As your family business expands and grows, you may consider passing on the reins to a new generation of leaders.
A business valuation can be an essential step in estate planning and generational wealth transfer.
Whether you are looking to transition into retirement, slowly starting to turn the business over to the next generation or simply beginning to think about an eventual exit plan, a business appraisal provides an accurate and reliable analysis of the value of the company so you can make informed decisions along every step of the journey.
What is a business valuation?
A business valuation is the act or process of determining the value of a business enterprise or ownership interest therein.[1] There are several business valuation approaches, including the asset approach, the income approach and the market approach. Under each approach, there are multiple valuation methods an appraiser must consider in the valuation of the subject entity. Each has its strengths, and the decision for which method(s) is appropriate to use is based on the specific circumstances of the business being valued.
Ultimately, a business appraisal aims to provide a clear and detailed snapshot of a company’s value as of a particular date, enabling stakeholders to make informed decisions.
Assessing the need for generational wealth transfer
One of the keys to a successful transition of a closely held, family business is a strong team of advisors that includes, but is not limited to, an estate planning attorney, a CPA well-versed in gift tax and estate planning issues and your financial advisor. The team will be responsible for drafting the plan and legal documents that will enable you to transfer the business to your heirs in the most tax-efficient way possible. Some examples of these planning techniques involve the use of trusts, recapitalization of the subject entity with voting and non-voting stock, gifts to the trusts or heirs, sales to the trusts or heirs or a combination of techniques.
Once planning is complete, it is time to hire the business appraiser. The planning and techniques that are used are critical as they drive what the appraiser is to consider in the valuation analysis. A business appraiser’s work product is done for a very specific purpose and should only be used for that purpose – in this case, gift tax and estate planning.
Let us consider a hypothetical scenario to illustrate why it is important to have the estate plan done before the valuation. You and your spouse have a business that is worth $30 million (considering no other assets you hold), which exceeds the estate exemption of $25.84 million for married couples in 2023. You also have two children who are involved in the business, and you believe both children are ready and able to begin to take over the business for you. The valuation date is assumed to be Dec. 31, 2023, so in other words, the appraiser steps in the shoes of a hypothetical investor and values the subject company as of Dec. 31, 2023. Your planning team has determined that you will gift 25 percent each to Child 1 and Child 2 on Dec. 31, 2023. In addition, your estate plan calls for you to gift 25 percent each to Child 1 and Child 2 on Jan. 2, 2024.
The focus of minority interest gifts to your children is important in these scenarios because the appraiser considers various discounts (such as, but not limited to, discount for lack of control, discount for lack of marketability, discount for non-voting shares). As stated above, this scenario assumes the value of the business is $30.0 million (considering no discounts). Each of the 25 percent gifts are likely worth less than $7.5 million ($30.0 million x 25 percent) because of discounts. For illustrative purposes, we assume a combined discount for lack of control and lack of marketability of 30 percent. The $7.5 million value is actually $5.25 million after taking the 30 percent discount ($7.5 million x [1 – 30 percent]). Four separate gifts of $5.25 million results in a value of $21.0 million on combined basis. Without considering any other assets of the married couple, the value of the transfers is less than the estate exemption for a married couple referenced earlier.
As with most estate planning, there are a number of other related factors to consider, such as income tax planning and basis step up. Any well-crafted plan gives consideration to all unique factors that can and will have impact.
Where does business valuation fit into generational wealth transfer?
The Internal Revenue Service (IRS) requires gifts to be adequately disclosed on a gift tax return, Form 709. “Adequate” generally means giving the IRS enough detail to describe the nature of the gift and the basis for the value reported. If you do not adequately disclose the gift when you make it, the IRS can argue the value of the gift up to three years after you pass, which could be 30-40 years down the road. A business valuation can help ensure you can argue over the value of the gift in real time rather than your heirs having to do it ten, 20 or 30 years later. This is another reason why it is important to have a CPA and attorney well-versed in estate planning as one of them will typically file the Form 709. They should understand the importance of filing an adequately disclosed gift tax return.
At Windham Brannon, our appraisal is designed to withstand IRS scrutiny if the gift tax return is audited, and it is also designed to help meet the adequate disclosure requirements.
Timing your valuation
Business valuations can play a critical role in planning wealth transfers, and now is the perfect time to complete this process since a valuation performed near year end can aid in both 2023 and 2024 gifts. Investing the time and financial resources now can help you and your advisors create an effective estate plan that meets both your immediate needs and those of future generations. For more information, reach out to your Windham Brannon advisor, or contact Matt Stelzman.
[1] The International Glossary of Business Valuation, Statement on Standards for Valuation Services No. 1 (SSVS No. 1).
