Updated: Aug 21, 2024
The statistics are surprising to those who learn that the percentage of business owners who have a realistic notion of what their companies are worth is as small as 5% to 10% or that the number of owners who have undertaken estate or buy-sell planning as they work towards retirement is as small as 10% to15%. At best, 1 of 10 owners know their company’s value and 1 of 7 have a succession plan.
As we approach the 2024 elections, five developments are coalescing to create a perfect storm of potential wealth evaporation associated with exiting business owners.
1. Historical aversion of business owners to properly plan for retirement/business succession at a time of unprecedented wealth transfer over the next 10 to 15 years
2. The stated plans of the democrat party to raise taxes across the board
3. The possible lapse of Trump tax cuts includes reversion to dramatically lower estate tax thresholds in 2025
4. Unfavorable court rulings from the US tax court
5. Other new reporting/transactional burdens such as FTC ban on non-competes, the Corporate Transparency Act, etc.
Planning with Foresight is Key
Given the vast amount of wealth which is about to be transferred across generations over the next 10 years and knowing that nearly 80% of owners plan to sell their firms to fund retirement, it is difficult to understand why so many are leaving their financial fate to chance. The wealth transfer of baby boomers, an estimated $70 trillion, is now underway with around 10,000 owners retiring each day.
Financial and wealth advisors are in a unique position to show owners why a proactive and accurate valuation of their companies is an absolute must. Such a valuation will:
Tell them—objectively—how much value they need to add to the business.
Provide you and them the ability to monitor progress toward their ultimate financial objective.
Determine whether and when they can reach their Exit Objectives.
Provide a basis for estimating and minimizing tax consequences particular to the exit path the owner chooses.
The greatest benefit of knowing the value of a client’s business now, before the owner is ready to exit, is to motivate them to act when action can do some good.
Unfavorable Court Ruling: The Connelly Case
When planning for retirement or the sale of a business, both tax laws and rulings from the Tax Court must be properly understood and appropriately addressed. A recent unanimous Supreme Court ruling (Connelly, As Executor of the Estate of Connelly v. United States) has created additional worries for business owners and the wealth advisors and exit planners who serve them.
Taxpayers Ignored Appraisal Requirements
A high-profile case which went from a District Court to the Court of Appeals on the way to the final Supreme Court finding discussed shortly. One interesting issue arose which considered whether a buy-sell agreement was able to fix the value of corporate shares for estate tax purposes. The agreement at hand provided two mechanisms for determining the price of redeemed shares. The principal mechanism was a “Certificate of Agreed Value” to be issued at the end of each year. Failing this, two or more appraisals were to be obtained. The parties in the subject case did neither.
The District Court found that the agreement did not fix the price of the shares as required to meet the Section 2703 requirements in the Internal Revenue Code. First, under the statutory requirements of Section 2703, there (i) must be a bona fide business arrangement, (ii) the agreement must not be a device to transfer property to the family for less than full adequate consideration, and (iii) the agreement must be comparable to similar agreements negotiated at arm’s length between unrelated parties. In addition, there are the following additional requirements under the Section 2703 regulations and the case law. There must be a fixed and determinable offering price, the agreement must be binding both during life and after death, and there must be a bona fide business reason. There must not be a testamentary disposition for less than full and adequate consideration.
The District Court concluded that although the buy-sell agreement was a bona fide business arrangement, it was a device to transfer property to the family for less than full and adequate consideration, in part because the parties ignored the appraisal requirement under the agreement and basically picked a $3 million redemption price for the shares. This finding magnifies the importance of having some type of valuation analysis performed in support of this type of share redemption.
Redeemed Value Was Less than FMV Due to Insurance Proceeds Omission
In a landmark decision this June of 2024, the Supreme Court affirmed a lower Court’s decision upholding the IRS position on how life insurance proceeds and redemption obligations should be treated for federal estate tax purposes. The case revolved around the valuation of a small, family-owned business by two brothers who sought to keep the firm in the family in the event of death or disability for one of the owners.
The brothers (Michael, the decedent, owned 75% and Thomas, the survivor, owned 25% of the shares) entered into a buy-sell agreement which allowed the surviving brother to buy the deceased brother’s shares. Because Thomas declined to directly purchase his brother’s interest, the corporation itself was required to redeem the shares using life insurance proceeds.
