Planning for Closely Held Business Owners Flashcards

Question

What are the different valuation methodologies?

Answer 1

1. Market Capitalization - Simplest method, calculated by multiplying the company’s share price by its total number of shares outstanding 2. Times Revenue Method - A stream of revenues generated over a certain period of time is applied to a multiplier that depends on the industry and economic environment 3. Earnings Multiplier - Used to get a more accurate picture of the real value of the company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. Adjusts current P/E ratio to account for current interest rates 4. Discounted Cash Flow (DCF) Method - Similar to earnings multiplier, this method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period number. The main difference between this and profit multiplier is that it takes inflation into consideration to calculate the present value 5. Book Value - This is the value of the shareholder’s equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets 6. Liquidation Value - Net cash that a business will receive if its assets were liquidated and liabilities were paid off today

Answer 2

1. Market Capitalization - Simplest method of calculating value. 2. Times Revenue Method - Can look at companies that are similar and see their valuations 3. Earnings Multiplier - Provides an accurate picture when looking at profits and cash flow 4. Discounted Cash Flow (DCF) - Provides an accurate picture to project future cash flow 5. Book Value - Most useful for business that have a lot of assets in their book 6. Liquidation Value - Simple, establishes a value for all the assets to pay off the liabilities, and then see what is left

Answer 3

1. Market Capitalization - Not necessarily the most accurate or fully representing methodology 2. Times Revenue Method - The industry multiplier may not be accurate compared to the actual business 3. Earnings Multiplier - Multiples can change over time as investors become more or less eager to own the shares based on market dynamics 4. Discounted Cash Flow (DCF) - Based on value to investor, as beneficiary of future cash flows, is the sum of those future cash flows. Based on estimates. Prone to errors 5. Book Value - Difficult to value if business mostly has intangibles. Does not consider a company’s future earning potential. Challenge in valuing assets that are difficult or expensive to value, when much of the value lies in the way it provides a financial benefit to the company. Not especially useful for complex businesses 6. Liquidation Value - Might be difficult if there are assets that are hard to value in a sale

Answer 4

* Valuation Discount * Minority Discount * Marketability Discount

Answer 5

The sum of each of the FLP interests combined does not equal the sum of the assets themselves because ownership of LP interest in an FLP does not convey any rights of management or control over underlying assets plus the FLP agreement prohibits the partners from freely transferring their interests to non-family members

Answer 6

* A discount for lack of control, is routinely applied to establish the estate and gift tax values of minority limited partner interests * This discount reflects the inability of a limited partner to control the operations of the FLP and to invest its assets in a manner that is advantageous to the limited partner. * The minority interest discount principle refers to the fact that the owner of less than a majority interest in an enterprise cannot by himself control day-to-day or long-range managerial decisions, impact future earnings, control efforts for growth, establish executive compensation, or access corporate assets through liquidation * Because the owner of a minority interest lacks control over the business, an acquiror of a minority interest pays less for that interest, on a pro-rata basis, than if he were acquiring a controlling interest in the business * In instances where the owner lacks the ability to exercise control over the operations of the enterprise, the owner’s interest can be worth significantly less than its liquidation value * Typically a 20-30% discount

Answer 7

* Applied to the value of limited partnership interests that do not offer a readily available market for trading * Such a discount reflects the fact that a partner who contributes assets to an FLP in return for a limited partnership interest generally has difficulty finding a buyer (if one exists) * Usually around 30% discount or higher

Answer 8

* Typically used for gift and estate tax savings, these discounts will be applied to LLCs, FLPs, closely held businesses where the property is transferring to a family member for the most part * Establishing the FMV first, then discounting the value of the property by considering the businesses' lack of control and lack of marketability * Once discounts are established and applied, can then look to transfer/sell * First minority discount applied, then lack of marketability discount (?)

Answer 9

* Third parties - The goal is to receive as much as possible while minimizing the tax/gain consequences of the sale * Employees - Employees know the existing business intimately, but may not have the money to be able to outright purchase the business from the owner. Financing can come from the seller, an outside financing source, or through an ESOP. Installment sales are an option if the seller helps with the monetary aspect up front, other sale structure options include leveraged buyout and ESOP * Family members - Opportunity to pass wealth and growth of business to family members that are typically in a lower tax bracket. Utilizing valuation discounts will help with estate and gift tax. Various sales structures like installment sales, bargain sale, intra-family loans, can help provide the buying family member pay for the business over time. This also keeps the wealth in the family, may be useful to look at valuation methods that provide a lower FMV so that there is less of a tax burden on the seller (?)

