Author: Gerald A. Shanker

Gerald A. Shanker, CPA/ABV, MST

Should Rules of Thumb Be Used to Value a Business?

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Should Rules of Thumb Be Used to Value a Business?I frequently receive requests to quickly value a business by applying a “rule of thumb”, that is, application of a simple formula to the gross or net income of a business to determine its value.  The value of a business is based on two factors: cash flow and risk.  Using a rule of thumb to value a business considers neither.

Rules of thumb are old wives’ tales of business valuation; no one knows where they come from or the basis upon which they were derived.

How rules of thumb get it wrong

As a simple example, consider two hypothetical businesses in the same industry (Company A and Company B).  Each has $2 million of sales and $400,000 net income.  Using a rule of thumb would result in both businesses having the same value.  But what if all of Company A’s sales came from a single customer, and Company B’s sales consisted of $100,000 each to twenty customers.  Which company is more valuable?  Company A clearly has more risk because the loss of a single customer would put it out of business.  However, this factor, and many similar factors, are never considered by rules of thumb.

In determining what they will pay for a business, investors consider projected cash flow and risk that projected cash flow will not be realized.  A fair market value buyer pays for cash flow; the greater the cash flow the more the buyer will pay.  Cash flow includes funds available for distribution during the period of ownership, as well as the amount received upon the sale of the business.  The cash flow is discounted at a rate based on risk; the greater the risk the higher the discount rate and the lower the business value.

Risks to consider

Risks common to many businesses include customer and/or supplier concentration, competition, lack of management depth, and product obsolescence.  This list is not all inclusive as most businesses are unique and may face other risks not mentioned.

We’ve got your back

Estimating the value of a business requires thorough analysis of the business, the industry, the marketplace, and the economy.   If you want to know the value of a business, don’t use a rule of thumb; engage a business valuation professional.  You will be glad you did.

Now Is the Time for Business Succession Planning

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According to several national surveys of closely held business owners, approximately three in five do not have any business succession plan in place.

At KRS, we specialize in advising owners of family and closely held businesses and our observations are consistent with the survey results.Now is the time for business succession planning

I am working with Joe, the owner of a profitable $75 million company, and we have been talking about succession planning for several years.  Joe is in his mid-sixties, in good health, and has no plan to retire in the foreseeable future.   Are you surprised that Joe has no succession plan for his business? Like many business owners, Joe can’t get his arms around the fact that having a plan doesn’t make retirement mandatory; it only protects the business (which is Joe’s most valuable asset) if he does.   Although we frequently discuss the importance of succession planning, Joe doesn’t seem to want to face the tough decisions involved.

Employee and customer concerns

Joe’s employees have been concerned about succession plans for quite a while.  When I met with him recently, Joe shared the fact that several of his major customers have also asked about his plans for the company.  Joe said that the customers don’t want to see the plan and don’t care about the financial arrangements, but they just want to know that the company will continue if something happens to Joe.  They want to know who will run the company if Joe can’t.  This is understandable, especially since the company is a major supplier for several customers.  The customers don’t want to risk interruption in product supply and they may reduce this risk by diversifying purchases among several suppliers if they don’t get answers, resulting in decreased revenue and profitability for Joe’s company.

Plan succession before it’s too late

Joe is the sole owner of his company, but succession planning is equally important in multiple owner companies.  In all cases, it is best to execute a plan while everyone is healthy and getting along.  When a triggering event occurs, it is usually too late.  If you are a business owner, review your succession plan today, and if you don’t have a plan, contact your attorney and CPA to start working on one.

Estate and Gift Tax Update: No Clawback After Increased Transfer Limit Expires

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Estate and Gift Tax Update: No Clawback After Increased Transfer Limit ExpiresThe Tax Cuts and Jobs Act of 2017 (“TCJA”) increased the lifetime estate and gift tax amount that may be transferred free from $5 million to $10 million per taxpayer, indexed for inflation.  This increased exemption applies to transfers made between January 1, 2018 and December 31, 2025.  On January 1, 2026, the lifetime exemption reverts to $5 million.

The IRS recently announced that the 2019 inflation adjusted exemption amount is $11.4 million, which allows a married couple to shield $22.8 million from transfer tax.

