COVID-19

An Opportunity for Gift and Estate Planning at Low Valuations

The disruption brought about by COVID-19 created certain industry “winners” and “losers.” Many of those that emerged as losers are small and medium-sized privately held businesses such as restaurants, bakeries, gyms, hair salons and spas, and the corresponding real estate holding entities that leased to such businesses, held retail and office space, and even apartment buildings. At this point, the most frequent question asked by business owners is: “Should I reopen my business or not?” While being on the losing side, it may be a good time for business owners to view this as an opportunity to take advantage of low business valuations to minimize estate and gift taxes and think about succession planning. The decline in revenues and even business closures due to COVID-19 still represent a unique opportunity for gift and estate tax planning. In addition, devalued assets of the recently deceased need to be valued at this time for estate tax compliance purposes. This article discusses various succession strategies that are part of an estate plan that may now incentivize small business owners to implement a strategy.

The disruption brought about by COVID-19 created certain industry “winners” and “losers.” Many of those that emerged as losers are small and medium-sized privately held businesses such as restaurants, bakeries, gyms, hair salons and spas, and the corresponding real estate holding entities that leased to such businesses, held retail and office space, and even apartment buildings. At this point, the most frequent question asked by business owners is: “Should I reopen my business or not?”

While being on the losing side, it may be a good time for business owners to view this as an opportunity to take advantage of low business valuations to minimize estate and gift taxes and think about succession planning. The decline in revenues and even business closures due to COVID-19 still represent a unique opportunity for gift and estate tax planning. In addition, devalued assets of the recently deceased need to be valued at this time for estate tax compliance purposes.

Lower values create a unique planning opportunity by allowing business owners to transfer a greater portion of their business assets and reduce their taxable estate. The decline in revenues in the first and second quarters of 2020 led to overall lower valuations, which provides an opportunity to gift at lower values; potentially allowing business owners to gift assets using their lifetime exemption that would have otherwise resulted in a taxable event prior to the pandemic. Given the additional uncertainty surrounding the U.S. presidential election and what might happen to the gift and estate tax exemption level, now may be the best time to do some gifting.

On the opposite side of the spectrum, industry winners experiencing an upturn should view this as an opportunity for growth, acquisitions, and estate tax planning in light of expected expansion. Some of the obvious winners are tele-healthcare practices, online grocery stores and other online retailers, PPE manufacturers, and digital entertainment companies.

Gift, Estate, and Income Tax Planning in the Time of COVID-19[1]

As mentioned previously, except for a few industries, such as tele-healthcare and grocery stores, business values have generally dwindled due to:

• Lower actual or projected revenues and earnings due to business closures
• Increased interest-bearing debt to pay employees and other fixed expenses
• Decrease in the value of tangible assets such as inventory, machinery, equipment, and real property due to changes in market demand and occupancy rates
• Increase in discount for lack of control and marketability due to liquidity issues in the market

In the present scenario, with the decrease in the value of business assets, those who are subject to federal or state estate tax or state inheritance tax should consider transferring the reduced-value assets in a tax-advantaged fashion.

With proper planning, the post-transfer growth in the assets potentially can escape estate, gift, and generation-skipping transfer (GST) taxes. Since assets are worthless now because of the pandemic situation, post-transfer growth will occur even if the asset values simply return to pre-virus levels. Any additional longer-term growth will also avoid transfer taxes.

Another economic development also makes transfer tax planning especially beneficial in the current scenario. Interest rates are currently very low, in part, as a result of the government’s efforts to support the economy. There are certain planning techniques such as Grantor-Retained Annuity Trusts (GRATs), sales to grantor trusts, Charitable Lead Annuity Trusts (CLATs), and intra-family loans that are particularly effective in low-interest-rate environments.

Loss harvesting—The financial markets have been very low over the past several weeks. Hence, if there is an unrealized loss in some of the investments, an individual should consider selling those assets and realizing the losses (a process known as “loss harvesting”). Assuming the unrealized gains on other assets, you can realize those gains before the end of the year and use the harvested losses to offset those taxable gains.

Roth Individual Retirement Account (IRA) conversions—A traditional IRA can be converted into a Roth IRA. The main advantage of a Roth IRA, unlike a traditional IRA, is that individuals will not have to pay income tax on the money they withdraw in retirement. The beneficiaries inherit the same tax benefit if the individual dies. When you convert a traditional IRA to a Roth IRA, income tax must be paid on the value of the converted assets. When, as now, asset values have declined, the tax cost of conversion may be substantially reduced, so now is a good time to consider a Roth IRA conversion.

Considerations in Gift and Estate Tax Valuations in Light of COVID-19

A key consideration in valuing companies at this time will be assessing the impact of COVID-19 on near-term and longer-term financial projections, which may not yet be known or quantifiable and likely will be subject to change. There are many forecasts with respect to a recovery in a “V” shape, “U” shape or even “W” shape. In addition, certain industries will bounce back earlier than others. For instance, restaurants may recover later compared to grocery stores and other retailers. Business appraisers right now are grappling with how to value the impaired and unprofitable businesses and how to value those that did well during the pandemic. A key question to ask business owners is: Has there been a fundamental change in their business that will impact their survival in the long-term? One thing is crystal clear: Recovery and growth will occur from a lower base than pre-pandemic levels and at a much slower pace, and driven possibly by whether the fundamental changes in consumer demand will be favorable or unfavorable for businesses.