Answer 10

* Getting cash increases personal liquidity and diversifies one’s assets, which in turn reduces stress and risk. Partial sales additionally reduce personal financial risk by often removing personal guarantees on company debt * Possible need to finance a portion of the transaction, which can leave some of your assets at risk. If you remain involved with your business after a sale, however, new owners face less risk and may be willing to finance more of the sale price on their own (?)

Answer 11

* To increase liquidity for a company’s stock, which may allow owners and employees to sell stock more easily. To acquire other businesses with the public company’s stock. To attract and compensate employees with public company stock and stock-options. To create publicity, brand awareness, or prestige for a company * Increased regulatory requirements, loss of privacy and control, and higher costs associated with being a public company (?)

Answer 12

* A variation of the installment sale and typically used among family members if the property owner has a short life expectancy. The note contains a provision under which the balance of any payments due at the date of death will be automatically canceled. The term of the SCIN must be less than the actual life expectancy of the seller, otherwise it will be taxed as private annuity * Good for when the seller wants to retain a payment stream that will not continue beyond their death. Good for when the estate tax benefits exceed the income tax cost that results from the premium payment for the cancel-at-death feature * Taxable gains are prorated over the payment period, can shift most of the profit from a high-income year to other lower tax-bracket years. Installment payments are broken up into return on basis, gain, and interest income. Taxpayer must report parts of the payment that represent gain and interest income. Note is canceled upon holder’s death * At death, the note is canceled and not included in the gross estate. When an installment note is canceled/unenforceable, it is treated as a taxable disposition on the note and that gain is taxable to the decedent’s estate as IRD. There is no IRD deduction allowed for the estate * Application of the 7520 rate is important, otherwise any interest rates below this amount are considered partial gifts to the buyer * Sale price of the property must exceed the actual FMV of the asset to reflect the risk of death. If the seller lives to receive all payments, they will have to report gain in excess of the actual gain that would have been realized had the property been sold at FMV.

Answer 13

* A recapitalization is generally income tax-free. Under IRC §368(a)(1)(E), no gain need be recognized upon a so-called “E reorganization.” In order to be valid, the reorganization must have a legitimate business purpose, such as estate planning, beyond mere tax avoidance * Gift non-voting shares of common stock to adult children and keeping remaining cumulative preferred shares. Keeping the cumulative preferred shares provides a qualified payment because owner has retained the right to receive dividends at at fixed par value. * Value of the gift equal the value of the stock reduced by annual exclusion & applicable discounts would be gift tax payable * Without a qualified payment the owner would have a retained interest of zero & the value of the gifted stock would be FMV of the business. Recapitalization also freezes the value of pref shares at par value no matter how much the business grows which further reduces the value of stock in the owner's gross estate at death * Minimum Value Rule: this applies so that the gift tax value of cumulative stock must be at least 10% of the total value of the business owner's stock. This technique allows the owner to retain control of the business, receive income from the preferred shares and freeze the preferred shares at par value and give members direct ownership in the business with the benefit of future appreciation on the common shares * Regarding taxes, the owner must retain the right to receive dividends at a fixed par value on the cumulative preferred stock at least annually therefore the gift tax will be applied only on the amount of common stock transferred not to the entire value of the common stock * Qualified interest: An interest is not considered qualified if the dividends are non-cumulative or if the owner retains extraordinary payment rights such as the right to exercise puts or calls and the right to convert shares or liquidate. An unqualified interest would cause the qualified shares to be taxed at FMV of the business interest not on the partial amount of the stock gifted * The cumulative preferred shares satisfy the owners income needs while providing them with a qualified payment in the form of fixed dividends. However, any appreciation in value of the business will occur outside the owner's estate. The non-voting common shares are removed from the owner's estate which avoids estate taxes * Noncumulative describes a type of preferred stock that does not pay stockholders any unpaid or omitted dividends. Preferred stock shares are issued with pre-established dividend rates which may either be stated as a dollar amount or as a percentage of par value

