Transition Structure, Family Dynamics and Tax Impact Come into Play

Key Takeaways:
  • A professional business valuation provides the documentation needed to support ownership transfers, satisfy tax requirements and reduce the risk of family disputes.
  • The right succession plan depends on family dynamics, deal structure and long-term financial goals, making an objective valuation a critical decision-making tool.
  • Understanding the true value of the business helps protect both generations by supporting fair ownership decisions, tax planning and a smoother transition.

 

Transferring ownership of a business to the next generation is a moment of pride for many family business owners. But even if the younger generation has actively worked in the business, succession is not just a matter of handing over the keys. There are many issues to consider, including the deal structure, impact of the deal on the parents’ tax situation and the business’s forward-looking financial situation, among others. 

An independent business valuation can help settle some of these questions and provide documentation that provides rationale for the deal, even if the business is being gifted to the owners’ children. 

No matter what the deal structure is, a professional business valuation is a key tool to help establish a rational basis, as well as settle or avert any family disagreements about the transition. 

Different Transition Structures

  • Gifting — When the owners gift a business to their child or children, a report must be made to the IRS documenting the value of the deal, even though no money has changed hands. Typically, this requirement is satisfied by a professional valuator’s value conclusion and a detailed report supporting it. Additionally, the parents must file a Form 709 gift tax return reporting the value of the transition as a gift. 
  • Installment sale — With an installment sale, where the younger generation will pay an agreed-upon price for the business over a set period of time, a valuation provides the basis for all parties to agree on the market value and the price of the business. Additionally, even though there is no specific form to be filed, the IRS will eventually want to know how much was paid for the business, so a valuation report should be kept in the business records.  
  • Combination gift/sale structure — This type of transaction is essentially a sale that features deep discounts for control and marketability, so the valuation will be at the lower end compared with similar businesses. It may be utilized for a business that is being transferred to multiple members of the next generation, most likely siblings, where one or more siblings will be minority owners without a controlling interest. In this situation, a professional valuation can help determine the individual value of each new shareholder’s share. 

Family Dynamics 

Family dynamics can play a significant role in determining the structure of a succession transfer, as well as who gets a controlling interest and who doesn’t. Perhaps one child has worked steadily in the business for many years, and another child hasn’t, but the parents want the benefits of ownership to accrue to each of their children. They may transfer a 51% controlling interest to the child who has worked in the business and a 49% minority interest to the other child. Again, a professional valuation is essential in this situation to properly determine the value of each child’s holdings. 

Not all parents want to gift a business to their children, preferring instead that the children have some skin in the game. If the children share in the risk of business ownership by having to finance their ownership, the parents reason, the children will be more likely to make good business decisions and be successful stewards of the family legacy. 

In other cases, timing may become an issue. If you are ready to retire and succeed the business to your child, but the child isn’t ready due to maturity issues or need for further education, there are ways to structure the transition to protect the business and give the next gen owner time to grow into their new role. 

There is no one right answer. What is right for one family is not necessarily right for another. However, regardless of how the transition is structured, all parties need to have a clear understanding of the value of the deal and how it affects them. 

Working with a professional valuator, as well as a team including your attorney, your accountant and your wealth advisor, can help mitigate a variety of issues that arise around family dynamics, such as: 

  • When you have a child who is not involved in the day-to-day business, how do you pass on part of your estate to them? You don’t want to gift a business to a passive investor who hasn’t contributed anything to its success. A valuation can help you determine how to equalize the structure of your estate to reflect each child’s role, whether active or passive. 
  • An objective professional valuation can help avoid making emotional assumptions about the value of the family business. Dad may think his business must be worth more than his competitor, Pete’s, business, which sold last year. But there may be factors that Dad doesn’t know about Pete’s business, such as the investment Pete made in upgrading equipment and the fact that Pete kept his debt under tight control. 
  • How do you let go? Many times, parents choose a deal structure that allows them to remain in control of the business — to their detriment. If a son or daughter is given a controlling interest in the business and the ability to build something successful, they need to be able to run it the way they see fit. Moreover, if Mom or Dad retains control and then passes away, the children may be unprepared to be in charge. There are ways to structure a transition so the successors receive minority interests over time, eventually becoming controlling owners after several years. 

Collaboration During Business Valuation 

Professional valuators work with the owners during the valuation, including the successors. A draft of the valuation report is shared with all parties, which is particularly important if the son or daughter has primarily worked on the operational side of the business and hasn’t been involved on the financial or management side. 

A valuation is forward-looking providing a forecast of profits and cash flow based on current performance and anticipated market conditions. It can provide peace of mind to all parties about the soundness of the transition. 

If the owners are still unsure about the structure of the transition, the valuation expert, in coordination with the company’s tax advisor, will provide information about interest rates that the IRS will determine as fair if the younger generation needs to finance the deal.  

The valuation report will also look at any buy-sell agreements to provide clarity for the professional team. In the absence of a buy-sell agreement, a valuation professional will be able to review the agreement drafted by the family’s estate planning attorney to consider its valuation impact.  

Gift and Estate Taxes: Key Issues 

Under the new permanent estate and gift tax laws, both parents have a lifetime exemption of $15 million — for a total of $30 million (as of the date of this article). Gifting a business, or even part of a business, can deplete that lifetime exemption significantly and impact future gifting of non-business assets if the value of the business approaches the exemption limit. 

This is why it is essential for the parents to have a wealth advisor, an estate planning attorney and a tax advisor on the professional team that is guiding the business succession. If the parents have significant non-business assets in their estate, gifting the business as a whole could hinder their ability to utilize gifting later to manage the size of their taxable estate. 

Risks of Not Obtaining a Valuation 

There are numerous risks associated with not obtaining a professional business valuation for the transition of a family business, including: 

  • Lack of documentation representing the fair market value of the company that may be required by the IRS if there are future tax issues. 
  • Lack of documentation that may settle any family disputes that could arise in the future. 
  • Risk of overleveraging or underfunding the next generation of owners. 
  • Outdated buy-sell agreements that may result in insurance mismatches or unenforceable terms. 

Questions? 

Transitioning your business to the next generation of family owners is a proud and happy event, but one that must be approached with clarity. A professional business valuation is a key tool that will provide insight about your business that will be needed during the transition process, and that will aid your team of professional advisors. 

If you would like to discuss obtaining a professional business valuation to guide the transition of your family business to the next generation of owners, contact an Adams Brown advisor.