Is your
business able to continue if you, the owner (or co-owner), dies, becomes
disabled, or otherwise are unable to work in the company, either voluntarily or
involuntarily.
Who
will be your successor? How will you prepare for the significant financial
interruption that will occur as well as how the loss will affect both the
customers and the employees?
In this
article we are going to address the valuation of your business in continuity
situations. Business continuity arrangements must cover both life and death scenarios.
Your challenge is to obtain a valuation that is consistent for both events.
As a
general rule in Exit
Planning, we
assign the “lowest defensible value” to a company, except when we anticipate a
sale to an outside third party for cash.
Unless
you anticipate selling to an outside third party for cash, you will receive
much of your payments for your ownership interest from the business; in the
form of deferred compensation, rental income, etc. The value of your stock (for
tax reasons) will be minimized.
This
same approach will be used in a buy-sell agreement at death. Why? First, the
Internal Revenue Service is not fond of two different valuations of the same
business interest: one high (because life insurance is funding the buy-out) and
one low (to avoid double-taxation consequences of a lifetime stock purchase).
As a result, we use the lowest defensible value in both life and death
transfers.
How
does this work in real life?
You
have two equal owners in a business that could be sold for a large amount to an
outside third party. If owner B wants to sell to an insider (son, employee,
etc.) the most tax-efficient way to structure this transaction is sell the
interest with the “lowest defensible value” and have a significant portion of
the payout come through the future income of the company.
To
achieve this goal, we typically would use non-qualified deferred compensation
plans, royalty and licensing fees, and increased rental fees for property
rented to the company. These tactics will both reduce the value of the business
(because they create financial obligations for the business) and to provide a
justifiable reason to pay monies to the owner after she leaves the business.
Should
B die before the lifetime exit plan is completed, owner A would be able to sell
the business to a third party instead.
The
difference between the lifetime value that B is entitled to and the total
amount she wants for her family (if she dies) can be made up with a life
insurance policy (owned outside B’s estate) for the difference (perhaps in a
revocable life insurance trust or a partnership). These techniques can also be
used if one owner is not insurable, for some reason or does not want to buy
life insurance.
It is
critical to obtain the services of a Certified Valuation Analyst to insure that
the valuation is both appropriate and defendable (if it is ever questioned by
the IRS).
Tagged business successor, business transfer
