(Excerpted from Chapter 20 of the book Buy-Sell Agreements for Closely Held and Family Business Owners)
This is not a book about how to value businesses. There are many books that address that topic, even some of mine. However, there are at least five valuation issues that can blow a buy-sell agreement process completely out of the water. I have seen each of the issues in disputed valuation processes where there have been disagreements over:
- The appropriate level of value
- Embedded capital gains for asset holding entities
- Tax-affecting of earnings in tax pass-through entities
- Marketability (or illiquidity) discounts applied to controlling interest valuations
- Key person discounts
The Appropriate Level of Value
We discussed the first process-busting issue, the appropriate level of value, in Chapter 14 so you are not only familiar with this issue already, but you know the best way to avoid having it arise in your valuation process. Remember, I recommend the Single Appraiser, Select Now and Value Now process described in Chapter 17. If you adopt this process, any misunderstandings will be discovered in the first appraisal, and your agreement can be fixed before a trigger event occurs.
This leaves four additional process-busting issues. Again, each of these issues should be avoided if you adopt the Single Appraiser, Select Now and Value Now valuation process for your buy-sell agreement.
Embedded Capital Gains in Asset-Holding Entities
If your business is primarily an asset-holding entity and there is substantial appreciation in the assets at the time of a valuation process, there is room for disagreement over the treatment accorded this issue by different business appraisers. The basic question is, of course, the appropriate treatment of any embedded capital gains that might exist relating to the appreciated assets.
Embedded capital gains exist when the market value of assets exceeds their book values on the books of entities. For example, if a company holds a single asset with a market value of $100 and a book value of $50, there is an embedded gain of $50 inside the entity. If the asset is sold, the capital gain will be triggered and due as a federal and, perhaps, state tax liability.
The embedded gains question from a valuation standpoint is the appropriate treatment of the gain. Is it a liability for valuation purposes or not? The potential disagreement is different whether your entity is a C corporation or a tax pass-through entity.
There are still quite a number of asset holding companies in existence that have retained the C corporation form of organization. Many of these entities are real estate holding entities. There are a significant number of C corporations that hold substantial amounts of appreciated real estate or securities. Let me illustrate the issue in a simple example. Assume the following:
- A C corporation holds real estate with a current market value of $10 million. This has been determined by an independent real estate appraiser with excellent credentials and knowledge of the market where the real property is located.
- The book value of the real estate is $1 million, so there is an embedded capital gain of $9 million inside the company.
- There are no other assets or liabilities on the books of the company, so the book value of shareholders’ equity is $1 million.
- The federal tax rate on embedded capital gains in C corporations is 40% and there are no state taxes on capital gains.
- The buy-sell agreement calls for two appraisers initially to provide appraisals of the business. If their conclusions are within 10% of each other, the price for purposes of the agreement is the average of the two conclusions.
- Two business appraisers have been retained, one by the company and the other by the estate of a deceased owner. The deceased owner held 20% of the stock.
- The buy-sell agreement is clear that no marketability or minority interest discounts are to be applied by the selected appraisers.
- Both appraisers have accepted the underlying real estate appraisals and have been asked to provide their opinions of the fair market value of the equity of the business.
Unfortunately, the appraisers’ conclusions are not within 10% of each other:
- The first appraiser found that the net asset value of the business, after writing up the real estate to its fair market value, was $10 million, and that the value of the deceased owner’s 20% share was $2 million. He did not consider the embedded capital gain of $9 million in his appraisal.
- The second appraiser stated that the embedded capital gain was a real liability of the company and that it should be considered dollar for dollar in the appraisal. She created an embedded capital gain liability of $2.6 million (40% times the gain of $9 million) and concluded that the net asset value was $6.4 million ($10 million minus $3.6 million). The estate’s 20% interest was therefore worth only $1.28 million.
$2 million is 56% greater than $1.28 million, so the agreement calls for a third appraiser who will, presumably, agree with one of the two appraisers or somehow split the difference. This buy-sell agreement is busted.
What is the correct treatment of embedded capital gains in asset holding companies? Appraisers and courts have disagreed. I have taken the position that in the context of fair market value determinations, embedded capital gains in C corporation asset holding entities are real liabilities and should be deducted, dollar-for-dollar, in appraisals. I wrote an article on the subject. You may want your advisors to read it before you sign your agreement. (“Embedded Capital Gains in C Corporation Asset Holding Companies,” Valuation Strategies, November/December 1998)
A great deal of confusion has been raised over tax-affecting in the federal gift and estate tax arena, where fair market value is the standard of value. The confusion arose following the repeal of the General Utilities doctrine in 1987, which eliminated the potential for liquidating dividends for C corporations and created the embedded tax issue.
Additional confusion has been created in the arena of determinations of fair value in state statutory dissenters’ rights and oppression cases.
If you stick with economics, I believe you will agree that if you have a C corporation asset-holding entity with substantial appreciated assets, you will want your appraiser(s) to tax-affect embedded capital gains.
Tax Pass-Through Entities
With tax pass-through entities, the question is the same. Should appraisers tax-affect embedded capital gains in tax pass-through entities? The short answer to this question, in my opinion, is no in most instances. When an asset is sold within a tax pass-through entity, the tax liability relating to any embedded capital gain becomes a pass-through liability of the owners (shareholders, partners, or members). However, other appraisers may disagree or just not know.
On the technical side of things, owners of tax pass-through entities have a separate basis for their investments outside the entities than the inside basis of the underlying assets. Assuming that distributions from sales of appreciated assets occur in the same tax year as gains are realized, holders of interests in tax pass-through entities will realize the expected economics of their investments if they pay for interests based on market values of assets without considering embedded capital gains. Sellers who sell based on consideration of embedded capital gains lose some of all of the benefit of their investment.
My advice as to the appropriate consideration of embedded capital gains for tax pass-through entities is that appraisers should not tax affect the gains in valuations for buy-sell agreements.
You may want to discuss this issue with your tax advisor and let him or her walk you through examples of what happens to buyers or sellers under varying assumptions about embedded gains.
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(Next Process-Busting Valuation Issue: Tax Affecting Earnings in Tax Pass-Through Entities)