One of the most important factors to consider in any business succession plan is the timing of the transition of ownership. Whether a sale or a gift (or combination of the two), no transition should occur before the next generation of leaders is identified and developed. However, a business owner should not unduly delay once the succession planning stars have aligned.
Interest Rates
Many planning techniques for business succession plans work best in a low interest rate environment. A full discussion of these techniques is beyond the scope of this article. In general, however, a lower interest rate environment is beneficial for succession planning because lower interest rates allow for better opportunities for the seller to finance the sale of equity or allow for smaller payments if a GRAT (grantor retained annuity trust) is utilized.
A transfer also may be preceded by a distribution to the ownership group that is financed through a borrowing. A “leveraged dividend” or “leveraged distribution” will allow the transferring owners to extract value from the business, and the balance sheet leverage will depress the value of the equity being transferred. Obviously, lower interest rates translate into a greater amount that can be borrowed.
Finally, a succession plan may involve the transferee borrowing funds from a third party (such as a bank) so that the transferor is paid in full at the closing of the transaction that implements the transfer of equity. In this case, lower interest rates clearly benefit both parties – the seller can expect a higher purchase price due to low rates and the purchaser can be more confident in borrowing funds if a lower interest rate applies to the repayment of the loan.
Income Tax Issues
Income tax rates have risen considerably in recent years. In addition to the increase in capital gains rates, most business sales will result in the application of the 3.8% Net Investment Income surtax, raising the effective federal tax rate to 23.8%. Pennsylvania’s 3.07% income tax rate will also apply, and there is a risk this tax rate will increase as well. It is unlikely we will see any significant retreat in tax rates given the level of government debt and amount of entitlement programs that need to be funded (don’t forget that increasing interest rates will increase the borrowing costs of the federal, state, and local governments, which in turn will lead to an increase in the consumption of tax revenues for debt service).
Another consideration is that business transfers often are seller financed. Normally, the seller elects the installment method of reporting his or her gain on the sale so that the taxable gain – and tax due – matches the receipt of installment financing payments by the seller. Pennsylvania does not allow installment reporting for sales of personal property such as stock, partnership interests, or LLC interests, so a sale before Pennsylvania’s income tax rates rise could be important in a larger transaction.
Finally, if there is an installment sale, the death of the note holder can present note holder challenges to the note holder’s estate. If your Will provides for the debt to be forgiven, then there will be “debt cancellation” income to the estate, which could create a tremendous income tax burden for the estate. So, getting started sooner rather than later (and with lower interest rates) hedges against this risk.
Valuation Rules
Generally speaking, the transfer of a family business involves the transfer of equity interests that qualify for a valuation discount for lack of marketability and lack of control. For example, the current owner of a corporation or LLC would transfer non-voting ownership interests (the lack of control discount), and transferability of those interests would be restricted by a “buy-sell” Agreement (the lack of marketability discount).
Under section 2704 of the Internal Revenue Code, the Treasury Department is granted the authority to issue regulations that disregard certain “restrictions” in determining the value of a family owned business if the restriction does not really reduce the value of such interest to the person receiving the business interest. In general, any restriction that decreases the value of an equity interest is disregarded for transfers between family members if the transferor and transferee end up with control of the business as a result of the transfer. An important exception is that a restriction imposed by state law cannot be disregarded. For example, state law restrictions on the rights of limited partners must be respected.
A high ranking Treasury official indicated earlier this year that proposed regulations would be issued in the Fall that expand the reach of section 2704. Specifically, the category of restrictions that are ignored for valuation purposes will be expanded. While it is not clear what the substance of the proposed regulations will be, there is little reason to believe that the proposed regulations will be taxpayer friendly. There is also a risk that the proposed regulations will be effective when released instead of when finalized after the comment period and that existing entities will not be grandfathered under the new regulations.
The loss of valuation discounts could be a significant blow to tax efficient succession planning. Although the threat of the proposed regulations should not be the sole reason to act, it may be the reason that pushes a succession plan to the finish line.
Conclusion
A succession plan takes years to put into place. There are many tax, financial, and, most importantly, family considerations that need to be addressed. Nevertheless, it is important to act upon a plan once the plan is in place. Forces outside of your control, such as interest rates and tax laws, could derail a plan before it is implemented.
