businesses change, markets change, the economy changes, which can alter the cost of producing those revenues. These changes can influence the selection of formulas, so that a formula which may seem appropriate in Year 1 may be wildly off base in Year 6.

A third common method for defining a fair valuation is to engage the services of a valuation firm. This approach is taken to arrive at an independent, neutral view. But there are ground rules that must be established to achieve a result everyone deems fair. Should the valuation value the entire company with no discounts and assign a pro-rata share to each owner? Should a minority owner’s interest reflect lack of control and lack of marketability discounts? Should these minority interests’ value also ignore above-market compensation paid to owners/officers, above market rent paid to related parties, and the like?
What about the proceeds from life insurance that was purchased to cover this buyout? Does the valuation analyst consider this a business asset and include it in the valuation, or is it to be treated solely as a funding mechanism for the buyout and ignored for the valuation?

Issues such as these must be addressed in the buy-sell agreement as they will significantly impact the valuation. The time to consider them and put the proper documents in place is now, when the business is running and partner exits are still a long way off, not at a time of crisis or disruption.

Changes in the Wind for Estate Taxation

Section 2704 Proposed Changes: Much Ado About Nothing? A Different Kind and Level of Estate Taxation? A Golden Opportunity? All the Above?

Estate TaxesThe December 1 IRS hearings on proposed changes to the Section 2704 Regulations demonstrated the significant opposition from taxpayers, advocacy groups and other interested parties. Thousands of comments, almost all against the proposals, were submitted. A record crowd attended the five-hour hearing. No supporter (or just one depending on the reporting source) came forward.

The controversy includes limits to valuation discounts many see in the proposed regulations. Experts disagree on the extent and intent of these limits.

After the hearing, some believed the IRS would rework their proposals. Others thought it may be moot.

As part of his sweeping tax plan, President-elect Trump calls for the elimination of estate taxes. Most presume this would include gift taxes. When/if this broad-reaching tax plan is passed depends on how many Senate Democrats Mr. Trump can persuade to join him to reach the 60 votes required. And where in his list of tax changes do estate taxes fall? Many times, we have seen proposed tax changes negotiated away.

Trump spoke of implementing a capital gains tax at death. Most agree stepped-up asset values would remain. The Tax Foundation thinks otherwise. They read into Trump’s proposal that estates over $10 million would effectively lose their stepped-up basis. They further believe the capital gains tax would be deferred until the inheritor disposed of the asset. (Interestingly, the Tax Foundation projects a repeal of estate taxes would lower federal government revenues by $240 billion between 2016 and 2025 and would have a positive 0.9% effect on GDP over the same period).

A capital-gains-at-death tax could mean an effective tax of 20%. It’s uncertain if the federal exemption would continue. In 2017, that exemption rises to $5.49 million ($10.98 million for a married couple).

Estate planning professionals are understandably unsure how to proceed. Many unknowns are in play.

One strategy is certain: with no change, a new tax or a tax repeal, moving assets out of an estate remains beneficial.

  • If no change occurs, the benefits seen today remain.
  • If a new tax is enacted, the benefits diminish but will still exist.
  • If the tax is repealed, this becomes a golden time to move assets, potentially federal tax free.

The biggest uncertainty: What happens when Democrats regain control?

Estate of Giustina V Commissioner

This recent estate tax case is rife with valuation issues.  And it is one of the few that the issues are clearly defined and resolved.

The United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) remanded the case to the Tax Court to reconsider its decision on the valuation of the Estate’s interest in the Giustina Land and Timber Company Limited Partnership (the “Partnership”).

On January 1, 1990, the Partnership was formed to operate a sustained yield timber harvesting company.  (A sustained-yield timber harvesting company looks to harvest timber and replace it with new plantings at a rate that will allow it to continue into the foreseeable future).  The partnership agreement stated the Partnership would continue in business until December 31, 2040, 50 years after it was formed.

The partnership agreement placed all control of the partnership into the hands of the two general partners.  This control included the ability to sell off the land and harvested products.  The agreement stated a general partner could only be approved or replaced by limited partners owning at least two-thirds of the limited partnership (“LP”) interest. (Note the two GP’s were family members operating through corporate structures.  The decedent was not a GP.  All limited partners were either family members or trusts for the benefit of family members).  To dissolve the partnership, the backing of the same two-thirds ownership of LP interests would be required.

Natale Giustina passed away on August 13, 2005 holding a 41.128% LP interest.  The Estate’s valuation expert and the IRS’ valuation expert opined widely divergent values, primarily from the IRS expert’s reliance on a net asset method and from very different results from the guideline company method.

