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Estate Planning for Proposed Tax Changes: Valuation Guidance for Privately Held Businesses

May 28, 2021, 8:00 AM

The Federal Estate tax laws have changed dramatically over the past several years. Under the Tax Cuts and Jobs Act of 2017 (TCJA), the amount of the exemption for taxable estates was doubled from $5 million to $10 million, indexed to inflation. In 2021 the exemption is $11.7 million per person. Originally, the sunset of the TCJA provided a return of the exemption back to a limit of $5 million in 2026. The increase in the exemption allowed more wealth to be transferred to heirs prior to any taxation.

However, during his presidential campaign, Joe Biden proposed to reduce the estate tax exemption to $3.5 million as well as increase the rates of the estate tax itself. If passed, these proposals will significantly increase the level of taxation on estates. The proposed changes may be enacted, perhaps as early as this year. As such, many individuals, particularly the owners of small businesses, have an interest in planning for their estates under the provisions currently provided under the TCJA rather than wait until either the TCJA provisions sunset, or the Biden administration proposals are enacted.

Further, in addition to the timing of the reduction of the exemptions, high-net-worth individuals can benefit from the uncertainty in the economy caused by the global pandemic. The economic impact resulting from the pandemic has affected us all, but not all of us equally. While the public markets have done well during the pandemic, many privately held businesses were adversely impacted. The return to normalcy is much more uncertain for these businesses, increasing their risk.

Risk is the exposure that the owner of an interest in a business expects in future returns from the business. Increased risk creates a requirement for higher returns to compensate for the risk, which in turn may reduce valuations of those businesses. Lower valuations under the current economic environment are helpful in proper estate planning for high-net-worth individuals since these valuations can be locked in under the provisions of the TCJA before hopefully returning to more “normal” valuations in the coming years.

Valuations of businesses for federal gift and estate tax purposes generally follow the provisions to be considered in IRS Revenue Ruling 59-60. The factors listed in Rev. Rul. 59-60 include:

  1. The nature of the business and the history of the enterprise from its inception.
  2. The economic outlook in general and the condition and outlook of the specific industry.
  3. The book value of the stock and financial condition of the business.
  4. The earning capacity of the company.
  5. The dividend-paying capacity.
  6. Whether the enterprise has goodwill or other intangible value.
  7. Size of the block of stock to be valued.
  8. Whether the stock is actively traded in a free and open market—either on an exchange or over-the-counter.

There are several current economic issues that impact valuations. The present economic environment may be beneficial to owners of privately held businesses and their estate planning in the sense that lower valuations may increase current estate planning opportunities, and perhaps even more so if the Biden administration’s proposals are enacted.

Valuation at its most basic level involves three components: cash flow, risk, and growth. There are numerous valuation techniques that utilize assumptions about these three components. The current economic environment created by the pandemic substantially impacts all three components in privately held businesses. For example, lower levels of business activity may reduce the cash flow that the business generates. The uncertainty of the longer-term economic consequences from the pandemic may increase the risk of investment in the business. Business growth may differ greatly by industry sector.

Typically, estate planning that includes a privately held business involves the transfer of only a portion of the equity in the business. The interest in the business being transferred is usually a minority, non-marketable interest, meaning that a particular interest does not have ultimate control over the direction of the business, nor is the interest readily salable to another party. Both factors may increase the risk to the individual transferring the interest in the business, lowering the pro-rata valuation of that interest. The lower valuation allows for a larger percentage of the business to be included as part of the estate planning under the current level of estate tax exemptions.

As an example, suppose John Smith is a 100% owner of the business, the equity of which is valued at $20 million. As part of his estate plan, Mr. Smith plans to transfer three 25% interests to three separate trusts for the benefit of each of his children. Assuming the 25% interests are unable to “control” the business and are not readily marketable, each interest has a fair market value much less than the pro-rata valuation of $5 million of 25% of the entire entity due to the increased risk from lack of control and marketability. Conversely, if Mr. Smith were to transfer the entire 75% interest rather than three 25% interests, facts and circumstances may indicate that the 75% has control and is more readily marketable, thus its fair market value may be pro-rata.

The difference between the non-controlling, non-marketable interests and the pro-rata value is also impacted by the current economic environment. Analysts have noted a reduction in merger and acquisition activity as sellers who can wait to sell under better economic conditions are doing so. The reduction in market activity may further add to the risk perceived by an owner of non-marketable interest, thus lowering valuations of those interests.

High-net-worth individuals, who own privately held businesses and who would like to maximize their estate tax exemptions, may have a shortening window of opportunity due to proposals to change the level of exemptions. Furthermore, valuations are likely to increase as economies emerge from the current conditions caused by the global pandemic. Now is a great time to check with your tax adviser about these changes and their potential impact.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Mark L. Zyla CPA/ABV, CFA, ASA is a Managing Director of Zyla Valuation Advisors, LLC, an Atlanta, Georgia, based valuation and litigation consultancy firm. He may be contacted by email at mzyla@zylavaluationadvisors.com.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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