One word: “taxes.” There are so many transactions in which the tax consequences visited upon a closely-held business and its owners, and, therefore the true economic cost of the transaction, will depend upon the valuation of the business, its property, or its equity.

The following discussion highlights some of the more commonly-encountered situations in which such valuations may be critical, and with which advisers to closely-held businesses should be familiar.

Transfers in Connection with Estate and Gift Tax Planning

Estate and gift taxes are imposed upon the taxable amount of property transferred by a taxpayer upon his death or during his life, respectively. The determination of the taxable amount, begins with the fair market value (“FMV”) of the transferred property.

Thus, the first step in formulating any estate or gift plan is determining the FMV of the assets that the client plans to transfer. This FMV will tell us whether the client will likely be subject to the estate tax and, in the event he will be, whether a gifting program can lessen that expected tax hit.

If a gifting plan is to be implemented, a valuation of the property to be gifted should be undertaken in advance, to ensure that the economic consequences of the planned transfers are understood.

For example, how much of the client’s exemption amount will be consumed by his transfer of shares of stock in a corporation or membership interests in an LLC, and how much gift tax will be owed in respect of those transfers? If the goal is to avoid using the client’s exemption amount – as in the case of a sale to a grantor trust – is the consideration paid by the trust sufficient so as to avoid a gift?

Paying the Estate Tax

Assuming the client will have a taxable estate, the valuation of the assets to be included in his gross estate for tax purposes may assist in planning for the satisfaction of the resulting estate tax liability.

Once there is an estimate for this tax liability, the client can implement a plan to provide the requisite liquidity, such as by acquiring life insurance. Over time, if the value of the business is determined to have changed, the amount of insurance coverage may be adjusted accordingly.

Additionally, if the client owns an active business, the valuation of his interest therein may help with planning to ensure that the client retains a sufficiently large interest in the business so that, upon his demise, his estate may utilize the fifteen-year installment payments option provided under the Code.

Finally, with the relevant valuation data, the client may be able to arrange for financing to be obtained from his business or investment entities in order to satisfy the estate tax liability.

Buy-Sell Agreements

Closely related to death (but certainly not limited to that situation), the dispositive provisions of a buy-sell agreement among shareholders or partners are very dependent upon an accurate valuation. For example, how will the buy-sell agreement affect the FMV of the equity at issue for tax purposes? Will the IRS be free to disregard the stated value, thereby placing the taxpayer in a position where the purchase price paid for his shares or partnership interests is not sufficient to cover his estate tax liability?

Statute of Limitations

If a gift of an interest in a closely-held business entity is not adequately disclosed on a gift tax return, the limitations period within which the IRS may assess additional gift tax will not begin to run. “Adequate disclosure” generally requires submission of the appraisal for the transferred property.

Income Tax Considerations of a Transfer

Adjusted Basis

The valuation of a decedent’s assets is critical not only to determine the estate tax ability, but also because it determines the tax basis for the decedent’s properties in the hands of his estate’s beneficiaries.

This basis will enable the beneficiaries to claim depreciation or amortization deductions for any qualifying property, and will also reduce their gain on a subsequent sale of the property.

Compensation

If property is transferred by a service recipient (“SR”) to a service provider (“SP”) in consideration of the latter’s services, the SP must include the FMV of such property in his gross income unless the SR’s rights to the property are subject to substantial risk of forfeiture.

Where the SP’s rights to the property are subject to risk of forfeiture, the SP may, nevertheless, elect to include the FMV of such property in his gross income for the year in which the property was received so as to prevent the subsequent appreciation in such property from being treated and taxed as compensation upon the lapse of the risk of forfeiture.

By the same token, the SR will have to withhold employment taxes based upon the FMV of such property where the SP is an employee of the SR.

Non-Qualified Deferred Compensation

The determination of FMV also figures prominently in various forms of non-qualified deferred compensation.

Where the SR grants the SP an option to acquire shares of stock or other equity interest in the SR, the strike price at which the option is exercisable may not be less than the FMV of the equity interest on the date the option was granted.

In the case of stock appreciation rights (“SAR”), when the SP has satisfied the conditions precedent to his being able to exercise the SAR, he becomes entitled to an amount equal to the difference between the FMV of the underlying shares on the date the SARs were granted and their FMV on the date of exercise.

Another similar situation is the case of a phantom stock plan, under which a SP will be entitled to receive an amount equal to the FMV of the underlying stock upon the achievement of certain benchmark events, such as the sale of the business.

In each of these situations, the failure to set a strike price or to establish a starting point at FMV may result in the deferral of compensation that, if not structured properly, could expose the SP to immediate income taxation with respect to the amount of the deferral (e.g., the spread in the case of an in-the-money option); it may also expose the SP to a 20% excise tax.

Reasonable Compensation

Speaking of compensation, a taxpayer-SR may deduct as an ordinary and necessary business expense a reasonable allowance for compensation paid to a SP for personal services actually rendered.

Although some may not view the determination of compensation for services as falling within the ambit of an appraiser’s job, that is only because they fail to recognize that the process of determining the FMV for services – i.e., reasonable compensation – involves the consideration of the amount that would be paid for like services by like enterprises under like circumstances (to use the language of real property appraisers, “comparables”).

Cancellation of Indebtedness 

In general, when a creditor cancels a debt owing to the creditor, the amount of this cancelled debt is treated as income to the borrower. However, there are exceptions to this general rule, some of which are dependent upon the valuation of the borrower’s property.

For example, gross income does not include any amount that would otherwise be includible by reason of the discharge of the taxpayer’s indebtedness if the discharge occurs when the taxpayer is insolvent. In that case, the amount excluded from gross income cannot exceed the amount by which the taxpayer is insolvent. In order to determine insolvency, the taxpayer must be able to establish the total FMV of all of his assets.

Under another exception, where a corporation transfers its stock, or a partnership transfers a capital or a profits interest, to a creditor in satisfaction of indebtedness, the borrower-entity is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the transferred stock or partnership interest.

Stay tuned for Part II, tomorrow.