How to Reap Gains From Estate and Gift Tax Exemptions
Owners of small companies may want to act to transfer minority interests in their business to take advantage of current federal estate and gift tax law. Understanding and applying proper valuation protocols is key.
Late in 2010, Congress passed legislation that increased the lifetime estate, gift and generation-skipping transfer (GST) tax exemption to $5 million per individual or $10 million combined, including spouses. The exemption was indexed for inflation and increased the tax rates on such transfers from 35% to 40%. In 2013, the exemption amount increased to $5.25 million.
While these provisions and rates cannot automatically expire and revert to a less favorable law, future legislation could reduce the lifetime exemption or further increase the applicable tax rates. In fact, President Obama’s proposed federal budget for fiscal year 2014 recommends reducing the lifetime estate, gift and GST tax exemption to $3.5 million per individual and increasing the effective tax rates to 45%.
Given the uncertainty surrounding the estate tax, many owners of closely held companies may look to transfer noncontrolling or minority interests in their family business to the next generation or key employees in order to take advantage of the current favorable federal estate and gift tax exemptions. With the lifetime exemption for 2013 set at $5.25 million, business owners are able to significantly reduce, or eliminate altogether, the tax burden imposed on transfers of ownership interests made to or for the benefit of the next generation or key employees.
This is especially relevant within the security alarm services industry, of which more than 90% of participants are closely held businesses with fewer than 20 employees. Let’s take a look at how applying proper valuations of minority interests can help business owners allocate the wealth of an entity in the most judicious manner.
Particulars of Fair Market Value
It has been well established that the value of a security alarm services business in an acquisition by a third party is primarily a function of recurring monthly revenue (RMR). However, due to factors such as lack of marketability and lack of control, discounts from the total (or enterprise) value of such businesses are available when valuing the company in the context of fair market value for estate planning purposes.
For tax purposes, fair market value is the price at which interests would trade in a transaction between a hypothetical willing buyer and willing seller, each having full knowledge of all relevant facts and neither being under any compulsion to buy or sell. The buyer and seller are unspecified parties, operating at arm’s length, who agree upon a price. In the case of most intergenerational transfers, the price being paid is for a noncontrolling illiquid (not easily converted into cash), minority interest.
By way of example, consider a fictional security alarm services provider, K&M Alarm Co. LLC, which generates RMR of $200,000. Taking into account the implicit RMR multiples of recent public acquisitions — including Tyco Int’l Ltd.’s acquisition of Brink’s Home Security, GTCR’s buyout of Protection 1 and Ascent Capital Group’s purchase of Monitronics — the prospective acquirer might value K&M Alarm at an RMR multiple between 25x and 45x. This range in multiple would also consider other relevant factors, such as company size, local market share, customer attrition rate, etc.
Applying the midpoint of this range (35x) to K&M’s RMR results in an enterprise value of $7 million, above the taxable threshold for an unmarried owner. This enterprise value is the marketable, controlling interest value of the entity assuming all of its shares are sold in a single block. In order to convert this value to a minority interest basis, an allowance for lack of control is applied in order to remove the implicit control premium.
Control premiums reflect the relative attractiveness of an investment in the acquirer’s eyes. Buyers tend to pay up for businesses with brand names and market recognition, as well as for companies with a “critical mass” and heft. Smaller companies are perceived to be less valuable than larger companies, all other things being equal. Untapped borrowing power available from an unleveraged balance sheet is attractive, just as substantial looming capital expenditures and deferred maintenance would be viewed as negatives. Synergy, or the ability to combine two or more entities so as to create more overall earning power after the transaction than existed before, often warrants a premium.
Controlling Interest Explained
The owner of a controlling interest in a business has the power to direct the management of the enterprise, and if the interest is sufficiently large it also has the ability to singly authorize the sale, merger or dissolution of the enterprise. In contrast, the owner of a minority interest lacks all prerogatives of control, including any potential economic benefits that the owner of a controlling interest enjoys.
Minority interests are therefore worth less than a proportionate share of the enterprise value and, thus, a discount for lack of control is warranted. The application of such a discount results in the freely traded value of a company, or the price at which it would trade in an active public market. Discounts for lack of control can vary considerably, from less than 10% to more than 30%.
In the case of security alarm services companies, recent public transactions suggest that a discount for lack of control of about 25% might be appropriate. Applying this discount to the enterprise value of K&M Alarm results in a freely traded value of $5.3 million. This freely traded value makes no allowance for the lack of marketability inherent in a minority block of nonpublic equity, an important negative element of value.
The existence of a ready market for an investment is of definite value to the owner, or to a potential buyer, and an investment that possesses such a market is worth more than an otherwise similar investment that lacks such a market. Moreover, the underlying objective of a family-owned business often is to retain ownership of the company within the family. Thus, the shareholder/buy-sell or operating/partnership agreements of these businesses typically contain provisions severely restricting, and often prohibiting, the transfer of interests to persons outside of the family unit. This factor may increase the inherent lack of marketability of a closely held business.
In the case of a minority interest, discounts for lack of marketability generally range from 20% to 40%. Selecting a discount at the midpoint of this range (30%) would result in an aggregate fair market value for all of the equity of K&M Alarm of $3.7 million, on a nonmarketable, minority interest basis. This conclusion of fair market value, which represents a 47% discount from the enterprise value of $7 million, is the price at which transactions of noncontrolling interests would be valued at for estate planning purposes.
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