Clients

entrepreneurs

So, you are thinking about making the jump to running your own company full time or you are considering leaving the corporate conglomerate world for a small start-up. Congratulations on your change of career and life – you will feel more in control while feeling out of control (if you know what I mean).

Before I read about your company’s IPO in the Wall Street Journal, please remember to implement some wealth preservation strategies now. While the company is private, in its youth and unknown, transfer a percentage of your ownership to an irrevocable trust for the benefit of your family members (spouse, kids, and future grandkids). At this point, the interest in the company that you are considering transferring to the trust may not be worth much. How do you determine the value of the stock/LLC membership interests that you are giving to the trust?

The gift tax regulations say you have to determine the company’s “fair market value”, which is what a willing buyer and willing seller would agree upon for a sale price. This means that you hire a professional business appraiser (don’t be short-sighted on cost; the amount you save in estate taxes could make the appraisal fee look like peanuts).

First, the business appraiser will review the traditional components of valuing your business – the financial data. But in addition, the appraiser must consider what a potential buyer is purchasing – a minority interest in a private company that has no market for its stock/LLC interests. Who would want that? Therefore, under the current federal gift tax laws, your ownership interest may be “discounted” by 20-40% due to lack of marketability (it is still a private company that has restrictions on sales to third parties) and lack of control (you will be transferring a minority interest in a private company).

In other words, your ownership interest in the company has limited appeal to a third party because such a buyer would have no say in how the company is operated and has no outside market to sell the shares to someone else. These restrictions have a dramatic effect on diminishing the “fair market value” of the stock in the company for transfer (gift or sale) purposes.

Ok, enough of the technical stuff – how does this save the entrepreneur on estate taxes?

Hypo: If an owner takes 25% of his/her ownership in the company during its infancy and transfers it to an irrevocable trust (under which the owner’s family members, but not the owner, are the beneficiaries) when the company is worth $4,000,000, the gift will be valued at $1,000,000 (the $4M value takes into consideration the discounts).

No problem and no out of pocket gift tax because you can gift away up to $5,250,000 (and increasing with inflation) over your lifetime and not be subject to any actual gift tax.

Here is when the fun starts. You work your tail off and grow the business to be worth $40,000,000 when you die, your family just avoided a 40% estate tax on $9,000,000 of appreciation on the 25% of the company owned by the irrevocable trust. A cool savings of $3,600,000 in taxes – way to go.