The Tax Court primarily agreed with the IRS.  The Court ultimately derived a value based on the net asset method and the cash flow method.  The Estate appealed.

The net asset method, in my view, is associated with liquidation, not with a going concern.  Under a net asset method, the value derives from the analyst’s belief of what the assets sell would for and liabilities be settled for in an orderly sale.  At the date of death, this Partnership had been in successful operation for almost 15 years.  Predecessor companies existed, dating back to the early 20th century.  The GPs had never expressed any intent to cease operations or sell off major assets.  This Partnership definitely qualifies as a going concern.  The Ninth Circuit apparently agrees.

In its initial decision, the Tax Court weighted the net asset method 25%.  It presumed there was a one-in-four chance a limited partner could either replace the two general partners or force a partnership dissolution.  As the Ninth Circuit pointed out, not only would this require the backing of limited partners holding two-thirds of the total LP interests, it would mean a new limited partner would turn against the GPs who just admitted him or her to the partnership.  (Alternatively, a transfer could occur to an existing limited partner without GP approval).  In such a cohesive family partnership, turning other family members against the GPs appears more hopeful than possible.  And, as I stated above, the GPs never expressed any intent to sell assets.  The fact the entity and its predecessors had been in operation for decades was significant evidence the Partnership was a going concern.

On remand, the Tax Court weighted the cash flow method 100%.

The Tax Court took issue with a component of the company-specific premium the Estate’s expert included.  All income-generating assets were timberland in Oregon, significant revenue and geographic dependencies.  The Estate expert added a 3.5% risk factor.  The Tax Court halved it under the presumption a buyer could force diversification.  The Ninth Circuit stated the Tax Court did not provide support for cutting this premium in half.  The Tax Court rescinded it.

The Estate expert applied a 35% lack of marketability discount.  The IRS expert applied a 25% discount. The Tax Court, in its initial decision, applied a 25% discount, but only to the cash flow result.  The Ninth Circuit did not question the Tax Court’s use of a 25% discount.  It pointed to the Estate expert’s statement that these discounts can range from 25% to 35%.  This supports the standard that all factors used needs to be thoroughly supported.  Support for discounting is among the most difficult parts of a valuation.  It’s one of the many reasons why a valuation is an opinion.

Normalizing Adjustments and Valuations

Valuations frequently assume a third party will purchase a business and primarily run it unchanged.  This does not mean a buyer will continue to pay expenses or a level of expense not considered typical.  Non-operating assets are typically excluded from a valuation, too.  Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.

Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements.  Expenses related to layoffs are an example of operating but non-recurring expenses generally removed.  If an income source or expense is not related to ongoing operations, it is subject to adjustment.

Discretionary adjustments look to income sources or expenses over which an owner has a choice.  Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment.  Rent paid to a related party is often based on the cash flow requirements of that related party.  For a property with no mortgage, for instance, below market rent may be paid.  This is an example of how adjustments can work as a reduction of expense or an addition to expense.

Various authoritative sources report officer/owner compensation based on industry type, size and location.  These sources can form the basis for this adjustment.  Real estate appraisals are frequently used as the source for an adjustment to market rent.

Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest.  Opponents say no, correctly stating a minority owner has no control over these discretionary expenses.  Proponents argue these adjustments should always be considered.  Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment.  A growing lack of investor interest leads to a decline in share price.

Proponents point to the derivation of yields used when calculating value based on cash flow.  These yields are often based on data from public equity markets.  As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.


What Is Fair Market Value? The IRS v The Taxpayer

James and Julie Kress (the “Taxpayers”) filed a lawsuit in United States District Court for the Eastern District of Wisconsin [Case 1:15-cv-01067-WCG] on September 2, 2015. They sought a refund of federal gift taxes and interest they claim were erroneously assessed by the IRS on gifts made in 2007, 2008, and 2009.

The Facts

The Taxpayers are shareholders of an S corporation. The shares are owned by members of the Taxpayers’ family and certain employees and directors. The company’s bylaws and shareholders’ agreement restrict transfer of shares by family members to other family members or to trusts, as defined in the bylaws. An annual valuation opines the value of minority blocks of the shares.

The bylaws and shareholders’ agreement also stipulate transfers of stock by non-family shareholders are subject to a right of first refusal by the company. The bylaws and stockholder agreements specify these transfers must be at 120% of the company’s book value at the time of transfer.

In the years stated above, minority shares were gifted to members of the Taxpayers’ family at Fair Market Value as determined by an independent valuation. These valuations took into account the restrictions on transfers of shares held by family members.

