Business Valuation Can Create Foundation for Succession and Estate Planning
Reduction in Estate Tax Exemptions May Impact Family Businesses
Most business owners think of obtaining a business valuation when they are considering selling the company. But for many family-owned entities – including family farms – a business valuation can be an essential part of succession planning and estate planning.
A myriad of estate tax laws, succession planning factors and family dynamics come into play when a family starts planning to transition its legacy business to the next generation. Ensuring that the estate is handled appropriately to minimize or avoid substantial federal estate taxes, as well as structuring a plan that treats family members equitably, often starts with a business valuation.
You probably would never consider selling a family legacy business to a third party without first knowing what it is worth. In such a case, you would obtain a business valuation.
The same logic applies to succession planning even if the legacy business will be kept within the family. Establishing the value of the legacy business enables the owners to achieve several goals:
- Creating an estate plan that minimizes or avoids federal estate tax by taking advantage of spousal portability.
- Treating all family members equitably if only one child will inherit the legacy business.
- Motivating younger family members to become involved in the business or farm once they understand its value.
- Making improvements in the business or family farm that can enhance its value.
Owners often think they have a good idea what their business or family farm is worth based on transaction prices of recent sales in their local area. But many hidden factors can affect a valuation, such as the condition of equipment and other assets, the strength of the financials and the health of the markets the business serves. Valuation can be estimated for certain purposes, but an estimate does not allow you to depreciate assets. A real business valuation can be used to support tax depreciation and deductions.
Very rarely do spouses die at the same time, so business owners with estates valued in the $4 million to $6 million range need to pay attention to what’s known as spousal portability. Since the federal estate tax exclusion, which stands at $12.06 million for 2022, applies to each partner, the total exclusion for a married couple is $24.1 million. The portability rule means when the first spouse dies and does not use his or her full estate tax exemption, the remaining exemption can be added to the surviving spouse’s exemption and used when they die.
With exemptions as high as they are right now, most taxpayers don’t need to worry about federal estate taxes. However, President Biden has included a significant reduction in the estate tax exemption in his tax proposals for the past two years. Even though Congress has failed to act on the proposal, there’s another issue on the horizon. The current exemptions are due to expire in 2025, at which time they would be cut in half. With property values soaring, many business owners and family farm owners will find their estates beyond the exemption levels and subject to the federal estate tax, unless they use the portability rules.
Knowing the value of your business is an essential part of estate planning when owners find their estates bumping up against the exemption levels.
Treating Family Members Equitably
In family legacy businesses, often one member of the younger generation emerges as the likely business leader, even if other siblings work in the business. In cases where a single child will inherit the business, owners may want to obtain life insurance to leave comparable wealth to the non-inheriting siblings as a matter of equitable treatment. Knowing the true value of the business helps determine how much insurance is needed.
Similarly, if the legacy business is left to all the siblings equally, but only one sibling really wants to work in it, he or she may want to buy out the other siblings. Again, a fair market value determined by a business valuation helps determine the buy-out price and preserve family harmony.
Even before serious succession planning begins, establishing a baseline business valuation is a good idea for contingency planning in a family legacy business. It’s not pleasant to think about, but sometimes bad things happen. A natural disaster strikes the business or farm and destroys the assets, or an owner becomes ill and dies young before the next generation is old enough to take over.
Every business should have a contingency plan, but for family businesses and family farms, a contingency plan is a must. A baseline business valuation can help support the tactics and contingencies in the plan, such as determining amounts of life insurance or compensating professional managers who can nurture the business while younger family members are learning the ropes. Updating the disaster plan and the business valuation periodically – say, every five years – can help keep it realistic and respond to changing markets and changing family priorities.
Motivating the Kids
What if you have an ambivalent child who is unsure whether they would want to continue the family business or farm? Bringing the kids along with a holistic point of view is helpful and involves talking to them about the direction and trajectory of the business and how they might contribute fresh ideas. Having the adults share such information with them can be energizing for young people, and letting a 20-year-old know how much the business is worth can go a long way toward motivating them about taking over.
Too often, learning the real value of a family business only happens after the owner dies and the next generation family owners find they can’t accomplish what they may have wanted – modernizing equipment, expanding into new markets – because the business is too undercapitalized to support their plans. Had a business valuation been done earlier, they may have had time to make improvements.
It is never too soon to plan for business succession and create an estate plan. If you would like to discuss how a business valuation can help get the process started, contact your Adams Brown advisor.