Valuation Adjustments – An Opportunity for Planners

Categories: Wealth Transfer Strategies

As Seen In NAPFA Advisor, June 2010
Article By: Joe Luby, CFP®

Valuation adjustments, often referred to as “discounts,” should be on the strategy list of every comprehensive planner. They can provide amazing tax efficiencies for clients, offer opportunities to collaborate with other professionals and allow the planner to bring an advanced planning technique to high net worth clients and prospects.
Traditional securities, such as stocks, bonds and mutual funds, are easily valued due to the liquid nature of their markets. Other non-traded assets are a little more difficult. What is the current fair market value (FMV) of your client’s real estate holdings? What is the current FMV of the partnership interest they own with their golf club buddies that invested in a private placement startup company? What is the FMV of your client’s personal business? See what I mean.
The FMV of these assets is important for a number of reasons. It directly affects your clients’ net worth statement. It affects their total estate value and the gift tax value when these assets are transferred to other family members and/or charity. It affects business transition and succession planning including the possible sale of a family run business. It could impact their liquid securities portfolio allocation. However, I submit that very few clients, much less their advisors, know the FMV of these assets or even a close approximation thereof.
Why not? Much of it has to do with an unspoken cost/benefit analysis. If a client isn’t considering the sale of a particular illiquid asset such as an apartment building, then knowing that asset’s current FMV may not seem important and thus not worth the expense of an appraisal. The same thinking applies to their personal business. Does it really matter if the business is worth $8 million or $10 million today assuming no pending sale or transfer activity? Maybe not, but how does one plan for the long-term financial security of the family if they don’t know the value of all the assets at their disposal?
Dr. Carl Sheeler, valuation expert and managing partner of Alison Appraisals and Assessments, Inc. in San Diego, has an interesting view on this topic. He gives presentations around the country about business valuation and often raises the question: how does one manage the liquid assets for a business owner without taking into account the value of the business from a prudent investor viewpoint? Dr. Sheeler also gives multiple examples of how performing a current business valuation and analysis has lead to significant opportunities to increase the value of the business by finding areas of weakness and improving them.
The FMV of an illiquid asset must be determined by a qualified appraisal as defined in the tax code. The qualified appraiser must take into account relevant factors that may impact the FMV of the asset being valued such as whether it is readily marketable should the owner wish to sell. The appraiser must consider the asset’s liquidity and whether the owner has a controlling interest which allows them to force distributions or otherwise control the management and operations of the asset. These are the three most common principles that give rise to a valuation adjustment or discount: lack of marketability, lack of control (minority interest) and lack of liquidity. There are other factors that apply in various circumstances, but these are the most common and universal. Assuming a minority interest in an illiquid non-traded asset, it is very likely that the appraiser will report a FMV that is less than net asset value (NAV) or book value.
Assume your client Bill owns 25% of a small manufacturing firm. The other 75% is owned in equal parts by three of Bill’s college buddies. They started the company together in their senior year and have been in business for 15 years. The company is profitable and growing. Bill decides to cash out by selling his minority stake and move to the mountains to become a ski bum. On paper, the book value of the company is $10 million, meaning that Bill’s stake is theoretically worth $2.5 million. But can he actually sell it for $2.5 million?
The three partners don’t want Bill to leave the company and also don’t have the means currently to buy him out. So Bill must find a buyer for his interest. After several months of putting out feelers, he finally has someone interested. However, they will not pay Bill’s asking price of $2.5 million and instead demand a FMV analysis. The qualified appraiser reviews the company in great detail including the history of the firm, the projections for the future, any contractual obligations between the partners which may be defined in the partnership agreement (LP) or operating agreement (LLC) or other documents (C or S corporation). The appraiser takes into account that the new buyer will be purchasing a minority interest in the company and will not be able to out vote the three close college friends that have been in business together for 15 years. The new buyer will not easily be able to convert his ownership to cash should he decide to sell at a later date. Thus the appraiser’s FMV report comes back reflecting a 50% valuation adjustment or discount and quotes the current FMV of Bill’s 25% stake as $1.25 million.
This is usually where negotiations between Bill and the potential buyer will begin. Bill may argue for higher than $1.25 million due to a variety of factors such as future cash flows, business opportunities or growth forecasts, etc. Whatever number they agree on will be the true FMV of Bill’s interest. The appraisal was the best estimate absent any actual sale transactions to compare.
