Rough Economy + Tax Change = A Wise Time to Transfer Wealth to Your Heirs

By Roy Bushman

The current estate and gift tax law is set to expire on December 31, 2012, after which estates worth $1 million or more will be faced with tax rates up to 55%. With the deficit discussions in Washington, D.C., it’s possible that Congress will allow the current law to expire to realize the tax revenue. Without estate planning, an unprepared person could leave his or her heirs a smaller percentage than what they intended.

When a person with a taxable estate dies, the estate tax return and the estate taxes are generally due in nine months. It may be difficult to come up with the cash needed for the taxes and still liquidate assets in an orderly manner to obtain the best sales prices.

Because of the difficult economy and the increased gift tax exemption, senior generation business owners may have a unique tax planning opportunity now. As part of the overall compromise reached by extending the Bush-era tax cuts, Congress has included a temporary, two-year increase in the gift tax exemption amount from $1 million to $5 million per person. For a husband and wife, the amounts are double.

Valuation multiples that are used by valuation analysts and business brokers to place a total value on a company have dropped significantly. For example, a company that previously could have achieved a valuation of 3-10 times Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) may now only be able to expect a valuation of 2.5-6 times EBITDA.

An increased gift tax exemption combined with lower business valuation multiples and decreased earnings provides an incredible window of opportunity. Consider a hypothetical family-owned construction company with aging owners who want to pass the company to the next generation. In Table One, the company earned $3.8 million in EBITDA in 2007, faced a 25% drop in earnings by 2011, and recovered earnings by 12% per year in 2012 and 2013.

Table One

 

2007

 

2011

 

2012

 

2013

 

EBITDA

$

3,800,000

$

2,850,000

$

3,192,000

$

3,575,040

                   

As you can see in Table Two, in 2007 the company was worth $22.8 million when we apply a valuation of six times EBITDA. After deducting the old single gift tax exemption of $1 million, we arrive at a taxable gift value of $21.8 million. Multiplying this by the 2007 gift tax rate of 45%1 produces a tax of $9,810,000.

Moving forward to 2011, the company has lost 25% of its earnings power, and the valuation multiple has dropped to 4 times EBITDA due to the poor economy. This produces a value of $11.4 million.With the new single gift tax exemption of $5 million, the taxable gift amount is $6.4 million. This results in a gift tax liability of $2.24 million. The tax savings from 2007 compared to a gift that was made in 2011 is more than $7 million.

                   

Table Two

 

2007

 

2011

 

2012

 

2013

 

EBITDA

$

3,800,000

$

2,850,000

$

3,192,000

$

3,575,040

 

Valuation Multiple

 

6.0

 

4.0

 

5.0

 

6.0

 

               

 

 

Company Value

 

22,800,000

 

11,400,000

 

15,960,000

 

21,450,240

 

               

 

 

Less: Single Exemption

 

1,000,000

 

5,000,000

 

5,120,000

 

1,000,000

 

               

 

 

Taxable Amount

 

21,800,000

 

6,400,000

 

10,840,000

 

20,450,240

 

               

 

 

Tax Rate

 

45%

 

35%

 

35%

 

55%

 

               

 

 

Applicable Tax

$

9,810,000

$

2,240,000

$

3,794,000

$

11,247,632


What happens if we roll this forward to 2012? In Table Two, we assume a modest economic recovery increases EBITDA by 12% and creates a better business valuation environment, thus increasing the valuation multiple from 4.0 to 5.0. You can see that waiting to gift a business interest until 2012 created an additional gift tax over 2011 by more than $1.5 million, and waiting until 2013 goes up to more than $11 million, an increase of more than $9 million over 2011.

With proper tax and legal planning, married couples can double their gift tax exemption for 2012 from $5 million to $10 million. We can use the same calculations as in Table Two and assume that the business is owned equally by the husband and wife or that they elect to have the split gift rules apply. By comparing Tables Two and Three, you can that the same business interest that would have cost $9,810,000 in taxes in 2007 using a single exemption would have cost $490,000 in 2011 with the spouse’s split gift election.

Table Three

 

2007

 

2011

 

2012

 

2013

 

EBITDA

$

3,800,000

$

2,850,000

$

3,192,000

$

3,575,040

 

Valuation Multiple

 

6.0

 

4.0

 

5.0

 

6.0

 

               

 

 

Company Value

 

22,800,000

 

11,400,000

 

15,960,000

 

21,450,240

 

               

 

 

Less: Married Couple Exemptions

 

2,000,000

 

10,000,000

 

10,240,000

 

2,000,000

 

               

 

 

Taxable Amount

 

20,800,000

 

1,400,000

 

5,720,000

 

19,450,240

 

               

 

 

Tax Rate

 

45%

 

35%

 

35%

 

55%

 

               

 

 

Applicable Tax

$

9,360,000

$

490,000

$

2,002,000

$

10,697,632


Estate planning should include an attorney expert in trust and estate planning, a wealth management advisor, a tax professional, and a business valuation expert.  A relatively small investment now could pay huge dividends in the future.


Endnotes:

(1)    For 2007, we have used the highest gift tax rate of 45% for simplicity.
(2)    Discounts for lack of control and lack of marketability may be available to decrease this value, on average, 10% to 35%.

Roy Bushman, CPA, is a Principal with Mort White Bushman CPAs in Cincinnati, OH. He is experienced in business valuations, including providing expert witness testimony and depositions regarding the value of closely held businesses, with a focus on construction contractors. He can be reached at roy@mwbcpas.com or 513-834-9034.