A Time for Planning?
It’s late August – again. As usual, many business owners are looking forward to having all of their employees back at work and ready to make the final push for a successful year.[i] Others, nearing retirement, and who may be contemplating the arrival of another winter, are considering whether it is time for a move to a warmer climate.[ii]
It may also occur to some of these owners – especially after having vacationed with their children and grandchildren – that it was time they planned for the transfer of their business interests or investment assets. Most of them have already been making so-called “annual exclusion gifts” to various family members.[iii] They may recall their advisers having told them about the greatly increased federal estate and gift tax exemption,[iv] and they may even remember that this benefit is scheduled to expire after December 31, 2025, if it is not eliminated sooner.[v]
With these thoughts in mind, a number of these business owners will visit their advisers to discuss the available estate and gift planning options, especially with respect to equity interests[vi] in their business. The advisers will likely tell them about outright gifts and gifts in trust,[vii] about installment sales and sales to grantor trusts,[viii] about GRATs,[ix] and about the importance of having a shareholders’ agreement or a partnership/operating agreement in place prior to making such transfers.[x]
Hopefully, the business owner will also be alerted to the possibility that regulations which were proposed by the IRS in 2016 – but withdrawn in 2017 – may be reintroduced after 2020;[xi] in that case, they could present a significant impediment to the tax efficient gift or testamentary transfer of interests in a closely held business.
The business owner is also likely to hear about the importance of retaining a knowledgeable and experienced appraiser, and of having a well-reasoned appraisal report to support any transfer of their business interests, whether by gift or by sale.[xii] A recent Tax Court decision illustrated the wisdom of this advice.[xiii] In the process, it also raised an interesting valuation issue.
Parent owned 49-percent of the voting stock, and 96% of the non-voting stock, of an “S” corporation[xiv] (“Corp”) that operated a lumber mill. The remaining outstanding shares were owned by members of Parent’s family.
Under the terms of a buy-sell agreement, the shareholders could not transfer their Corp stock unless they did so in compliance with the agreement. Any sale of stock that caused Corp to cease to be an S corporation would be null and void under the agreement, unless Corp and shareholders of a majority of its outstanding shares gave their consent. If a shareholder intended to transfer their Corp stock to a person other than a family member, the shareholder had to notify Corp, which had the right of first refusal with respect to those shares. If Corp declined to purchase the shares, the other shareholders were given the option to purchase them. If Corp or the other shareholders exercised their option to purchase shares, the purchase price would be the fair market value of the shares. Fair market value, for purposes of the agreement, was to be mutually agreed upon or, if the parties could not come to an agreement, determined by an appraisal. Under agreement, the reasonably anticipated cash distributions allocable to the shares had to be considered, and discounts for lack of marketability, lack of control, and lack of voting rights had to be applied in determining the fair market value.
Corp was the general partner of a limited partnership (“Partnership”) that invested in, acquired, held and managed timberlands which provided Corp’s inventory. Partnership was organized for the purpose of ensuring Corp with a steady stream of timber, and sold almost all of its production to Corp.
The ownership of the two entities was almost identical. In addition, Corp’s management team (paid by Corp) managed Partnership, and Partnership paid Corp a fee for administrative services, including human resources, legal services, and accounting. The companies also lent money to each other (for which interest was charged), sending cash where it was most needed.[xv]
Beyond that, Corp used Partnership’s property to secure bank loans that were integral to Corp’s operations,[xvi] and that allowed it to maintain cash flow at times when a loan would not otherwise have been available. The companies were joint parties to these third party credit agreements, but the loans were reported on Partnership’s books because its property served as collateral.
Corp had broad powers as the general partner of Partnership, including the powers to buy, sell, exchange, and encumber partnership property. The limited partners (which included Parent and members of their family) did not participate in Partnership’s management, although they had the right to vote on the continuation of the partnership, the appointment of a successor general partner, the admission of an additional general partner, the dissolution of the partnership, and amendments to the partnership agreement. The unanimous consent of all partners was required to admit an additional general partner or to dissolve Partnership.