Answer 14

* Expedites the sales process as it eliminates the need for third-party lenders, banks, and extensive paperwork. The reduced red tape allows for a smoother transaction, making the property available to the buyer without the typical waiting period, ultimately resulting in faster closings * Risk of unfavorable loan terms From the Seller. Sellers who are extending their own financing (also called “taking back a mortgage”) often charge a higher interest rate than institutional lenders, because of the increased level of risk that the buyer will default (fail to pay, or otherwise violate the mortgage terms) * Seller financing can be used to defer capital gains taxes on the sale of a business or property. Deferring your capital gains tax means that you don’t have to pay taxes on the money you make from the sale until a later date. Typically, when a business is sold, the seller will pay taxes on the entire profit

Answer 15

* Typically a leveraged buyout, where shareholders are bought out using mostly borrowed funds. The acquirer group (buyer of business) seeks to issue debt instruments and then use target-generated cash flow (the purchased business) to pay off principal plus interest. The debt instruments can go to third-party lender, target shareholders, or the target itself * There are a number of anti-abuse provisions which requires structuring the LBO very carefully. A number of code section rules that will lead to tax issues if not followed * With the borrowed funds, the acquirer is able to purchase the business while retain ownership, but must be cognizant of high interest payments in the early years, and nondeductible principal repayments in the later years. Will typically require a combination of selling company assets to pay down deb and/or increasing income/cash flow from the retained business assets * Seller will have to realize gain on the sale of the business when sold if done outright. With leveraged buyout and use of debt instruments, may fall under installment sale rules

Answer 16

* The seller of the annuity (annuitant) conveys complete ownership of a property to a buyer who is obligated to make periodic payments to the annuitant for a specified period of time. Usually this is the annuitant’s lifetime, but can also be for the life of their spouse or another party * Payments structured as an annuity. It is a fixed payment that is calculated using IRS valuation tables based on the annuitant’s life expectancy and current interest rates * Good for when a client wishes to retire and shift control of a business to a family member or key employee. Good for when a client wishes to remove a sizable asset from their estate. Good for when a client owns a large parcel of non-income-producing property and wants to make it income producing. Useful when estate is very large and the major or sole heir is a grandchild or two generations below the client (considered a sale and isn’t subject to GSTT). Good for when the family’s objective is to keep certain property in the family or direct it to specified family members and the current owners do not want it subject to a will contest or statutory rights that might thwart their directive wishes * Risks are that all payments cease at annuitant’s death, even if only one payment was made. If annuitant outlives their life expectancy, the buyer might pay more than anticipated. If the buyer predeceases the annuitant, the buyer’s estate must continue to make any remaining annuity payments throughout the annuitant’s lifetime * Each annuity payment to an annuitant is treated partially as a tax-free return of capital, partially as capital gain, and balance as ordinary income. When the annuitant recovers their basis, the entire payment is taxed as ordinary income. Buyer isn’t allowed any deduction for payments * No gift if the buyer’s annual payments to the annuitant are actuarially equal to the FMV of the property sold. If the value of the promise made to the buyer is less than the value of the property transferred, the difference will be considered a gift by the annuitant * Not includable in taxable estate. Annuity payments are not included either. If annuity is joint, the payments continue until the second death

Answer 17

1. Market approach - Compares private company to other companies in the public securities markets. Includes adjusting financial statements of the private company, analyzing multiples of the public securities, and making adjustments for the differences between the private company and its publicly traded counterparts. Private transactions of other companies bought and sold in the marketplace can also serve as evidence of the subject company value. Information is difficult to find and sometimes not reliable 2. Income approach - Involves measuring some level of income or cash flow and capitalizing these amounts into value. The value of a company to any investor is always the present value of its future income or cash flow. Analysis of the private company’s past performance is the best indication of its future performance. Sometimes forecast of future cash flows is determined to be a more reliable expectation of the company’s future performance 3. Adjusted balance sheet approach - Used in situations such as real estate and other types of holding companies. Involves adjusting the assets of a company to their FMV and deducting all outstanding liabilities. Situations for this approach arise when application of the market or income approach yields a value below the company’s book value, or when those approaches are eliminated from consideration altogether. In those cases, adjusted balance sheet approach is used to establish a valuation floor, since every company is worth at least the FMV of its assets less its liabilities

