Impact and Opportunities for Estate, Gift, and Tax Planning

In a recent presentation, Brown Edwards' valuation experts broke down the complex world of business valuation into understandable components that every business owner should understand when working towards their estate planning or succession goals.

Business valuation combines both quantitative and qualitative factors - much like the sport of pickleball combines elements from different sports. We pull from various components of the fields of accounting, finance, and economics, along with qualitative factors that impact a company's value.

The valuation process utilizes three main approaches: the income approach, market approach, and asset approach. The income approach, often considered most important when valuing an operating company, focuses on a company's ability to generate future income or cash flow. When performing valuations, we typically analyze five years of historical financial data to identify trends that help estimate future performance.

A crucial part of the process involves normalizing financial statements. This means adjusting for items that don't reflect normal operations. For example, PPP loan proceeds during COVID represent a perfect example of a non-recurring item that needs to be removed from historical performance. Other common adjustments include excess officer compensation and related party transactions, such as non-market rent payments.

The market approach compares your business to similar companies that have been sold or are publicly traded. However, this approach can be challenging with some privately held companies because finding truly comparable businesses is difficult, and we often have limited data about private transactions. Due to this subjectivity, the market approach rarely receives primary weight in valuing private companies.

The asset approach is particularly relevant for asset-intensive operating businesses, asset holding companies, or real estate companies. This isn't just about looking at book value - we're determining the economic value of assets. Sometimes this requires bringing in specialists like real estate appraisers, mineral appraisers, or equipment appraisers to properly value specific underlying assets.

Working capital analysis is another important component. For instance, if your business has $10 million in cash but only generates $2 million in annual revenue, you likely don't need all that cash for operations. The excess would be considered a non-operating asset, similar to a beach house owned by the company that doesn't contribute to business operations.

A recent court case, Connelly versus United States (2023), has important implications for business owners with redemption agreements or stock purchase agreements. The court decided that life insurance proceeds received by a company add to its value, even if those proceeds are designated to buy out a deceased owner's interest. This ruling has led some companies to consider moving policies outside of the company structure.

For business owners considering the transfer of ownership interests, the Wandry Clause has become an important tool. This allows for a defined dollar amount of transfer rather than a specific percentage interest, with the actual percentage being determined once the final valuation is completed. However, the specific language in these documents is crucial - the phrase "as finally determined for federal gift tax purposes" must be included to avoid potential challenges.

Recent developments have also made it more acceptable to tax-effect the earnings of closely held businesses, S-corporations, and partnerships in valuations. While the IRS historically resisted this practice, recent court cases, including the Cecil case involving the Biltmore family, have provided precedent for tax-affecting.

Every business valuation is unique - the presenters noted that after performing hundreds of valuations, they've never seen two exactly alike. The estate planning process requires careful consideration of numerous factors and often benefits from a team approach, including CPAs, attorneys, and other advisors.

For business owners considering a valuation, it's important to understand that this process takes time and requires coordination among various professionals. Whether you need a valuation for estate planning, succession planning, or other purposes, working with qualified valuation professionals who understand these complexities is crucial for getting a defendable value for your business.

The most important takeaway is that business valuation isn't just about applying a formula or multiple - it's about understanding your specific business, its industry, its risks and opportunities, and how all these factors come together to determine value. With proper planning and professional guidance, you can ensure your business valuation meets your needs and stands up to scrutiny.