The IRS challenged these amounts. It determined the gifts should have been valued at 120% of book value, the value which the company’s shareholders agreement and by-laws provide for transfers by non-family members.

The Issue

Fair Market Value is defined as the value a property would receive if it were sold in the open market. Among other factors, it assumes the buyer and seller are reasonably knowledgeable about the property in question, they are acting in their own best interest and neither party is under any undue influence.

In this Case, we see two sets of values. One is the values determined by the independent valuations, the other is 120% of book value. The Taxpayers assert the transfer price calculation for non-family members is to simplify transfers. (Shares transferred by non-family members typically had different, and much higher, bases than those transferred between family members).

The Taxpayers claim the restrictions on family transfers are a “bona fide business arrangement.” The restrictions, they claim, were not designed to attain discounted values.

So who is right?

The Taxpayers believe an independent valuation of their company should address the stock restrictions unique to family-owned shares. Because of these restrictions, the value of the shares is heavily discounted. The family contends the restrictions are intended to centralize ownership of the company in the family, not to lower the fair market value of transferred shares.

The IRS has been and is continuing to scrutinize transfers of stock among family members, especially those with high discounts. A perceived goal of the IRS is to prevent businesses from reducing the value of their shares through the imposition of severe restrictions limiting transferability of shares by family members. The IRS claims its valuation at 120% of book value better reflects what an external party would expect to pay for shares. It should be noted employees and directors are not third parties.

This case remains pending.

DOL Proposes New Definition for Fiduciary

Since 1975 and prior to April 2015, the definition of fiduciary as put forth by the Department of Labor included a five-part test. Only if all five parts listed below were met would an adviser be considered a fiduciary. Advice was given:

  • as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
    on a regular basis;
  • pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
  • that will serve as a primary basis for investment decisions with respect to plan assets; and
  • that will be individualized based on the particular needs of the plan or IRA.

In the April 2015 proposed rule, the definition of fiduciary is expanded. If a person meets this definition below, s/he is considered a fiduciary:

  • provides investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an IRA owner or fiduciary, including advice regarding rollovers and distributions from ERISA plans and IRAs;
  • for a fee or other direct or indirect compensation; and
  • either (a) acknowledges the fiduciary nature of the advice, or (b) acts pursuant to an agreement, arrangement, or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.

Exceptions, or carve-outs, are provided:

  • statements or recommendations made to a “large plan investor with financial expertise” by a counterparty acting in an arm’s length transaction;
  • offers or recommendations to plan fiduciaries of ERISA plans to enter into a swap or security-based swap that is regulated under the Securities Exchange Act or the Commodity Exchange Act;
  • statements or recommendations provided to a plan fiduciary of an ERISA plan by an employee of the plan sponsor if the employee receives no fee beyond his or her normal compensation;
  • marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan;
  • the identification of investment alternatives that meet objective criteria specified by a plan fiduciary of an ERISA plan or the provision of objective financial data to such fiduciary;
  • the provision of an appraisal, fairness opinion or a statement of value to an ESOP regarding employer securities, to a collective investment vehicle holding plan assets, or to a plan for meeting reporting and disclosure requirements; and
  • information and materials that constitute “investment education” or “retirement education.”

A comment period expired in June with an expected final hearing date in late July 2015.

The DOL specifically carves out valuation analysts from the role of a fiduciary. At Jennings Business Valuation, we always consider it our mission of providing a defensible valuation that is fair to all to include all participants in the ESOP, as well as its Trustees and the company that sponsors it.

IRS May Try to Restrict Discounts

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.

DOL v PBI Banks, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan

No case is clear cut, but lessons often can be learned.  In the recently filed action, the Department of Labor v PBI Bank, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan (United States District Court for the Northern District of Indiana, Civil Action: 3:13CV1400), some, but not all, of the issues surrounded the valuation report.

In this initial ESOP transaction, multiple drafts of a valuation report were produced.  The ultimate valuation, according to the Department of Labor’s filing, failed to consider several items.

  • No marketability discount was applied.  Though drafts of the report included a discount of 5%, the final version had none.
  • The stock purchase agreement included an earn-out agreement which provided the selling shareholders an amount equal to 40% of future earnings over a specified threshold for about eight years.  The valuation, according to the Department of Labor, failed to address this issue.
  • A stock option plan set aside 20% of Company shares for the selling shareholders, at a strike price of $4.08 per share.  The valuation for the initial transaction provided a total value of $42,379,000 for the 1,000,000 outstanding shares, according to the Department of Labor.  At the valuation date, these options apparently were “in the money” but according to the Department of Labor, the dilutive effect was not considered in the final report

Note that all of the above statements are based on our interpretation of the Department of Labor’s filing, not on a final Court decision.

