In the first installment of this series, we asserted that, as the seller of a business, YOUR tax strategy will vary depending on who the buyer is. We began the conversation with the scenario involving the transfer of a company within the family. Acknowledging that the Internal Revenue Code is a complex body of text, we noted how to use that complexity to eliminate any income tax burden on the sale within the family and substantially reduce the likely estate tax burden on the senior generation’s estate. In this installment, we will continue the discussion about transfers within the family.
When it comes to the sale of a company to an unrelated third party, that unrelated third party is typically looking to purchase your entire company. Few would be up to buying a non-controlling minority interest. In the buyer’s eyes, a minority interest will lack managerial control. As such, an unrelated third party buyer will likely be willing to pay less for a minority interest than what its pro rata value might suggest. For example, if an entire firm is valued at $30 million, then a one-third interest in that company will likely be valued at less than $10 million. How much less is dependent on the facts and circumstances of the specific company. But, a 10% to 25% might not be unusual.
In the eyes of an unrelated third party buyer, the minority interest presents another challenge. If the buyer subsequently wants to sell the interest, who will buy it? The scarcity of buyers of minority interests that you faced will confront your buyer trying to sell. This lack of marketability of a minority interest further devalues what a buyer will pay. How much less will again be dependent on specific facts and circumstances. It might reduce the final price by another 10% to 25%. Other factors can affect the ultimate price as well.
The discussion above involved an unrelated third party buyer. Weren’t we supposed to be talking about a transfer within the family? Indeed, yes. When we talk about valuation, we need to look at what any unrelated third party buyer – that is, the “market” – might expect. This is how the Tax Court is going to look at the matter. If any unrelated third party buyer would price an X% interest in your company with a 35.4% discount, then it is justifiable for the sale or gift of an X% interest in your company to a family member to be valued with a 35.4% discount.
With this concept of discounts to value squarely in view, we will note that a one-third interest in your company should receive a greater valuation discount than a one-half interest in your company. A one-fourth interest should receive a greater valuation discount than a one-third interest. And so on. The smaller and smaller the interest, the greater and greater the discount.
Now, let us turn to the transfer of your company to your family. The more family members you have “downstream,” the smaller the size of business interest each will receive. In our example of an entire firm that is valued at $30 million, with many family members each receiving a fairly small percentage of the business, a discounted value of only $15 million might not be unreasonable.
Let’s say that the transfer is a sale to 10 family members – children and grandchildren. You sell 10% of your firm to each. You retain a qualified valuation expert to establish the price of these 10% chunks. Using our example above, the expert identifies a price of $1.5 million each. (As a cautionary note, you absolutely need a qualified valuation expert.) You sell each 10% interest in exchange for promissory note. (As a cautionary note, certain other aspects of such a transaction are necessary to ensure economic substance.) The total of your promissory notes from your 10 family members is $15 million.
Let’s turn back to our first installment article. We saw that a sale of your company to a specific type of trust will allow you to sidestep the income tax liability related to the sale. The sale involved the use of a promissory note. Because your estate now holds a promissory note – that, like a bond, does not appreciate – you have accomplished an “estate freeze.” That is, your firm’s (and estate’s) future growth is now in the hands of your kids. Without such a transfer, your $30 million company growing at 7.5% per year for 20 years would be $120 million upon your death. With such a transfer, you have a $30 million promissory note and a much smaller estate tax problem.
Building upon the strategy in our first installment article, we are not going to sell your business as a whole to a single trust. We are going to break up your company into chunks. One chunk will be sold to a trust for the benefit of Child #1. Another chunk will be sold to another trust that is for the benefit of Child #2. And so on. Depending on the facts and circumstances of both your business and your family, it might well be we get the transferred value for tax purposes down to $15 million. Thus, what might have been a $120 million asset upon your death is transferred to the family as if it were only $15 million.
We must always restate that this is only one strategy. The right one for you and your family might well be different and your results could be better or worse than those illustrated. The key point of it all is that possibilities exist. In our next installment, we will move to sales to unrelated third parties.
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For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at Eric@EdisonAvenue.com or 239.738.6227. Also, visit our Edison Avenue website at www.EdisonAvenue.com or my personal website at www.BuySellFLbiz.com.
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