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Article added or updated:
09/05/2011 |
PROTECTING YOUR BUSINESS AND YOUR ESTATE
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08/07/05
By David M. Kauppi, CBI, President Mid Market Capital, Inc.
As Penn State professor William Rothwell ominously points out in the
forward to Exit Right: A Guided Tour of Succession Planning for Families
in Business Together, more than 40% of the people who run the closely
held operations that comprise 80% of the North American economy will
retire by 2007.
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Those businesses will either be sold to a third party or management
team, closed down, or passed on to the next generation, which is the
focus here.
Tax laws still favor home ownership with mortgage interest as a
tax-deductible expense. The government has also encouraged the passing
of a businessfrom one generation to the next with several favorable
estate and gift tax rulings. Estate planning attorneys have utilized IRS
ruling 5960 to minimize the estate and gift tax owed for a business
either gifted to or inherited by the next generation. The businessis
often placed in one or more LLC ’s and divided up into minority pieces to
take advantage of very substantial and legal minority discounts, often
as high as 40%.
A businessowner will have, for example, 4 children. Two sons will be
actively involved in running the businesses and two daughters have built
lives separate from the business . Because 85% of the value of the estate
is tied up in the value of the business , to be “fair” the businessis
gifted and willed to the four siblings in almost equal proportion.
Because the sons are running the business , they will get slightly more
of the businessand slightly less of the remaining estate. This gives
them majority interest in the business . After dad leaves the business ,
the two sons will continue to run and grow the businesswithout any
input or participation from their two sisters.
Typically the businessdoes not pay any dividends and the two sisters’
portions are non-liquid because there is not a good market for selling
minority stakes in a privately held business . There is generally a very
restrictive buy sell agreement that favors the majority holders. The
sisters have no idea what the “fair value” of the businessis, with
their only indication an official IRS gift tax or estate tax return with
40% discounts applied. If the enterprise value were, for example, $50
million and the two sisters owned a combined 40%, you would think that
they had an asset worth $20 million.
The only document they have seen, however, is the gift or estate return,
valuing their portion at only 60% of that number, or $12 million. The
brothers feel entitled to the lion’s share because the sisters had
nothing to do with building this business . The brothers pay themselves
big salaries and benefits and pay out little of no dividends. They may
approach the sisters with gift tax return and restrictive buy sell
agreement in hand and offer to generously buy out the sisters for a
combined 8 million, because that is “all the company can afford to pay.”
After this transaction takes place, let’s look at how dad’s estate was
fairly divided. Originally the brothers were left with 60% of the $50
million business , or $30 million and a minor portion of the remaining
estate. The sisters were left with 40% of the business , or $20 million
and the bulk of the remaining estate of $10 million. That appears to be
fair. However, the buyout of the sisters for a combined $8 million
results in an effective estate distribution of $42 million to the
brothers and $18 million to the sisters. This is not what dad intended,
but it happens all the time.
This is a very complex and emotional issue and there are no simple
answers. Generally, dad had his identity tied up in the businessand
wants it to live on through his sons. This is a noble, yet impractical
thought if all the siblings are not actively involved in the business .
The children often inherit the restrictive buy sell agreements that
favor the brothers running the businessand scare off investors that may
have been interested in a minority stake.
Much of the value from a privately held businessis derived from the
benefits of working in the business . There is the very real concern that
the integrity of the gift or estate tax businessvaluations will be
compromised if the sisters are bought out at a price approaching a
pro-rated division of total enterprise value.
Unfortunately, in most cases, nothing is done and as a result there are
literally hundreds of billions of dollars of minority interests in
privately held businessthat are providing little return or no return to
their owners. One of the keys to unlocking the liquidity in these
minority interests is for the businessowner to recognize this situation
prior to building his estate plan. Unfortunately, after the fact, a fair
outcome is contingent upon the majority owners honoring dad’s original
intent of fairness and working toward that end.
David Kauppi is a Merger and Acquisition Advisor with Mid Market
Capital, Inc. MMC is a private investment banking and businessbroker
firm specializing in providing corporate finance and business
intermediary services to entrepreneurs and middle market corporate
clients in a variety of industries. For more information or a free
consultation please contact Dave Kauppi at (630) 325-0123, email
davekauppi@midmarkcap.com or visit our Web page
www.midmarkcap.com.
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