Under the partnership agreement, limited partners were restricted in their ability to transfer their interests in Partnership. No transfer of partnership units was valid if it would terminate the partnership for tax purposes. The consent of all partners was required for the substitution of a transferee of partnership units as a limited partner. A transferee who was not substituted as a limited partner would be merely an assignee of allocations of partnership profits and loss. Limited partners were also subject to a buy-sell agreement, which restricted transfers of their interests in Partnership. It mirrored Corp’s buy-sell agreement.
Parent formulated a succession plan with the goal of ensuring that the business remained operational “in perpetuity.”[xvii] As part of this plan, Parent created various trusts (including generation skipping trusts) for the benefit of their issue.[xviii] Parent gifted over 26-percent of their Corp voting shares and all of their non-voting shares to these trusts. Parent also gifted over 70-percent of their limited partnership interests in Partnership to the trusts.
Parent filed a federal gift tax return[xix] for the above transfers. The return included an appraisal report which valued the Corp voting and non-voting shares, as well as the Partnership limited partnership units.
The IRS examined Parent’s return and determined that the fair market values of the equity interests transferred had been understated on the return.
Parent petitioned the U.S. Tax Court.[xx]
The Court began by explaining that the fair market value of property transferred as a gift is “the price at which it would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” The willing buyer and seller are hypothetical persons, not any specific or named person.
Closely Held Business: Relevant Factors
When determining the fair market value of unlisted stocks for which no recent sales or bids have been made, the Court explained, several factors should be considered, including: the company’s net worth, its earning power and dividend-paying capacity, its goodwill, the economic outlook in the industry, its management and its position in the industry, the degree of control of the business represented in the block of stock to be valued, and the value of stock in similar, publicly traded companies.[xxi] When determining the fair market value of an interest in a partnership, the value of the partnership’s assets may be considered, along with the same factors considered in determining the fair market value of stock.[xxii]
Income vs Asset Approach
Parent’s valuation expert (“Expert”) valued Partnership and Corp as going concerns,[xxiii] and relied on an income approach – specifically the discounted cash-flow method – and a market approach in valuing the units of Partnership and Corp that were transferred as gifts. Expert determined a value for these interests on a non-controlling, nonmarketable basis, after adjustments and discounts.
The IRS also valued Partnership as a going concern,[xxiv] but relied on an asset-based approach – specifically, the net asset value method – and a market approach in valuing one Partnership limited partnership unit. After applying adjustments and discounts, the IRS determined the value of Partnership on a non-controlling, nonmarketable basis.
The Court noted that it was not bound to follow the opinion of any expert where it was contrary to the Court’s own judgment, stating that it may adopt or reject an expert’s opinion in whole or in part. The Court emphasized that valuation is a question of fact, and the factors considered in determining value should be weighed according to the circumstances in each case.
The Court continued by describing the three generally accepted approaches that are used to value equity interests in closely held businesses: the income approach, the market approach, and the asset-based approach.
The income approach uses either the direct capitalization method[xxv] or the discounted cash-flow method[xxvi] to convert the anticipated economic benefits that the holder of the interest would stand to realize into a single present-valued amount.
The market approach values the interest by comparing it to a comparable interest that was sold at arm’s length in the same timeframe, accounting for differences between the companies by making adjustments to the sale price.
The asset-based approach values the interest by reference to the company’s assets net of its liabilities.
The Court observed that, when valuing an operating company that sells products or services to the public, the company’s income receives the most weight. When valuing a holding or investment company, which receives most of its income from holding debt, securities, or other property, the value of the company’s assets receives the most weight.
The primary dispute between the parties was whether Partnership should be valued using an income approach or an asset-based approach.[xxvii]
Operating vs Holding Company
Parent contended that Partnership was an operating company that sold a product – logs – and, therefore, should be valued as a going concern with primary consideration given to its earnings.
The IRS, on the other hand, contended that Partnership was a holding company and, therefore, the value of its underlying assets[xxviii] should be given primary consideration in the valuation.