How can we use this knowledge and opportunity for clients? Knowing that illiquid assets may be subject to substantial discounted valuations, planners can assist clients in a variety of wealth transfer situations to reduce the tax impact that would otherwise apply. For example, assume Bill was not selling his interest but rather transferring it to several trusts for his children’s benefit and assume that gift tax would normally apply. In the example above, Bill is able to use the lower $1.25 million figure for reporting the value of the gifts rather than the $2.5 million book value, saving him one half the gift tax due.
The most common application of valuation adjustment principles is by use of a family limited partnership (FLP) or family limited liability company (FLLC). These entities are regular LPs or LLCs except they are owned entirely within a particular family (i.e. no outside non-family partners or members). The common scenario has Mom and Dad, the senior generation family members and source of wealth creation, establish the FLP/FLLC and transfer various assets into it. Typical holdings include real estate, family businesses, other partnership interests, securities portfolios, etc. Mom and Dad then transfer minority interests in the FLP/FLLC via gift or sale to various children, trusts and/or charities. Prior to the transfer they retain a qualified appraiser to perform an analysis and determine the FMV of the minority interests to be transferred.
The same valuation adjustment principles described above apply to these interests. Lack of marketability, lack of control (minority interest) and lack of liquidity all factor in to the FMV report for the FLP/FLLC interests. Adjustments or discounts in the range of 25% to 50% are common on these assets.
FLPs/FLLCs can be combined with numerous other wealth transfer techniques to maximize the benefit from the valuation adjustment. For example, a client may transfer discounted assets to a charitable lead trust (CLT) that has been “zeroed out” for gift tax purposes meaning that no taxable gift is made upon funding the trust. The client’s children or trusts for their benefit might be the final principal beneficiary of the CLT. Any amount above the discounted FMV will ultimately pass tax free to the heirs. Discounted assets can be used to fund grantor retained annuity trusts (GRATs) in the same fashion.
Another common scenario involves the sale of discounted assets to intentionally defective grantor trusts (IDGTs). As a grantor trust, the tax consequences of activity in the trust flow back to the grantor. So the sale of assets from the grantor to the trust does not result in a taxable event, nor does interest paid on a note from the sale generate taxable income since the grantor is selling an asset to himself for tax purposes. The IDGT will typically have the grantor’s children as beneficiaries. Instead of gifting assets to the trust and incurring gift tax or using up the grantor’s lifetime gift tax exemption, the grantor will sell minority interests in the FLP/FLLC to the IDGT in exchange for a promissory note payable over a term of years. The sale price is the FMV as determined by the appraisal rather than NAV or book value of the FLP/FLLC interest.
For example, assume a 10% FLP/FLLC interest with a book value of $1 million. The FMV as determined by qualified appraisal reflects a 40% adjustment down to $600,000. The client will sell the FLP/FLLC interest to their IDGT in exchange for a promissory note of $600,000. The additional $400,000 of value is effectively passed tax free to the next generation.
Planners and clients can also use private investment fund structures such as those offered by Jagen™ Investments to achieve the same type of discounts. Private investment funds apply the same valuation adjustment principles found in FLPs/FLLCs without the hassle of forming, funding and managing a FLP/FLLC. The administration and qualified appraisal process are handled at the fund level which saves the client and their advisors time and money. In addition, these funds are typically IRA compliant which means clients can get discounted valuation advantages on Roth conversions and other IRA distributions reducing the tax impact of those transactions.
The devil is always in the details so you must ensure that you work with very qualified advisors including attorneys and CPAs who understand this area in depth. There are common mistakes to avoid and many best practices to implement in order to achieve the desired outcome for your clients. These are important because the IRS, for obvious reasons, is not a fan of valuation adjustments and loves to challenge them when possible. Assuming the proper steps are taken in establishing and operating the FLP/FLLC, it often comes down to an argument over what the FMV really is. In many cases this results in a judge trying to decide between the taxpayer’s valuation expert and the IRS’ appraiser, where the judge must determine whose valuation analysis is most accurate. It is not uncommon for judges to find the actual FMV somewhere in the middle between the two experts numbers (i.e. taxpayer’s appraiser says 45% discount, IRS’ appraiser says 15% discount, judge goes with 30%).
This may also be the best time to implement valuation adjustment strategies with high net worth clients because we don’t know what Congress will do with the estate tax just yet. There are proposals floating around that would limit or disallow discounts in various circumstances. If you have clients and prospects that could benefit from discount valuation planning it is best to move quickly to implement these strategies ahead of any potential changes down the road.

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