Tax Secrets of the Wealthy: Book value to value your business

It can be dangerous to your tax health

Business owners — most of them readers of this column — call me with all kinds of what’s-my-business-worth questions. It’s amazing that most business owners don’t have a clue as to the real value of their businesses.

You’ll like this story. A column reader (Joe) called to hire our firm to help him prove that book value was the right price to be used to buy out his 50 percent partner (Ralph). Joe was willing to pay $5 million for Ralph’s half of the business. the book value was almost exactly $10 million.

Ralph wanted $6 million. Not a penny less. Joe sent us a small stack of financial data. Our valuation of the business clearly showed that the cash flow of the business would easily pay off the $6 million price. Fact is the total business had a real fair market value in the range of $14 million to $16 million. Joe — although he didn’t think it or know it until we did a proper valuation — actually was getting a bargain purchase at $6 million. On the other hand, if Ralph had hired a professional business appraiser, he would have asked for (and been entitled to) a $7 million to $8 million price.

Interesting enough, the Joe/Ralph scenario was played out in the courts back in 1992 (Lauder vs. Commissioner, T.C. Memo. 1992-736). Here’s the story: Joe Lauder (his real name) entered into a buy/sell agreement with his family. What was the price for the stock? You guessed it — book value. The court held that the agreement was binding while Joe was alive and after he died. It also held that the agreement served the legitimate business purpose of preserving family ownership and control of the corporation. But for estate tax purposes, the court ruled that the book value did not reflect the price that would have been negotiated by two unrelated parties. The book value was only $615 per share and was the value Lauder’s estate wanted to use. Thumbs down held the court, pinning a $1,485 value per share as determined by a professional appraiser.

What’s the lesson to be learned from these two real-life stories? Forget about book value when you want to determine the real value of your business. Whether you are buying or selling a business or want to whip the IRS for tax purposes, work with a professional appraiser.

Here’s a hint if you are a family business and must have your business professionally valued because you want to sell/transfer the business to one or more of your kids (typically kids who work in the business). You’ll like what you are about to read.

First, recapitalize (replace your current voting stock with voting and non-voting stock) your business … say 100 shares of voting stock and 10,000 shares of non-voting stock. Here’s the tax magic that results: You keep the voting stock (100 shares) and control for as long as you live. Transfer the non-voting stock (10,000 shares) to the kids. You’ll get three discounts for tax purposes: (1) Discount for general lack of marketability; (2) Discount for minority interest (automatic, since the stock can’t vote); and (3) A discount because a share of non-voting stock is obviously worth less than a share of voting stock.

Let’s say the discounts total 45 percent. What does this do for you? The answer is really a gift from the IRS. A business valued at $1 million is only worth $550,000 for tax purposes — a $10 million business only $5.5 million for tax purposes. If the business is properly valued — easy to do — by a professional appraiser, the IRS never (in my experience) complains.

Wait, it even gets better. Sell your non-voting stock to an intentionally defective trust (IDT). The entire transaction is tax-free to you and the kids [or an unrelated buyer, for example, your employee(s) or other third person(s)].

Remember, done right — and it’s easy to do — the tax savings for you and your family are huge.

© 2008 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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