Implicitly, these uncertainties need to be reflected in the valuation, and a risk-appropriate discount rate also needs to be considered. There is no set approach to account for market uncertainties as the impact will be different for different businesses in different states and regions.

Consider multiple scenarios. It is imperative currently to work with business owners to “seriously consider” using several discount and growth rates for different time frames (e.g., short-term, midterm and long-term). Since uncertainty still exists right now for valuation dates during COVID-19, consider multiple scenario analyses and projections that are probability weighted.

Good timing for gift and estate valuations but… Valuations for gift and estate tax purposes may be lower now, but are the negative impacts temporary or long-term?

Discount for lack of control (aka minority discount) and discount for lack of marketability (DLOM). In the wake of the 2008 financial crisis, the IRS was scrutinizing valuations that simply increased DLOM without much explanation. To avoid IRS audit trouble for valuations impacted by the current pandemic, DLOM assumptions need to be fully explained.

For minority interests in privately held companies, discounts for lack of control and lack of marketability may have increased due to liquidity issues in the market. Since volatility is a factor in determining an appropriate DLOM, the extreme volatility of the market currently materially increases DLOMs. In addition, DLOMs should be adjusted upward because a) the abnormal conditions in the market will limit investments in illiquid privately held companies; and b) certain state restrictions being put in place to limit the spread of COVID-19 are limiting the ability of prospective buyers to conduct due diligence and even meet with financial and legal advisors.

Mystery of the cost of capital during COVID-19. The impact of the current market uncertainties (COVID-19, U.S. elections, trade war, etc.) on business operations should be critically considered in developing a cost of capital for the valuation of the business. In determining the nature and extent of the impact on the business and valuation assumptions, the following potential issues may need to be considered:

• Production delays or limitations
• The impact on human capital
• Regulatory changes
• The risk of loss on significant contracts
• Store or facility closures
• Loss of customers or customer traffic
• The impact on distributors
• Supply chain interruptions

Implicitly, these uncertainties need to be reflected in the cash flows; however, a risk-appropriate discount rate also needs to be considered. There is no set approach to account for market uncertainties as the impact will be different for different businesses in different regions.

Commentary on subsequent events. If the valuation date is December 31, 2019, and the valuation report is dated after the COVID-19 pandemic became known or knowable in March 2020, it is best to include a discussion on the meaning of “subsequent events” in the valuation.

Some businesses are doing well but… As mentioned previously, not all companies are being negatively impacted by the pandemic. But the big question is: Will a spike in business last? Is it simply a shift in demand (e.g., stockpiling) that will even itself out? Or did the business reinvent itself to some extent so that it will come out stronger than before? For example, a firm may have pivoted or ramped up its online e-commerce capabilities so that it is better positioned to deal with the new normal.

PPP and CARES Act. The provisions provided under the CARES Act create one-time events that alter income and market inputs to valuation. The PPP and other short-term small business support provisions could impact valuations as cash infusions from PPP benefits the business but can also affect net income, causing a spike in its valuation and making adjustments for any one-time tax benefits necessary. Among the items to consider are:

• Whether PPP loans will be forgiven and treated as a grant, or whether they are low-interest loans and treated as debt, and how that determination alters projected net income or cost of capital.
• How the SBA covering six-months of Small Business Debt Relief Program payments alters cash flow, increases net income or changes cost of capital.
• If conducting a market approach, whether comparable companies benefited from the CARES Act provisions and how that alters their multiples.
• If acceptance of CARES Act funds indicates a business is under duress and as a result, past financial results are not indicative of future operations.

Generally, all these should be factored into the valuation if the business tax provisions were known, or should have been known, as of current valuation data or on a valuation date that falls when COVID-19 still prevailed.

Conclusion

Following are just a few planning techniques that take advantage of this volatile time where asset values are still depressed and interest rates are extremely low:

• Grantor-Retained Annuity Trusts (GRATs)
• Sales to an Intentionally Defective Grantor Trust (IDGT)
• Charitable Lead Annuity Trusts (CLATs)
• Spousal Lifetime Access Trust (SLATS)
• Swapping assets with a grantor trust
• Intra-family loans

One of the keys to many of these strategies is to obtain a supportable valuation of the assets involved in the strategy, especially when dealing with closely held businesses or a fractional interest in a business as there are many factors that need to be considered at this time as outlined above. During these unprecedented times, please contact your tax advisor for assistance with gift and estate valuations and to review your current estate plan to ensure it continues to meet your needs.

[1] Source: Abstract, Article, “Estate, Gift, and Income Tax Planning in the Time of COVID-19”, https://www.jdsupra.com/legalnews/estate-gift-and-income-tax-planning-in-24667/

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Angela Sadang, MBA, CFA, ASA, ABV, is a Principal at Marks Paneth LLP. She is a designated Chartered Financial Analyst charter holder, an Accredited Senior Appraiser in Business Valuation and Intangible Assets Valuation from the American Society of Appraisers, and Accredited in Business Valuation  from the AICPA. She has been involved in numerous transfer pricing and valuation projects.

Ms. Sadang can be contacted at (212) 201-3012 or by e-mail to asadang@markspaneth.com.