Valuation victory Eases Succession Problems

RAISE YOUR HAND if you own all or a portion of a closely held business. Raise the other hand if you intend, sooner or later, to transfer your interest in the business to a family member (usually one or more of your business kids). Based on 40 years of experience, Id say that about 40% of you reading these words will have both hands up. The IRS, with a big assist from the courts, now agrees with the

RAISE YOUR HAND if you own all or a portion of a closely held business. Raise the other hand if you intend, sooner or later, to transfer your interest in the business to a family member (usually one or more of your business kids). Based on 40 years of experience, I’d say that about 40% of you reading these words will have both hands up.

The IRS, with a big assist from the courts, now agrees with the position my office has been taking for 15 years. Finally! What a fight!

The following is an example of what the courts are doing and saying:

You (Joe) operate your family business (Success Co.) as a corporation. The assets of Success Co. include a number of appreciated assets, such as investments in stocks, land and buildings. Also, many assets subject to depreciation — mostly equipment — are on the books for much less than their current value.

Now suppose that Success Co. is correctly valued (for tax purposes) at $5 million. The value of specific assets that Success Co. owns is $3 million, but they are only on the books as $2 million. So, if Success Co. were to sell the assets or actually liquidate (although neither Joe nor Success Co. intend to sell the assets or liquidate), there would be a $1 million profit. Say the tax on the profit would be $400,000. The question that faced the court was, should the value of the corporation be reduced by $400,000 to $4.6 million?

“Yes,” said the court, turning thumbs down on the IRS’ claim to ignore this built-in-gains discount (actually the potential tax due for an asset sale or corporate liquidation).

As a practical matter, this case allows you to take three valuation discounts: one for lack of marketability; a second for built-in-gains of assets even if you don’t intend to sell them or liquidate (technically a part of the marketability discount); and a third for minority interest if you are transferring 50% or less of your stock to one person (for example, Joe gives 30% of his Success Co. stock to each of his two children).

After these three discounts, a $6 million company may only be worth in the $3 million to $3.5 million range for tax purposes. Truly a great victory!

The right value of your business, whether transferring to your kids, for estate planning or for other purposes is one of the most important tax impact considerations in the law.

We have known how to transfer your business to the younger members of your family, tax-free, for years. Now, with this huge valuation victory, we can hit the IRS with both guns blazing, and they can’t fight back. The law is
on our side.

(But a warning: Don’t be aggressive. Follow the rules to victory.)

How income tax works

You must read what follows. Then pass it on to your friends. Save copies to give to your kids and grandkids.

I did not write this, although I wish I did. The author is T. Davies, professor of accounting at the University of South Dakota School of Business. This came to me in an e-mail.

Here it is word-for-word. Enjoy!

Let’s put [income] tax cuts in terms everyone can understand. Suppose that every day, 10 men go out for dinner. The bill for all 10 comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men — the poorest —would pay nothing; the fifth would pay $1; the sixth would pay $3; the seventh $7; the eighth $12; the ninth $18, and the 10th man — the richest — would pay $59. That’s what they
decided to do.

The 10 men ate dinner in the restaurant every day and seemed quite happy with the arrangement, until one day the owner threw them a curve (in tax language, a tax cut).

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by $20.”

So now dinner for the 10 only cost $80. The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still eat for free.

But what about the other six men, the paying customers? How could they divvy up the $20 windfall so that everyone would get his own “fair share”?

The six men realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would end up being paid to eat their meal.

So the restaurant owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay. And so the fifth man now paid nothing, the sixth pitched in $2, the seventh paid $5, the eighth paid $9, the ninth paid $12, leaving the 10th man with a bill of $52 instead of his earlier $59. Each of the six was better off than before. And the first four continued to eat for free.

But once outside the restaurant, the 10 customers began to compare their savings.

“I only got a dollar out of the $20,” declared the sixth man, pointing to the 10th. “But he got $7!”

“Yeah, that’s right,” exclaimed the fifth man, “I only saved a dollar too. It’s unfair that he got seven times more than me!”

“That’s true!” shouted the seventh man. “Why should he get $7 back when I got only $2? The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison. “We didn’t get anything at all. The system exploits the poor!”

The nine men surrounded the 10th and beat him up. The next night he didn’t show up for dinner (or, in the real world, he took his business out of the country), so the nine sat down and ate without him. But when it came time to pay the bill, they discovered a little late what was very important. They were $52 short of paying their bill!

Imagine that!

And that, boys and girls, journalists and college instructors, is how the tax system works. The people who pay the highest taxes get the most benefit from a tax reduction.

Tax them too much, attack them for being wealthy, and they just may not show up at the table anymore. Where would that leave the rest? Unfortunately, most taxing authorities anywhere cannot seem to grasp this rather straightforward logic!

Irv’s comments: The sad part is we have not figured out how to beat the income tax. Earn and you pay. Earn more and you pay more. Sad!

But happily, we do know how to beat the estate tax, legally. To learn how, go to my Web site: www.taxsecretsofthewealthy.com.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Plaza, Chicago, IL 60606; via e-mail at [email protected]; or by phone at 312/207-1040.

TAGS: Taxes