Gifts and Estate Valuations
June 22, 2016
What Business Leaders Should Know About Gift and Estate Valuations
Thinking about tax efficient transferring of wealth via private company stock to loved ones or trusts through gift and estate transfers?
Any gift whether in life or at death, (except for specific “qualified” gifts), can create a taxable event for the individual giving the gift/effectuating the transfer. With gifting individuals typically try to optimize by not exceeding the annual exclusion amount. The IRS defines a gift as “any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.” As long as the gift of a business interest is considered a “complete gift”, where there exists no exchange in equal value from the recipient to the giver, this tax law applies. This section of the tax code applies to tangible and intangible gifts. Gift taxes apply to gifts transferred during life whereas Estate taxes apply to gifts transferred at death. Where tax is concerned, the value of the gift needs to be calculated in order to execute the tax. Therefore, the question with private stock/company ownership is: How much is my business ownership worth?
Why hire a professional to perform my valuation?
When determining the amount of tax that is owed, those giving the gift will lobby for the lowest possible value in order to minimize their tax liability. But, tax authorities are very aware of this desire for devaluation and have passed severe consequences for those found manipulating business values for tax purposes. Depending on the severity of the understatement, the penalties can range from 20% to 40%.
In an effort to avoid an accusation of purposefully devaluing an asset for tax purposes and the subsequent scrutiny from the IRS, a Fair Market Valuation (FMV) conducted by a professional third party is deemed necessary in order to provide a defensible argument. Experienced valuation professionals know how to assess your business and how to value interests, intangibles, and property at fair market value. The expertise and unbiased nature of the third party appraiser creates a layer of defense between the asset and the gifter, while also tapping into valuation and case law knowledge as well as years of experience. A simple internet search will find hundreds of cases over the years where “fair value” has been a point of argument between the IRS and the asset owner, although some commenters suggest that these are becoming less frequent.
When valuing certain business interests, there are ratifiable discounts that can and should be taken in valuing to closely held interests. These discounts account for illiquidity, when applicable, lack of control, and other factors to devalue the asset in a certified way, decreasing the tax liability for the gifter, as supported by academic studies and approaches. Understanding which discounts to apply and the extend they should be applied relies on the judgement and again knowledge of case law of experts in the valuation industry. A Discount for Lack of Marketability (DLOM) is applied to the value of the asset to account for the illiquidity of a portion, or the whole, of a closely held business when compared to a publicly traded interest. As there may be no readily available market for the asset, it would be much more difficult for someone to immediately sell a closely held interest, therefore a DLOM is applied to account for the value of an interest below its intrinsic value on a fully marketable basis.
In addition, when purchasing a majority interest in a company, a premium is paid for the “control” the purchaser then receives as the authority to make decisions for the business and direct its future. A Discount for Lack of Control (DLOC) is applied in certain instances to minority interests where no such control exists, to account for the loss of the premium that would usually be applied in a majority purchase.
Various court proceedings have ratified these discounts over the years. They are common practice in the valuation industry, but cannot be applied uniformly in all circumstances. The American Institute of Certified Public Accountants (AICPA) acknowledges that “estimating a discount for lack of marketability is challenging, and [no one method] is completely satisfactory in all respects.” A working and active knowledge of these court rulings and the methods needed to calculate the discounts is necessary to present a defensible case for discounting values. Unfortunately, there is no plug-and-play method that works, and it usually comes down to a careful judgement call from a qualified expert who considers all the circumstances unique to the case.
With an experienced, third-party valuation professional, employing all their experience to produce a defensible value for the business owner that satisfies the valuation authorities, a business owner will have a FMV of their interest while correctly assessing the amount of taxes due.
How do I best optimize gift and estate taxes?
While this question is usually handled by a certified financial planner and/or qualified estate planning legal counsel, there are some exclusions that can be used to decrease or avoid some gift and estate taxes of which business owners should be aware.
For smaller gifts during life, there is an annual exclusion that permits gifts of $14,000 (applicable to calendar year 2015) or less to be given each year without triggering any gift tax to any person. It is unlikely, however, that this exclusion will account for the entire value of a gift of most material business interests. Also, for gifts during life or at death, each taxpayer has an aggregate lifetime exclusion of $5.45 million (applicable to calendar year 2015) which they can use as a credit to offset gift or estate tax. Both of these exclusions are adjusted on a regular basis (every 4 or so years) for inflation.
For those U.S. citizens giving to a U.S. citizen spouse, gifting is unlimited. Furthermore, with “portability”, an election can be made to have the unused lifetime exclusion of the deceased spouse transfer to the surviving spouse, thereby lessening the potential to inadvertently transfer tax liabilities from one spouse to the other. Whether or not you choose to use your lifetime exclusion is an issue to consider in consultation with a financial planner and/or estate planning attorney, but choosing not to use this exclusion will result in tax liability at the time of transfer.
For an extensive review of the laws and policies surrounding Gift and Estate Tax visit the IRS website.