Are You Valuing Your Business Correctly for Estate Planning?

Insights from Jason A. Lederman, head of Stein Adler’s Private Wealth Services team.

My clients consistently underestimate the value of their businesses. During my client onboarding process, I send a questionnaire, which includes questions about assets. More often than not, clients with large operating businesses that are worth millions of dollars forget to include the ownership of their business in their schedule of assets. On an intuitive level, this makes some sense. They take a salary, but the business itself reinvests excess working capital into its operations. Company profits, capital assets and good will, after all, belong to the business… right? Well, not really.

As far as the IRS is concerned, stock or other ownership interests in closely held businesses are assets that must be valued and included on an estate tax return. The valuation of business interests can be looked at in different ways, i.e., by reference to market comparisons, income or sales, subject to minority or other discounts, etc. However, one way or another, all ownership interests in businesses must be valued.

Smart clients who operate businesses with partners often will try to maximize value in their businesses and think through business succession by entering into a buy-sell agreement. Such an agreement usually provides that a living partner (in a cross purchase arrangement) or the business itself (in a redemption arrangement) agrees to buy the ownership interest of a predeceased partner at some agreed upon price. Liquidity for the purchase is often provided by separate life insurance contracts taken out on the lives of all partners.

Until the unanimous Supreme Court decision in Connelly v. Commissioner, most estate planning lawyers interpreted the law to say that, in a redemption situation, proceeds of the life insurance were *not* to be considered an asset in valuing the company. The rationale, basically, is that the incoming proceeds are cancelled by a liability in the form of a payable to the predeceased partner’s family. The Supreme Court has now clarified that life insurance proceeds *must* be included in the company valuation, which potentially increases the value of the predeceased business owner’s estate, thereby increasing his or her estate tax liability.

This poses a big problem for clients with businesses who, sometimes, do not give much thought to the 40% or 50% marginal rate estate tax awaiting their families. Will the life insurance provide enough liquidity to pay the tax? If not, what will happen? Can anything be done to plan around or limit tax exposure? These and related questions are what estate planners think about in planning for business owners. Sometimes we help families deal with these issues when they have not been planned for, which can be time-consuming, inefficient and not maximally effective.

If you own a successful business, you are good at what you do. But don’t forget to surround yourself with a team with the right skills to deal with tax issues and save your family headaches in the long run.