Parent rejected the IRS’s asset-based valuation because there was no likelihood of Partnership’s selling its assets.
According to the Court, not all companies lend themselves to be characterized as simply an operating company or a holding/investment company. The Court gave the example of a company whose real property plays a significant role in its income-producing operations.
When valuing an interest in a company that has aspects of both an operating company and a holding or investment company, the Court stated that it would not “restrict [its] consideration to only one approach to valuation”.
The Court pointed out that Partnership’s timberlands were its primary asset, and they would retain and increase in value, even if Partnership was not profitable on a year-to-year basis. Therefore, it may be appropriate to consider an asset-based approach in valuing an interest in Partnership. However, the Court noted that Partnership was also an operating company that planted trees and harvested and sold the logs; it also expended significant time, effort and capital to ensure that its operations were efficient.
Thus, Partnership was different from a holding or investment company, such that an income approach may be appropriate in valuing an equity interest therein.
A Combined Approach?
The Court concluded that Partnership had aspects of both an operating company and an investment or holding company. Because Partnership did not fit neatly into either category, the Court suggested that a valuation that combined consideration of Partnership’s earnings and of its assets, and that weighted each appropriately, may be necessary.
An asset-based approach, the Court stated, necessarily assumes access to the value of Partnership’s underlying assets through a hypothetical sale. The likelihood that Partnership would sell its assets went to the relative weight to be given an asset-based approach; the less likely Partnership was to sell its assets, the less weight would be assigned to an asset-based approach.
The parties disagreed on two points that were relevant to whether Partnership would sell its assets: (1) whether Partnership could sell its assets, and (2) whether Partnership should be considered separately from Corp, or as a single business enterprise with Corp.
The IRS contended that circumstances could arise in which Partnership could and would sell its assets. Parent argued that holders of limited partnership units could not force a sale of its assets under the partnership agreement, and that Corp, which had the exclusive authority to direct Partnership to make such a sale, would never exercise that authority. The IRS argued that this position inappropriately considered specific – rather than hypothetical – buyers and sellers.
The Court disagreed with the IRS. It stated that Corp’s exclusive authority (as general partner) to exercise control over Partnership under the partnership agreement, its interest in Partnership’s continued ownership of the timberlands, and the restrictions imposed on limited partners under the partnership agreement, did not depend on how many limited partners Partnership had or who they were.[xxix] These restrictions, the Court stated, applied to the interest because of the partnership agreement and the rights held by Corp, and would have been taken into account by any hypothetical buyer and seller of a limited partner interest.
A Single Operation?
As further support for its position, Parent argued that Partnership and Corp should be treated as a single business operation even though they were separate legal entities.
The IRS countered that because Partnership and Corp were separate legal entities, the Court should treat them as such and ignore their interdependent relationship when valuing them.
The Court found that Corp’s continued operation as a lumber mill company depended on Partnership’s continued ownership of timberlands, and there was no likelihood that Corp, as Partnership’s general partner, would direct Partnership to sell its timberlands while Corp continued operations as a mill. In addition, the two entities had almost identical ownership, and they shared administrative staff.
Expert’s report was consistent with the “single business” approach in that it ignored the intercompany debt between the two entities (and the free flow of cash between them as needed), because he regarded them as interdependent parts of a single enterprise, or as “simply two pockets of the same pair of pants.”
On the basis of these facts, the Court concluded that Partnership and Corp were so closely aligned and interdependent that, in valuing Partnership, it was appropriate to take into account its relationship with Corp and vice versa. Contrary to the IRS’s objection, the Court found that this approach did not ignore the status of the two as separate legal entities,[xxx] but recognized their economic relationship and its effect on their valuations.
The Court, therefore, concluded that an income-based approach was more appropriate for Partnership than was the IRS’s net asset value method valuation.[xxxi]
Thoughts on the “Single Business”
The Court accepted Expert’s analysis on most of the issues raised by the IRS with respect to the valuation of Corp and Partnership, including as to valuation approach, tax-affecting and discounting. Expert’s report was detailed and thorough, and was supported by empirical data, whereas the IRS failed to consider several items and, therefore, was unable to mount much of a challenge.