The corporation was valued as an operating business at around $4 million, leading Thomas to view Michael’s shares as being worth about $3 million (75% of $4 million). The IRS, though, took the view that the corporation was worth about $7 million, pointing to the additional $3 million in insurance proceeds, making Michael’s shares worth a bit more than $5 million (75% of $7 million). The court’s position resulted in an additional estate tax liability of nearly $900K.
Justice Thomas explained that “a simple example proves the point [that] an obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds.” The court posited a corporation holding $10 million in cash and nothing else, with each of its 100 shares accordingly worth $100,000 ($10 million divided by 100). Suppose, it writes, that the corporation redeems twenty shares from one of the shareholders. “To redeem [the] shares at fair market value, the corporation would thus have to pay $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares).”
For the court, that example pretty much resolves the case.
“Because a fair-market value redemption has no effect on any shareholder’s economic interest, no willing buyer would have treated [the] obligation to redeem … as a factor that reduced the value of those shares.”
The court dismissed the taxpayer argument “that the redemption obligation was a liability” as something that “cannot be reconciled with the basic mechanics of a stock redemption.” Justice Thomas queried, “[i]f a very interested buyer showed up the day after Michael died, would Thomas sell the business to him for 3.86 million?” He further noted “the value has to go someplace. The 3 million goes someplace. Does it go into the value of the remaining stocks? And if it is there, why isn’t the appropriate valuation $6.86 million?”
Although acknowledging that the decision “will make succession planning more difficult for closely held corporations”, the court pointed to a variety of transactional devices that might have worked better and stated that “[e]very arrangement has its own drawbacks” and “its own tax consequences.” Because the arrangement the brothers selected “meant that [the corporation] would receive the proceeds and thereby increase the value of Michael’s shares,” the surviving brother must be taxed on that increased value.
Solution? Plan Ahead and Work with Financial Advisors
Despite the apparent impediments to transferring business wealth in the US today, there are many strategies available to business owners who plan ahead to minimize the state and federal tax burden at the time of exit. In short, these options include:
1. Review Buy-Sell Agreements – Structure buy-sell agreements with tax implications in mind as the details can significantly affect estate tax liabilities. Inclusion of some type of appraisal requirements are necessary to meet Section 2703 requirements.
2. Consider Cross-Purchase Agreements – A cross-purchase agreement, where shareholders, or trusts for the shareholder’s benefit, purchase insurance on each other, can avoid complications by ensuring insurance proceeds go directly to purchasing shares without inflating estate tax values.
3. Evaluate Life Insurance Policies – Analyze the impact of life insurance policies on your estate’s valuation. Ensure policies are adequately valued and structured to avoid unexpected tax liabilities.
4. Seek Professional Valuation – Regularly obtain professional valuations to understand potential tax impacts and ensure compliance with current market values and tax regulations.
5. Consult Tax and Legal Experts – Work with estate planning attorneys and tax advisors to review and update your corporate agreements and structures, ensuring they align with current laws and court rulings.
6. Plan for Future Tax Obligations – Set aside funds or develop financial strategies to cover potential tax liabilities arising from share redemptions or corporate obligations.
7. Document Agreements Thoroughly – Maintain detailed records of all agreements, valuations, and transactions to support your estate’s position in case of disputes with the IRS.
This recent Supreme Court decision in Connelly v. United States brings into clear view the critical importance of diligent estate (and gift) tax planning. By proactively implementing, reviewing and structuring buy-sell agreements, evaluating life insurance policies, and consulting with various financial professionals, business owners can optimally surf today’s stormy seas of exit and retirement planning. Business owners on Main Street and in the Middle Market are facing lower exemptions, higher tax rates, more onerous tax court findings and ongoing economic uncertainty which can only be addressed via proper planning.
26 U.S. Code § 2703 – Certain rights and restrictions disregarded
U.S. Code
(a)General rule For purposes of this subtitle, the value of any property shall be determined without regard to—
(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or
(2) any restriction on the right to sell or use such property.
(b)Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
(1) It is a bona fide business arrangement.
(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
(3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.
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