Congress has delivered a huge gift in the form of an increase in the gift tax exemption rates as part of the overall compromise reached by extending the Bush-era tax cuts. Tucked nicely inside the tax cut package, which included extensions of generation-skipping tax breaks and estate tax extensions, is a temporary, two-year increase in the gift tax exemption rate from $1,000,000 to $5,000,000 per person. For a husband and wife, the amounts are double. This presents a unique, short-lived opportunity.
Over the past few years, revenues for the average firm have fallen by 20% to 30%. For many companies, bottom lines moved into negative territory before modestly improving to reasonable profit levels. Credit markets have tightened significantly. Consequently, valuation multiples that are used to place a total value on a company have also fallen. An average company that makes between $2M to $20M in EBITDA (earnings before interest, taxes and depreciation) used to be worth about 3.0 to 10.0 times EBITDA.1 This same company with lowered earnings may now be worth, on average, 3.0 to 6.0 times EBITDA.2 This combination of decreasing EBITDA, lowered business valuation multiples, and an increased gift tax exemption produces a dramatic opportunity.
Consider this. In Table One below, our hypothetical company earned $3,500,000 in EBITDA in 2007, lost 25% of its earnings to earn $2,625,000 in 2011, and recovered earnings by 10% per year in 2012 and 2013 of $2,888,000 and $3,177,000, respectively.
Referring to Table Two (below), in 2007, our hypothetical company is worth $21,000,000 when we apply a valuation multiple of 6.0 x EBITA. Subtracting the old, single-gift tax exemption amount of $1,000,000 results in a taxable gift value of $20,000,000. Multiplying $20,000,000 by the 2007 gift tax rate of 46%3 produces a tax of $9,200,000. Rolling forward into 2011, our hypothetical company has lost 25% of its EBITDA, and its valuation multiple is now 4.0 x EBITDA. That produces a taxable company value in 2011 of $10,500,000. Subtract the new single gift tax exemption amount of $5,000,000 in 2011 to arrive at a taxable gift amount of $5,500,000. This results in gift tax liability of $1,925,000.4 The tax savings in 2011 compared to 2007 is a whopping ($9,200,000 - $1,925,000) $7,275,000!
If we roll this analysis forward for to 2012, what happens? Like any good storm, the strongest winds occur at the beginning. In our example above, in 2012 we assumed that a moderate recovery produces both increased EBITDA by 10% and a better business valuation horizon. As such, the business valuation multiple has also risen from 4.0 to 5.0 x EBITDA. This results in an increase in taxable value of our hypothetical company to $14,440,000 and a gift tax of $3,304,000. Although the tax result in 2012 is certainly much better than the $9,200,000 in taxes produced by applying the 2007 rules, waiting until 2012 allowed the market to improve and increased gift taxes by $1,379,000 (for a total of gift tax of $3,304,000) compared to 2011.
Waiting until 2013 will cost you dearly. In 2013, if we assume the economy continues to rebound, in our example EBITDA increases by another 10%, and valuation multiples return to historic levels of 6.0 x earnings. Further, the gift tax exemption increase expires and returns to its $1,000,000 per person level and the gift tax rate jumps to 55%. The same opportunity to gift a business interest in 2013 costs $9,934,000 compared to the $1,925,000 price tag that a 2011 gift offers. The cost of waiting until 2013 is $8,009,000!
For those who possess private equity interests or interests in a combination of public and private interests held by private ownership entities, does it get any better than this? Believe it or not, Ripley, it does get better.
Married couples with proper tax and legal planning can double their 2011 and 2012 $5,000,000 gift tax exemption to $10,000,000. Using the same calculation as in Table Two, we assume that the company is owned equally by husband and wife, and we double the exemption amount to produce Table Three on the following page. The results are staggering. The same company that would have cost $9,200,000 in gift taxes using a single exemption in 2007, with proper planning, now costs only $175,000 to gift exactly the same business interest in 2011. This is a savings of $9,025,000. What is the effective tax rate on this transfer in 2011? How does 1.67% sound?! Only interstate Internet commerce is cheaper.5
If a couple waits until 2013, the opportunity is lost. In our example, gift taxes rise from $175,000 in 2011 to $9,384,000 in 2013 as the gift tax horse has expired. In other words, it is 54 times more expensive to wait two years. In two years, your effective gift tax rate will increase from 1.67% to 49.2%.
Let’s say it together: carpe diem! It is a perfect storm for individuals and couples wanting to transfer wealth. Consider that, at some point, (cryonics clients please ignore this section) everyone exits their business interests. You must transfer your wealth at some point. Minimizing the tax effect of the transfer is critical to wealth preservation. Although the rules could change or be extended beyond 2012, there are no guarantees. Act now.
Your storm-chaser tool kit should contain your trust and estate attorney, tax professional, wealth management advisor and business valuation expert. Leverage them in order to harness this powerful alignment and potent opportunity.
Remember, the real gifting season begins January 1, 2011.
Frank A. Wisehart, M.B.A., CPA/ABV CFE, CVA is the Director of Business Advisory Services at Schneider Downs, an audit, tax and advisory firm in Columbus, Ohio and Pittsburgh, PA that has been in business since 1956. Frank Wisehart has 15 years of experience in business valuation, management consulting, litigation support, forensic accounting, fraud investigation, transaction due diligence and expert testimony. He may be contacted at (614) 586-7118 or firstname.lastname@example.org.
For information related to the tax benefits of this extension, please contact Melanie LaSota, Director, Estate and Trust Tax Services, Schneider Downs at email@example.com. To receive further information related to wealth management benefits associated with this tax cut package, contact Jeff Acheson, Partner, Schneider Downs Wealth Management Advisors at firstname.lastname@example.org.
Schneider Downs provides accounting, tax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.
1 “Rules of Thumb for Business Valuations,” June 27, 2008, http://www.articlesbase.com/small-business-articles/rules-of-thumb-for-business-valuations-464866.html.
2 “Determining Your Company’s Value: Multiples and Rules of Thumb,” July 15, 2010, Barbara Taylor, The New York Times, http://boss.blogs.nytimes.com/2010/07/15/determining-your-companys-value-multiples-and-rules-of-thumb/
3 In our analysis for 2007: rather than use the graduated tables, which start at a gift tax rate of 41% and then increase; for simplicity, we have used the highest gift tax rate of 46%.
4 This value is before consideration of discounts for lack of control and lack of marketability which may be available. Including these discounts could reduce the taxable amounts, on average, from 10% and 35%.
5 For those who do not know, in general, interstate Internet commerce is not taxed.