The typical tv game shows allow only about 10 seconds for the contestant to give the right answer. Okay, try this quick quiz: what is the most valuable asset you own? Hands down, almost every business owner answers, “My business.” Good!
Next question: what’s your business worth? Silence! Yes, hands down, the most common answer is no answer — given 10 seconds or 10 months.
So what happens in real life when those same business owners or their families must value the business? Hey, things happen. Things like gifts of the family business stock to the kids; death, requiring valuation for estate tax purposes; or divorce, where valuation becomes an expensive tax battle. Or, how about buying or selling a business? The wrong valuation can rob you of hard-earned dollars. It can even cause your business to be sold to pay taxes.
There are three business valuation myths that I hear from business owners and their families when I consult with them.
First, the business is worth book value (usually this value is too low). Second, the value is eight to 10 times after-tax earnings (usually, this value is too high). Or, third, an S corporation is worth more than a C corporation (a corporation that pays income tax) because the S corporation doesn’t pay federal income tax (this is just plain wrong — there’s no difference in value).
Well, think about this: There are two piles of stock in front of you. One pile is made up of the likes of ibm, Microsoft and at&t, with a total value of $2 million. The second pile is the stock of Your Family Co., also worth $2 million, valued by the “right” (even the irs would agree) valuation method.
Think for a minute. Which pile is worth more? Right, the first pile. Just call your broker and you can have $2 million in your hands, less the broker’s commission, in just a few days. What about the value of the second pile - Your Family Co. stock? Well, the fact is that the courts give you a discount for general lack of marketability of about 35%, or about $700,000. That 35% discount will save your estate about $350,000 in taxes.
What’s the lesson to be learned? If your business is one of your most valuable assets, get a professional valuation of it done now!
Why? It is a necessary step in every tax plan that allows you to transfer your wealth to your family free of all estate taxes.
Your retirement plan
Most people think that qualified retirement plans (pension plans, profit sharing plans, iras, 401(k) plans, etc.) are the best thing since sliced bread. After all, a current deduction for contributions to your plan plus tax-deferred accumulation of earnings could never be a bad tax move. Right?
The clear answer is it all depends on: 1) whether you need the money and, in fact, use those plan funds for your retirement (a great tax deal); or 2) you turn out to be rich (my definition of rich is you are in the highest income tax bracket — 40% — and highest estate tax bracket — 55%).
If you are currently rich or become rich in the future, all of your qualified plan money, in the end, will be a tax rip-off. Why? How can this be?
Well, if you have $750,000 (or less) in all your plans combined, the irs will get 73%, your family only 27%. For every dollar over $750,000, the irs’ share jumps to 79.75%, your family’s share down to 20.25%.
It’s just a matter of arithmetic. All of your unspent plan dollars get hit with two taxes (income and estate). Those dollars over $750,000 get socked with an additional 15% excise tax. Sorry, but that’s the law. So, if you’re rich (by my definition), or likely to become rich, you are probably wondering if there is a way out of this tax trap.
Here’s one way: The annuity/insurance strategy. Suppose Joe has $1.75 million in his qualified plans. Joe (60 years old) is married to Jane (also 60). Suppose Joe has the plan trustee buy a joint and survivor annuity (continues to pay as long as either Joe or Jane is alive) that pays $130,000 per year. The income tax would be $52,000 ($130,000 times 40%), leaving Joe and Jane with $78,000.
They use $25,000 to make an annual gift to an irrevocable life insurance trust (ilit) that buys a $2 million second-to-die policy (on Joe’s life and Jane’s life). After both Joe and Jane are gone, the ilit will hold $2 million free of taxes for Joe and Jane’s family.
Not only was the full $1.75 million in the qualified plans replaced, but additional tax-free wealth was created. The variations on the Joe and Jane scenario are endless. The point of this article is that you don’t have to stand by helplessly while the irs robs you and your family of your qualified plan wealth.