There is one point, however, that warrants a closer look: Parent’s and Expert’s argument – with which the Court agreed – that Partnership and Corp should be treated as a single business operation for valuation purposes, including for purposes of determining whether an income-based valuation method should be applied.
It is not uncommon for what may be thought of as single trades or businesses to be operated across multiple entities for various legal and economic reasons. For example, the real estate out of which a corporate business operates may be owned by a separate LLC; a business that has branches in different states, may have organized each branch as a separate corporation; a restaurant and its related catering business, that share centralized purchasing and accounting, may be formed as separate business entities.
Moreover, the Code provides a number of opportunities for the owners of separately organized businesses to combine or aggregate the separate entities for a specific tax purpose. For example, the regulations under Sec. 199A of the Code allow individuals to aggregate two or more qualified trades or businesses and to treat them as a single business for purposes of applying the “W-2 wage” and the “UBIA of qualified property” limitations, and potentially maximizing their Sec. 199A deduction;[xxxii] and Sec. 469 allows grouping of activities into a single activity for purposes of applying the material participation test, provided the activities form an “appropriate economic unit.”[xxxiii] In each of these examples, the degree of common ownership and control is considered, as are the interdependencies of the business activities.
But for estate tax purposes?
The only “estate tax aggregation” provision that immediately comes to mind is found in Sec. 6166 of the Code. Under this section, if the value of an interest in a closely held business that is included in a decedent’s gross estate exceeds 35-percent of the adjusted gross estate, the tax attributable to such interest may be paid in installments.[xxxiv] The term “interest in a closely held business” includes an interest as a partner in a partnership, and an interest in a corporation, carrying on a trade or business if 20-percent or more of the total capital interest in such partnership, or 20-percent or more in value of the voting stock of such corporation is included in determining the decedent’s gross estate. For purposes of applying the 35-percent test, interests in two or more closely held businesses, with respect to each of which there is included in determining the value of the decedent’s gross estate 20-percent or more of the total value of each such business, shall be treated as an interest in a single closely held business.[xxxv]
The decision discussed above, however, was not concerned with the proper application of a statutory or regulatory aggregation rule, but with a valuation principle that considered the economic reality of the business relationship between two related entities in determining their respective values. At least in concept, such a valuation addresses the facts as they are on the valuation date[xxxvi] – it is not required to “correct” the results of the relationship by reallocating payments or revising terms to reflect arm’s-length dealing.[xxxvii] Thus, a hypothetical buyer or seller of either Corp or Purchaser would have recognized the benefit of Corp’s position as a general partner of Partnership, as described above.
Would the result have been the same if Corp had not been the general partner of Partnership? Under different circumstances, would the IRS be justified in arguing for a greater value where the dealings between related entities resulted in favorable, below-market terms for the entity being valued? Or would such a position only be supportable where the entity favored has the ability to veto any change in the relationship; i.e., has the ability to prevent the substitution of arm’s-length terms?
Bottom line: if the values reported on a business owner’s gift or estate tax returns are to withstand IRS scrutiny, it is incumbent upon the business owner’s advisers to learn as much as they can about the intercompany dealings among the owner’s related business entities, and it is imperative that the transferor-owner provide their advisers and their appraiser[xxxviii] with as much information as possible regarding such dealings.
[i] Some are glad to have their golf-playing partners back in the office.
[ii] I only think such thoughts on February mornings, after I’ve removed the ice from the car and shoveled the driveway. I come to my senses when I’m back at my desk.
[iii] Currently set at $15,000 per individual recipient for a gift of a “present interest” in property. IRC Sec. 2503(b).
[iv] Currently set at $11.4 million per individual donor. IRC Sec. 2010.
[v] I.e., the larger exemption amount will not be available for gift transfers and testamentary transfers made after that date. IRC Sec. 2010(c)(3)(C). Query whether it will disappear even sooner if there is a change in Administration and in the Senate after the 2020 elections.