Because the increased tax exemption was temporary, there was uncertainty whether gifts exceeding $5 million made under these provisions would be clawed back into the estates of decedents dying after the 2025 expiration of the increased exemption amount.   In other words, if you made a $10 million gift in 2025 and died in 2027 when the exemption is $5 million, would your estate owe tax on the $5 million excess?

On November 25, 2018, the IRS answered this question with the issuance of proposed regulations, which indicate that gifts made before January 1, 2026, will not be clawed back to the estates of decedents dying after December 31, 2025.  The issuance of these proposed regulations strengthens a tremendous opportunity for the tax-free transfer of wealth, including ownership interests in closely held businesses.

Gifting closely held business interests

For those considering gifting closely held business interests, the process is more complicated than gifting assets such as marketable securities, the fair market value of which is readily determinable.  To gift a business ownership interest, a valuation of the business and the gifted interest must be performed by a qualified business appraiser.  Although 2025 is distant, those who wait until the last minute may encounter problems obtaining the required business valuation.  You may recall 2016, when the IRS proposed rules eliminating valuation discounts in estate and gift valuations.  There was a mad rush to get valuation reports completed, with limited capacity to complete this work.

We’ve got your back

If you have a large estate, this is a tremendous opportunity to save transfer taxes, which get to a 40% tax rate very quickly.  If your estate includes a closely held business, you would benefit by starting the process sooner rather than later. Once this opportunity is gone, it will be gone for good.  Contact your advisors today to get the process going.

Understanding Family Business Dynamics

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The Family Business – It’s Not Easy!

Managing a family business presents unique challenges not faced by businesses owned and operated by unrelated individuals.  If not addressed, family issues can divide the family and damage or destroy the business.  The larger the family, the more difficult it is to address the challenges. Ignoring the problems is Understanding Family Business Dynamicsnot a solution because they will not go away.

Statistics show that only 10 to 15 percent of family businesses make it to the third generation and only three to five percent make it to the fourth generation.

Typically, the business is started by the first generation and the founder’s children go to work in the business.  While the founder is alive and well, he or she takes the lion’s share of the compensation and profits and, most of the time, everyone appears to get along.  After the founder is gone, the second generation may continue to get along, but in many cases, it becomes a competition to see who can take the most and work the least. This puts a great deal of financial stress on the business because it now may have to support two, three or more families at the level that it previously supported one.

If the business does make it to the third generation, there are many more children involved and the problem grows exponentially, which almost always leads to its demise.

Compensating family members fairly

When it comes to family business, fair is not equal.  Although the business may be owned by many family members, the ones that actually work in the business must receive fair compensation for the jobs they do.  If one family member is the company’s top salesperson and her older brother is a part time worker, they should not receive equal compensation.  For a family business to succeed over multiple generations, there can be no entitlement.  The top performers can get a job anywhere; they do not have to stay in the family business.  If the performers leave, the entitled people are in trouble.

If after everyone receives fair compensation for their services, profits can be distributed to all owners, but only in an amount that will leave the business with enough cash to continue operations.  The business should never make the mistake of borrowing to make distributions.

To succeed in the end, business decisions must be right for the business and family decisions must be right for the family.  All of the children may not be interested in the business, or your youngest daughter may have more to contribute than your oldest son.  When it comes to the business, each family member should be evaluated based on what they bring to the table, not who their parents are or the order in which they were born.

We’ve got your back

At KRS CPAs, we know business is personal for you and your family. Learn more about our services for family-run businesses and contact me at 201.655.7411 or [email protected] to discuss your situation.

 

Is it Time to Update Your Buy-Sell Agreement?

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Buy-Sell AgreementsWhy should you have a buy-sell agreement?

Buy-sell agreements are among the most important agreements entered into by business co-owners. Notwithstanding the importance, many businesses do not have buy-sell agreements in place, and for many that do, the agreements are ambiguous and outdated.

An effective buy-sell agreement will eliminate or reduce the disputes arising from the death or retirement of a shareholder or partner, and the absence of an effective agreement may result in a protracted and costly dispute.

Is your existing agreement still effective?

To determine if an existing buy-sell agreement still works for a business, the value of the business should be calculated pursuant to the agreement, as if a triggering event had occurred. If there are not disputes over interpretation of the agreement, all parties believe the value result is fair, and the funding mechanism is in place to make the required payments, then the agreement is still acceptable.

