Document View

Some of the reasons you may need to value your business include: gifts or a sale of the family business to the kids, death, or divorce. The wrong valuation can rob you and your family of hard-earned dollars. It can even cause your business to be sold to pay taxes. The author outlined five-step process for the best way to transfer your business to your kids. It is called the "tax-free transfer strategy." These are: 1. Recapitalize the company. 2. Have the company valued. 3. Take appropriate discounts. 4. Elect S corporation status if you are now a C corporation. 5. Transfer only the nonvoting stock to the kids using an intentionally defective trust.

Copyright Penton Media, Inc. Jun 2008

Do you own all or part of a closely held business? Like it or not, some day you'll have to value that business.

Some of the reasons you may need to value your business include: gifts or a sale of the family business to the kids; death (requiring valuation for estate tax purposes); or divorce (where valuation becomes an expensive legal battle). How about buying a business or selling your business to a non-family person? The wrong valuation can rob you and your family of hard-earned dollars. It can even cause your business to be sold to pay taxes.

Let's say you want to value your business because the time has come to transfer your business to the kids. Why? You want to slow down, the kids are ready (and, of course, want to run the show), and the estate tax monster will enjoy a big payday if you get hit by a bus. These are all good reasons, yet you are torn. Why? You don't want to give up control. Does all or any part of this apply to you or someone in your family?

If so, keep reading. You are about to be delighted at how easy it is to transfer your business to the next generation, save a ton of taxes and still stay in control for as long as you live.

About 90% of the calls we get from readers of this column (either from a business owner, one of the business owner's kids or their CPA or lawyer) involve valuing the business for a sale/gift or other transfer to the younger generation. What you are about to read is routine (for us). We've done it hundreds of times. It always works, it's easy to do, and best of all, the IRS is never a problem.

Let's run through an outline of the five-step process for the best way to transfer your business to your kids. We call it the "tax-free transfer strategy."

Assume Joe owns 100% (it can be any percentage) of Success Co.

Step 1. Recapitalize Success Co. A "recapitalization" is a fancy name for turning your old voting common stock (Joe owned all 200 shares of Success Co.) into voting (say 100 shares) and nonvoting stock (say 10,000 shares).

Step 2. Have Success Co. valued. I have written eight books on business valuation and have given dozens of lectures and seminars on the subject. If you shoot for the right valuation (not high or low), competent business valuation experts always seem to come very close to the same valuation for a profitable business.

Admittedly, non-profitable businesses are a challenge to value. Joe's business is profitable and was valued at 5.1 times pretax earnings. Whether you operate as a C corporation, S corporation or other entity, it does not change the value of the business. The appraiser's report valued Success Co. at $6 million.

Step 3. Take appropriate discounts. Joe is transferring only the 10,000 non-voting shares to his kids. The tax law awards you three separate discounts: a discount for lack of marketability and a minority discount (because the nonvoting stock has no vote, it automatically gets this discount). Also, the fact that a share of nonvoting stock is worth less than a share of voting stock wins you a third discount. Typically, the combined discounts amount to about 40%.

So, the value of Success Co.'s nonvoting stock is only $3 million for tax purposes ($5 million multiplied by 40% equals a $2 million discount).

Step 4. Elect S corporation status if you are now a C corporation.

Step 5. Transfer only the nonvoting stock to the kids using an intentionally defective trust (IDT). An IDT does two great tricks: First, it transfers all of Success Co.'s nonvoting stock to the kids tax-free. This is one big deal, saving about $800,000 in taxes for each $1 million of the stock price (in this case, real-dollar tax savings of $2.4 million). Second, because Joe keeps all of the 100 voting shares of Success Co., Joe remains in absolute control for as long as he lives. There are many variations of the tax-free transfer strategy to accommodate the endless number of various family and business circumstances that come up in real-life business succession situations.