[vi] The transferred interests may be voting or non-voting interests.
[vii] Trusts for the benefit of one’s descendants may be a good option for creditor protection, if structured properly.
[viii] The grantor-parent would continue to pay the income tax on the trust’s income. IRC Sec. 671.
[ix] Grantor retained annuity trusts. IRC Sec. 2702. A good vehicle in a low interest rate environment.
[x] Such an agreement can help ensure that the business is operated smoothly and that it (or the value it represents) remains within the family; it may include transfer restrictions, special voting requirements, buy-sell arrangements (including the purchase of life insurance), drag-along rights for the parent-donor, etc.
[xi] Again, depending upon the 2020 election results.
[xii] The selection of the transfer vehicle will depend, in part, upon the owner’s desire to continue receiving cash-flow from the transferred interest.
[xiii] Est. of Aaron U. Jones v. Comm’r, T.C. Memo 2019-101.
[xiv] IRC Sec. 1361.
[xv] A not-uncommon practice in the case of related closely held businesses.
It is not clear whether promissory notes were issued to evidence this indebtedness.
[xvi] It is unclear whether Corp paid Partnership anything for this service or accommodation.
[xvii] According to an old Yiddish proverb, “Man plans, God laughs.”
[xviii] Basically, descendants. Probably a so-called “dynasty” trust.
[xix] On IRS Form 709.
[xx] IRC Sec. 6213.
[xxi] Reg. Sec. 25.2512-2(f)(2); Rev. Rul. 59-60.
[xxii] Reg. Sec. 25.2512-3(a).
[xxiii] Meaning that each had the ability to continue operating for the foreseeable future.
[xxiv] The parties did not dispute that Partnership was a going concern. Rather, they disagreed on whether it was an operating company that sold a product or a holding company that simply held its assets as an investment for its partners.
[xxv] In brief, taking the net cash flow or net operating income for a single year, then applying a capitalization rate (derived from market data); the method assumes that both these elements remain constant in perpetuity.
Any income-based approach is all about the time value of money.
[xxvi] Basically, the present value of future cash inflows and outflows over a period of time (which are projected, and account for expected changes), then applying a discount rate.
[xxvii] The parties also had several other points of dispute, including the propriety of “tax-affecting.” https://www.taxlawforchb.com/2019/05/determining-the-value-of-an-s-corp/
The Court found that Expert more accurately took into account the tax consequences of Partnership’s flow-through status than did the IRS for purposes of estimating what a willing buyer and willing seller might conclude regarding its value. Expert’s adjustments included a reduction in the total tax burden by imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of a future dividend tax avoided that an owner might enjoy.
[xxviii] Its timber.
[xxix] In other words, their right to vote on the continuation of Partnership would not avail them in the face of Corp’s opposition and the requirement of a unanimous vote.
[xxx] Though, under these facts, any creditor of either entity would likely have had a good shot at reaching the assets of both entities.
[xxxi] The IRS also contended that Parent’s 35% discount for lack of marketability was excessive. The Court disagreed, pointing out that Expert’s report included a detailed appendix which explained the reasoning behind the discount for lack of marketability, including both empirical and theoretical models. Expert then discussed the effect that restrictions on transferability (like the ones in the buy-sell agreement) have on a discount, as well as the other factors considered by the courts in determining discounts. The IRS did not even consider the restrictions in the buy-sell agreement.
[xxxii] Reg. Sec. 1.199A-4.
[xxxiii] Reg. Sec. 1.469-4.
[xxxiv] Up to ten installment payments, beginning on the fifth anniversary of the original due date for payment of the tax.
[xxxv] IRC Sec. 6166(c).
[xxxvi] The date of the gift or the date of death, as the case may be.
[xxxvii] It is implied that such a situation would not arise in the case of unrelated persons, who are assumed to have acted at arm’s-length with one another.
[xxxviii] Perhaps with the latter having been retained by the adviser under a Kovel arrangement?