Many companies that perform this exercise find the existing agreement to be unsatisfactory and in need of change.  It is much better to perform this exercise and identify problems with the agreement prior to occurrence of a triggering event.  In the evaluation of the results of this exercise, the parties will usually be open minded and fair, because they do not know if they will be a buyer or a seller when the actual triggering event occurs.

Types of buy-sell agreements

Buy-sell agreements generally fall into three basic categories: fixed-price agreements, formula agreements, and agreements requiring the performance of a valuation.

In fixed-price agreements, the price is specified in the agreement and is generally funded by an insurance policy, which was purchased at the time the agreement was executed. These agreements usually contain a provision requiring the fixed price to be periodically updated, but this provision is frequently disregarded.  Problems can arise when a triggering event occurs and the fixed price value has not been updated, the triggering event occurs after the expiration of the original term insurance policy, or the insurance benefit is no longer sufficient to fund the required payment.

In a formula agreement, the business value is generally determined by a relatively simple formula such as a multiple or percentage of net or gross income. The problem with formula agreements is that although the formula undoubtedly made perfect sense when the agreement was drafted, it may no longer be relevant or yield a result that bears any relationship to current value.  Furthermore, if net income is a component of the formula, each expense paid by the business can become the subject of a dispute.

Agreements that require the performance of a valuation by a qualified expert are most likely to yield a fair result and less likely to be the subject of a dispute, as opposed to fixed-price or formula agreements. This business valuation will require payment of professional fees, but these fees will be far less than those that would be paid in the event of a dispute.

Crucial agreement provisions

To avoid or reduce disputes upon occurrence of a triggering event, a buy-sell agreement should include the following provisions:

Standard of Value – This is an important element of a buy-sell agreement. In New Jersey, the most frequently used standards of value are fair value and fair market value.  An agreement that uses the generic term “value” and does not state the standard of value to be used will be the subject of dispute.

Triggering Events – Common triggering events in a buy-sell agreement include shareholder death, disability, and retirement. Other triggering events that should be considered are divorce, loss of business or professional license, or one’s continued failure to perform duties. The agreement should also distinguish between normal retirement at or within a range of ages stated by the agreement, and early retirement, which occurs prior to this age or range.

Valuation Date – Upon the occurrence of a triggering event, the valuation date is the effective date of the valuation. In performing the valuation, the valuation analyst can only use information that was known or knowable as of the valuation date.  This is important because an event occurring subsequent to the valuation date cannot be considered in the valuation.

Discounts and Premiums – Discounts for lack of control and lack of marketability frequently give rise to disagreement between business valuation practitioners, as well as between practitioners and the Internal Revenue Service. To avoid controversy over application and amount of discounts, consideration may be given to specifying a range or maximum discount in the buy-sell agreement.

Tax Effecting – Most closely held businesses operate as S corporations, partnerships, or limited liability companies taxed as partnerships. With limited exception, none of these companies pay federal or New Jersey income taxes.  They are commonly referred to as pass-through entities, because the business income or loss passes through to the owners for inclusion and taxation on their individual income tax returns.  Because pass-through entities do not pay income taxes, controversy exists whether income tax expense should be recognized in the valuation of these entities.  In drafting a buy-sell agreement, consideration should be given to expressly addressing tax effecting in the agreement.

Although it is impossible to anticipate every contingency and the source of every possible disagreement, an effective buy-sell agreement that is understood by all will go a long way in reducing disputes. Business circumstances change, and the buy-sell agreement may require periodic updating to reflect such changing circumstances.  It may be uncomfortable for the parties to discuss sensitive buy-sell agreement issues, but it is far worse to ignore them.  Issued not addressed do not go away, they become bigger and more often than not must be decided by a judge.  Review and update your buy-sell agreement today to avoid future problems.

We’ve got your back

If you have questions about buy-sell agreements or require an independent business valuation, contact KRS CPA partner Gerald Shanker at 201.655.7411 or [email protected]. You can also learn more from these buy-sell agreement and business valuation blog posts.

 

This article was originally published in the New Jersey Staffing Alliance July 2017 newsletter.

 

 

Set the Standard of Value in Shareholder and Partnership Agreements

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Set the standard of value in business agreementsDefining “value” can help you avoid negative consequences

Do the valuation provisions of your shareholder or partnership agreement specify a standard of value? If they do, is the standard of value “fair value,” “fair market value,” or something else? If the standard of value is not fair value or fair market value, does the agreement define the standard of value to be used in the event a valuation of the business is required?