Answer 18

* A device for spreading out the taxable gain on the sale of an asset and deferring income tax on the gain from the sale of the property. Instead of the owner receiving payment outright for selling property, they receive payments spread over a set term of years * Good for selling property to individuals/family members that may not have enough capital to purchase property outright. Good for when an individual in a high income-tax bracket holds substantially appreciated real estate, and can be an effective estate freezing device when the sale is between family members and the business is rapidly appreciating * Taxable gains are prorated over the payment period, can shift most of the profit from a high-income year to other lower tax-bracket years. Installment payments are broken up into return on basis, gain, and interest income. Taxpayer must report parts of the payment that represent gain and interest income * The installment note holder can choose to forgive all or a portion of payments made by the buyer if they want to apply the gift tax exclusion or exemption to the payments * At death, any remaining installment payments due at the seller’s death is included in the gross estate. The entire unrealized gain on the balance of the note is accelerated and must be recognized. The right to receive payments on the installment obligation is treated as IRD and the payments are taxable income to the new recipient. No step-up in basis at death

Answer 19

* An interest-free or below-market-rate loan. Money is lent at either below-market interest rates or with no interest. They must be actual loan agreements and should be put in writing. The loan terms, including interest rate, should be clearly stated. Typically employed in loans between family members * Not many tax advantages, but may be useful to allow the individual borrowing the funds achieve a certain goal * Loans less than $10,000 or $20,000 from a married couple are exempt from gift and income tax rules (with exceptions). Both income and gift tax consequences otherwise. * When a lender makes an interest-free loan, they may have to pay income tax on the imputed interest that they should've received. The forgone interest is deemed a gift and will also be subject to income tax by the lender. The amount subject to gift and income taxation is the difference between the applicable federal rate and the interest actually payable under the agreement between the parties.

Answer 20

* A transaction in which a donor sells property at a price below the FMV. * Typically occur between family members or to charity. * The difference between the FMV and the actual sales price is considered a taxable gift, which can be offset by the donor's annual exclusion. Donor will realize income and pay capital gains tax to the extent that the sale price exceeds their basis in the asset. For a bargain sale to charity, the donor receives an income tax deduction for the gifted portion, not for the portion sold to charity

Answer 21

* A sale-leaseback involves one party selling property to another party and then leasing back the same property. A gift-leaseback, a gift of property to an individual or to a trust is subsequently leased back. Must be a legal transfer of property for the full FMV of it. The amount of lease payments must be reasonable and at FMV * Good for removing property from an owner's estate and provide income to family members in the form of lease payments. Good for when a client has significant assets but poor cash flow. Good for when a client is in a high income tax bracket and wants to divert highly taxed income to a member of their family in a lower tax bracket. Good for when a client owns rapidly appreciating property and would like to shift that future wealth to a family member and save estate taxes on that appreciation * For sale-leaseback, the seller must pay tax on any gain realized just as for any other sale. For gift-leaseback, the donor has made a taxable gift to the beneficiary or trust and may have to use a portion of the unified credit to offset the tax. Future growth is removed from the client's estate

Answer 22

* It's an irrevocable trust designed to preserve family wealth by transferring appreciating property and income to family members, which reduces the value of the grantor's estate * Good for a business owner who wants to transfer business to a trust for the benefit of their family at a low gift-tax cost and receive an income stream that can be used to supplement or fund their retirement * Transfers to IDGTs are completed gifts for gift tax purposes; defective for income tax purposes. The assets are not included in the grantor's estate, but the income is taxed to the grantor, who is treated as the "owner" of the trust for income tax purposes * Grantor can sell or transfer assets to an irrevocable trust. Since the grantor pays the income tax generated by the trust, the trust essentially grows tax free. Having the grantor pay the income tax also reduces the amount of tax owed. Trust income is taxed at 37% at a lower income threshold than an individual

Answer 23

* Limited liability entity created under state law. Ownership of partnership interests typically limited to family members of the same family. Partnership tax rules apply * Good for when parents want to transfer wealth to their children in a tax-efficient manner but also want to retain control of their assets and continue to manage their property * At formation, family members contribute property in return for ownership interest in the capital and profits. Divided between general and limited partnership interests. General partners typically retain a small interest while maintaining complete management and control. They assume personal liability for debts in the FLP. Limited partners receive partnership interests with potential for appreciation on their interests * Important to make sure that assets transferred to the FLP has legitimate family business purpose and that the FLP runs as a business entity * Gift tax and estate tax valuation benefits are also associated with FLPS. As a general rule, the value of an FLP interest is worth less than direct ownership of a percentage of the assets

Planning for Closely Held Business Owners Flashcards

(47 cards)