Other issues outside the valuation report trumped those mentioned above.

The ‘lesson learned’ here is to ensure the valuation analyst knows the intricacies of an ESOP, particularly with the initial valuation.  At our firm, we review all important company resolutions and agreements, those directly associated with the ESOP and those created contemporaneously with the ESOP transaction.  We look at the financing arrangements.  We discuss all of items these with the Plan Administrator, the Trustee and company management.

We don’t opine unless we’re satisfied the final opinion is reasonable, fair to all parties, and, most importantly, can be supported. A DOL auditor recently remarked to a client our work product was among the most thoroughly documented he had reviewed.

Estate of Diane Tanenblatt v Commissioner of Internal Revenue

In this recent United States Tax Court case (T.C. Memo. 2013-263) concerning a real estate holding company operating as an LLC, two valuation issues were discussed: the sole consideration of a net asset value technique and the extent of lack of control and lack of marketability discounts. In an unrelated issue, the petitioner later attempted to negate his own expert’s property appraisal.  The Court rejected his attempt.

Net Asset Value Method
The two parties’ experts both relied on a net asset value technique.  The Court, in its decision, remarked,

“It is well established that, in general, an asset-based method of valuation applies in the case of corporations that are essentially holding corporations, while an earnings-based method applies for corporations that are going concerns.” Estate of Smith v. Commissioner, T.C. Memo. 1999-368, 1999 WL 1001184. That rule of thumb is no doubt based in part on the notion that a holding or investment company may be managed not for current income but, rather, for appreciation in the value of its holdings. If ownership interests in a holding or investment company are not traded in an established market, then net asset value may be the best indicator of the firm’s value. See, e.g., Hess v. Commissioner, T.C. Memo. 2003-251, 2003 WL 21991627;  Estate of Ford v. Commissioner, T.C. Memo. 1993-580, 1993 WL 501917, 53 F.3d 924 (8th Cir. 1995). The point is well stated in Rev. Rul. 59-60, sec. 5(a), 1959-1 C.B. 237, 242: “In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.”

“We have on occasion been presented with, and sanctioned, the valuation of a closely held real estate firm using a weighted approach, i.e., using both a net value approach and an income capitalization approach, attaching weight to each. E.g., Estate of Andrews v. Commissioner, 79 T.C. 938, 956-957 (1982); Estate of Weinberg v. Commissioner, T.C. Memo. 2000-51. We have here no evidence that an explicitly income-based approach to valuing the subject interest would necessarily have reached a different valuation conclusion, or what that valuation conclusion would be.”

The Court validated a lack of control, or minority, discount applied as the membership interest must be valued under the willing buyer-willing seller paradigm.  The Court pointed out that the willing buyer and willing seller did not have to have the same personal characteristics of the actual buyer and actual seller.  This is key when membership interest transfers are restricted to within the defined group, in this instance, a family group. Chapman Glen Ltd. v. Commissioner, 140 T.C.  (May 28, 2013).

“Certainly, in applying the willing buyer-willing seller standard to determine the value of the subject interest, it would be appropriate to take into consideration limitations in the operating agreement on the rights of a nonfamily member transferee to participate in control and management of the LLC and limitations on the transferee’s rights otherwise to be treated as a member.”

The IRS valuation expert, John Thomson of Klaris, Thomson & Schroeder, Inc, explained the lack of control discount or minority interest discount: “The hypothetical minority interest investor cannot control, or has little influence on, the disposition of assets, the payment of distributions, the appointment of management, or other prerogatives of control. Therefore, a lack of control discount is applied to account for the absence of these control features.”

His discount, which the Court affirmed, was at 10%.  The original petitioner’s valuation provided by the petitioner prepared by Management Planning, Inc. applied a lack of control discount at 20%.  No support for either of these discounts is provided in the Court filings.

The Court indicated a lack of marketability discount was appropriate to allow for the restrictions in the members agreement regarding transfers of interests.  Mr. Thomson provided a 26% lack of marketability discount.  Management Planning, Inc. applied a 35% lack of marketability discount.  The Court sided with Mr. Thomson.  Again, no support for either of these discounts is provided in the Court filings.

The Tax Court continues to allow both lack of control and lack of marketability discounts, though, as in the past, the justification for the scope of these discounts remains nebulous.  The Court allowed a net 33% discount from the pre-discounted value of the proportionate interest.