The Internal Revenue Service defines fair market value as “The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Depending on the characteristics of the ownership interest being valued, minority and marketability discounts may be applied in valuing the ownership interest under the fair market value standard. The amounts of these discounts are fact sensitive, but discounts between 30% and 40% are not uncommon.

The impact of Brown v. Brown

The fair value standard was created in New Jersey in the case of Brown v. Brown 348 N.J. Super. 466, which is basically fair market value without discounts. The Court’s logic in this divorce case was that since the business was not being sold, the nontitled spouse should not suffer discounts in the distribution of marital property.

I have also been involved in a situation in which the agreement used the term “value” without definition. The parties in that dispute spent a significant amount of money on professional fees that resulted in an arbitrator deciding on a definition.

As you can see, the use of the single word “market” in the standard of value may have a huge impact on the valuation result. What does your agreement say, and is that what you intend?  Although discussing this issue and updating business agreements may be uncomfortable for some, it is far better than ignoring this issue, because doing so may very likely end up in litigation.

Is Your Business Ready for 2017?

Posted by Gerald A. Shanker on

Budget Projections Offer a Road Map to Success

I know that many businesses do not prepare projections, and among the ones that do, many do not use them to monitor results. Many believe that one of the most important steps in achieving personal goals is to write them down.  Preparing and monitoring a budget for your business is similar to a person listing his or her goals.  It introduces accountability, and can be used as a road map for the upcoming year.

preparing a 2017 budget can lead to financial successHow to prepare a budget projection

Using Microsoft Excel, list the months in columns across the top with a total column after December, and income and expense accounts on the left. Add a line for total expenses, and below that a line for net income. Insert formulas to sum total expenses and annual total income and expenses in the column to the right of December.

How much money do you want to make? Start the projection by entering the net income for each month of the year.  Next, enter projected monthly expenses for each month of the year.  Hint: the current year monthly financial statements will be a big help in estimating future expenses.  Now, enter a formula in each month of the sales line that adds net income and total expenses.  Based on projected expenses and budgeted net income, this will show you the monthly sales necessary to achieve this profitability.  Is this sales number realistic and achievable?  If not, which expenses can be reduced?  Does your business offer some products and services that are more profitable than others?  Preparing projections will force you to deal with these issues, and help you understand what drives the profits in your business.

Monitoring business performance

This process is not as overwhelming as it may seem. It will become much easier once you do it, and it is a valuable tool for monitoring business performance.  If you need help, contact your CPA firm; they have all the necessary historical data and the expertise in preparation of financial projections.

Treasury Proposes New Tax Regulations to Limit Discounts in Intra-Family Wealth Transfers

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Proposed Regs Would Impact Family Limited Partnerships

A popular tax saving technique used by wealthy taxpayers involves transferring assets such as real estate or securities to a family limited partnership, followed by a gift of partnership interests to family members. For estate and gift tax purposes, the value of partnership interest transfers are discounted, that is the transfers are reported for less than the value of the underlying partnership assets.

Discounts are permitted because partnership interests transferred are minority interests and also subject to significant restrictions, such as restrictions on transferability of the partnership interest.   Although the Internal Revenue Service has contested these discounts, Federal Courts have consistently allowed discounts in the 30% to 35% range for cases with the correct fact pattern.

intra-family wealth transfersLast week, the Treasury issued proposed regulations which, if adopted, would severely limit taxpayers’ ability to discount for intra-family wealth transfers. As they would affect family limited partnerships, the proposed regulations would require that in family controlled entities, many of the restrictions giving rise to discounts would be disregarded, effectively eliminating such discounts.  If discounts are eliminated, property transfers would be at fair market value of the underlying property, potentially resulting in increased federal estate and gift taxes.

Now Is the Time to Transfer Wealth to Family Members

The proposed regulations are subject to a 90-day public comment period, and will not go into effect until the comments are considered and then 30 days after the regulations are finalized. If you have a federally taxable estate and are considering wealth transfers, now is the time to do it.  Although there is uncertainty whether the proposed regulations will be adopted, and if they are adopted what the final version will say, the window may be closing on an opportunity for intra-family wealth transfers at a greatly reduced transfer tax cost.

If your estate is close to being taxable, act quickly and contact your tax advisors.  Once this window is closed, it may never open again.

