Transition Strategy – Gifts to Family Members
In our last article, we discussed the pros/cons of a sale of a business to family (mainly children). In this discussion, we will highlight transferring ownership to the children through a systematic “gifting” strategy. This strategy was a bit more common a decade ago before the Estate and Gift exemption (“Lifetime Exemption”) was raised from $1 million to $5 million and is now $11.8 million per individual (or $23.6 million for a joint couple) which makes estate tax concerns far less common in terms of number of individuals/families. However, for the high net worth individual client, there is still significant tax savings from implementing a gift tax strategy that utilizes the $15,000 (adjusted annually for inflation) per donee per year. So, every year, a husband and wife could “gift” in total $30,000 of cash or cash equivalents to their children or grandchildren without utilizing any of their Lifetime Exemption.
The value for this “gift” is deemed to be “fair market value” at the time of the gift. Fair market value is defined by the Internal Revenue Service (Revenue Ruling 59-60) and at a high-level is the cash or cash equivalent value between a hypothetical willing buyer and seller both having knowledge of all relevant facts and not being under any compulsion to sale. So, for cash gifts, this is pretty straight forward. However, for gifts of closely-held business interest that do not have a readily observable price then herein lies the opportunity for valuation discounts. Under the statutory definitions and tremendous amount of case law, the following are a sample of the most common discounts allowed for a minority interest:
- Discount for Lack of Control – cannot control compensation or distributions, change management, or force a sale of the company;
- Discount for Lack of Marketability – cannot be converted quickly into cash like three days for a publicly traded security; and
- Discount for Lack of Voting Rights – since the shares do not have voting rights, they must be worth less than the equivalent voting shares
There is not set rule or formula for determine the exact valuation discount. It is always a facts and circumstances analysis by the valuation professional. Generally, the steps we see undertaken to maximize valuation discounts by limiting control of the interest being gifted is to recapitalize the company. For an operating company (usually an S-Corporation), recapitalization begins by creating two classes of shares of voting and non-voting stock, both being identical with the exception of voting privileges. The non-voting shares are then gifted to children (or into trust for benefit of children). For holding companies (generally real estate), the same idea is executed by utilizing limited partnership or LLC interest.
So, for a basic example, a married couple has three kids. In 2019, they would like to transfer to them in trust the maximum amount without utilizing any of their Lifetime Exemption. Most easily, they could make cash gifts of up to $90k (3 children x 2 parents x $15k annual exclusion). However, if they were to transfer non-voting shares or limited partnership interest, then $150k of value could be transferred assuming a modest 40% overall discount (selected discount for illustration purposes only).
In addition, even if running the Company is not in their future, transferring ownership in your business removes future appreciation and income from your estate. We have seen this structure successful many times when it comes to a future sale of the Company for significantly higher value than the original gift. Again, it is important to have the right optics in this situation, so it is probably too late to gift and expect any significant valuation discounts if the letter of intent is already in hand.
Summary: In conclusion, although it may not be as commonplace as it used to be, a one-time gift or a systematic gifting strategy is still one of the best ways for high-net worth individuals that own a closely-held business to transfer minority ownership to the next generation at a significantly reduced valuation, retain control of the business, and minimize estate and gift transfer taxes. However, it still takes the proper advisory team (attorney, CPA, valuation professional) with the relevant experience to ensure that any strategy not only minimizes any possible transfer taxes but also is in agreement with the client’s overall goals and objectives. Please do not hesitate to contact us to help with any business transition needs.
Transfers to Management Team / Key Employees
Transfers to Employees (ESOPs) – Overview
Transfers to Employees (ESOPs) – Technical Discussion
This article is simply a high-level overview of complex topics and does not constitute valuation, tax, or legal advice. Readers of this article should seek the services of skilled and experienced professionals.
Vision Point Capital focuses its services in three pillars of consulting for business owners: 1) Valuations; 2) M&A Advisory, & 3) ESOP Advisory. Working with business owners and their advisors is in our DNA. Please check out our website at www.visionpointcapital.com for more information about our services and team members.