Family Limited Partnership May Result in Significant Estate Tax Reduction

Posted by Gerald A. Shanker on

 

When Natale Giustina died in 2005, he owned a 41% limited partner interest in a partnership named Giustina Land & Timber Co. Limited Partnership. The partnership owned 47,939 acres of timberland and had 12 to 15 employees.  It earned profits from growing trees, cutting them down, and selling the logs.  The partnership had continuously operated this business since its formation in 1980.

Keyboard with hot key for estate planningAll limited partners in Giustina Land were members of the same family, or trusts for the benefit of members of the family. The partnership agreement provided that a limited partner interest could be transferred only to another limited partner or to a trust for the benefit of another limited partner unless the transfer was approved by the two general partners.

Although this case has a long history, the final decision determined the value based entirely on the partnership’s value as a going concern, which is the present value of the cash flows the partnership would receive if it were to continue operations. To put it another way, the value was determined based on the cash that a partner would receive from company operations rather than would might be received if the partnership assets were sold and the proceeds distributed to the partners.

For twenty-five years, general partners Larry Giustina and James Giustina ran the partnership as an operating business.  The court was convinced that these two men would refuse to permit someone who was not interested in having the partnership continue its business to become a limited partner.  Therefore, the only cash flow available to limited partners is the cash flow from operations. In determining the value of the partnership, the court applied a 14% capitalization rate to $6,333,600 projected normalized pre-tax cash flows to arrive at a value of $45,240,000.  This value is over $105 million less than the value of the partnership assets.

Why the taxpayer prevailed

Valuation cases, especially those involving family partnerships, are very fact specific. The taxpayer prevailed in this case because the business had operated continuously for twenty-five years, and there was no indication that it would not continue to operate.  The asset value was not considered the valuation because the only way that a limited partner could receive the asset value was on the dissolution of the partnership, which the court concluded was unlikely.

The taxpayer’s position in this case was strengthened by the fact that the partnership had been operating a business for twenty-five years. There is no requirement that a partnership operate for this length of time, however, a partnership formed shortly before death or asset transfer may be more susceptible to successful IRS challenge.  Also, to be respected by the IRS, a family partnership must have a business purpose.  Tax reduction does not qualify as a business purpose.

With proper planning, a family limited partnership may be an effective option to reduce estate and gift taxes. However, there are many technical requirements.  If you are interested in establishing a family limited partnership, you should consult a tax professional.

A Few Considerations Before Acquiring a Small Business

Posted by Gerald A. Shanker on

 

Whether you are buying a retail store, a franchise, or a service business, your due diligence and valuation process is not much different than that employed in purchasing a multi-million-dollar business.

The three main things you want to know when you’re considering purchasing a small business are:

  1. What is the amount and timing of money you expect the business to generate in the future?
  2. When you are ready to sell the business, how much will you be able to sell it for?
  3. What is the risk that items 1 and 2 will not occur as expected?

business valuationAs evident from these questions, the thing to focus on is the future. Although the seller will certainly focus on past performance, what happened twenty, ten, or five years ago is of little significance; you want to know what will happen in the future.

It is not uncommon for small business buyers and sellers to agree on a price based on an industry “rule of thumb” formula such as three times net income or 80% of gross revenue. Unfortunately, rules of thumb are nothing more than old wives’ tales.  Every business is unique and no business should be purchased based on a formula purported to be applicable to an entire industry.

Sometimes a buyer thinks that he or she is buying a business, but they are really buying a job. On the most basic level, the value of a business is based on the amount of money you can earn above and beyond the value of the services you provide to the business.  For example, if you earn $100,000 per year as an employee and you have the opportunity to purchase the business where you are employed, the purchase would make sense only if it gave you the opportunity to increase your earnings. Investing in a business is risky.  If you purchased the business and continued to earn the same $100,000, you would not receive any return for taking the risk, and would be better off investing your money elsewhere.

Get professional advice before buying a small business

Professional advisors understand the issues; know the questions to ask and procedures to employ to help you understand the business you are considering and what it is worth. The earlier in the process that you get professional advice, the better off you are.  Even if you just ask your CPA to look at the last few years’ tax returns of the business and offer comments and questions, you will save a lot of time and money, and get unbiased advice from an experienced professional.

For more about understanding how to value a business you’re considering purchasing, read “Why You Need a Business Valuation.“