COVID-19 and Gift and Estate Assessments: One Year Later
Most businesses affected by the COVID-19 pandemic have not yet fully recovered. Depending on the type of business and industry, some businesses may take a long time to rebound to pre-pandemic levels or to reinvent themselves, move to a new business model, or change market strategy.
Businesses have remained afloat from 2020 to 2021 thanks to PPP loans and other forms of government assistance, but many are still hampered by the lingering effects of COVID-19 closures and related mandates. The many uncertainties that persist, including what could happen to the level of gift and inheritance tax exemptions, create a rare planning opportunity by allowing business owners to transfer more of the company’s assets. to even lower values and reduce their taxable wealth. But with impending tax changes that could take effect in 2022, the window of opportunity is narrowing and there is no better time than the present.
As we wind down 2021 and more than a year after the COVID-19 disruption, here’s a recap of some highlights of the business valuation applicable in a gift and inheritance tax context.
Discount on market value in private companies
How do you estimate a COVID-19 discount for lack of merchantable quality (DLOM) for investments in private companies? To offer fractional interests in private companies, it is appropriate to overlay the DLOM with a “COVID-19 marketing discount” as this process helps organize thinking and support professional judgment. A suggested methodology for determining an appropriate ‘COVID-19 marketing discount’ is based on weighting factors such as those used in Mandelbaum v. Commissioner, Memo TC 1995-255. (in a landmark decision, Justice Laro provided a framework for evaluating non-marketing rebates in minority interest cases) and Internal Revenue Service DLOM Job Aid. However, the categories would be changed to accommodate the current situation, such as the effect of closure and stay-at-home orders, employee issues, supply chain issues, PPP loans or whatever. other support. Since the process collects much more qualitative information than quantitative data, significant professional judgment is required and conclusions will always fall within a wide range. A caveat with this method, as with any discount, is to double-count a risk that has already been factored into the discount rate, cash flow multiplier, or other discounts.
Businesses impacted by COVID-19
For businesses affected by COVID-19, scenario-based analysis is reasonable and appropriate. Typically this involves a slightly complicated detour from the standard discounted cash flow (DCF) method and the development of a multi-scenario DCF and weighting for each DCF scenario.
For example, the best case scenario will be a short period of recession and a slightly negative impact on financial performance; a base scenario or an intermediate scenario will be a one-year recession period and a slightly unfavorable financial impact; and the worst case will be a 2 year recession period and a very unfavorable financial impact. Depending on the distribution of the projected net cash flows and the percentages used for the probabilities of each scenario, the result will be either symmetrical or skewed. If it is symmetrical, the probability weighted value will be the same.
There are various opinions regarding the application of a multi-scenario DCF, and it is more important to consider the impacts in the benefit streams rather than in the risk factor. Also, the time frame is not limited to a 5-year DCF – it can be two years, three years, or whatever is reasonably appropriate. In a multi-scenario DCF, a valuation analyst can examine whether the company concerned can even survive for a certain period; determine if the business can improve and to what extent; and estimate a certain level of standard operations after the pandemic. It is also useful to determine or consider using different risk rates for different discrete time periods.
One caveat to this method is that even with cash flow adjustments for the additional risks of COVID-19, the projections will still be less reliable than before. Therefore, the discount rate will need to reflect some of the additional risks. Furthermore, IIt may also be appropriate to consider the use of ranges for a value opinion, as opposed to a single number.
Is the market approach still relevant?
Many valuation experts point out that merger and acquisition (M&A) transactions during COVID-19 require special consideration. The target business may be particularly strong, or there may be powerful synergies in the business. Additionally, the use of market-based multiples is problematic, as the values of the numerator and denominator may not reflect the impact of COVID-19.
While there are various techniques for adjusting multiple public company guidelines and multiples of M&A transactions to deal with the impact of COVID-19, some assessment experts are offering alternative market-based methods for valuation dates occurring after mid-February 2020. A method is envisaged. the following for the M&A guideline method. If the target’s purchase price reflects the impact of COVID-19 (affected purchase price) but the profits used in calculating multiples do not (unaffected profits):
- Calculate the multiples based on the assigned purchase price and the target’s unassigned profit. This calculation will provide the relevant M&A multiples.
- If COVID-19 affected the profits of the affected business (affected profits), adjust the affected profits to quantify the unaffected profits of the affected business.
- Apply the M&A multiples allocated to the unallocated earnings of the subject company to estimate the value of the subject company as affected by COVID-19 (COVID-19 value).
Assessment date – Timing of the date of the gift
Between 2020 and 2021, there have been numerous opportunities for low-valuation donations, especially for businesses impacted by COVID-19. An assessment done before COVID-19 may be out of date and should be updated after COVID-19 to take into account the impacts of the pandemic.
Many business owners ask: How do you screen when you don’t know how long will COVID-19 last? This is one of the million dollar questions, but note that the assumptions must be supported by reliable sources. Valuation experts cite sources such as the Congressional Budget Office (CBO) and McKinsey, which have performed analyzes on times of economic recovery. The CBO’s June 1, 2020 report says that due to the global pandemic, it will be 10 years before the country’s real gross domestic product matches the bureau’s projections from January. According to McKinsey, in a moderate recovery, it could take more than five years for the most affected sectors to return to 2019 levels.
If a pre-COVID-19 assessment date is being prepared in a post-COVID-19 environment and the impact of the virus was not known or knowable on the assessment date, the assessment should not not take into account COVID-19 but a section on subsequent events should be added to the assessment report. The American Institute of Certified Public Accountants (AICPA) recently released a toolkit for subsequent events that includes frequently asked questions and sample disclosure language. Reminds valuation analysts who adhere to the AICPA valuation standards that disclosure of a subsequent event is not required, and it is up to the valuation analyst to decide if it is appropriate. to make the disclosure.
New tax law in 2022?
Uncertainty remains over a new tax law under the current presidential administration. On September 12, 2021, the House Ways and Means Committee released the text of a bill to fund the Build Back Better Act. This bill contains significant changes to tax legislation aimed at reducing tax planning opportunities for high net worth private clients. Below are some highlights of some of the proposed changes that have implications for the assessment:
- The exemption amount is reduced from $ 11.7 million to approximately $ 6.02 million effective January 1, 2022.
- Valuation discounts for gift tax and inheritance tax purposes are eliminated, except for assets of the entity used in an effective active business or commercial activity for transfers made after the date of promulgation.
- The maximum tax rate for long-term capital gains is raised from 20% to 25%. The effective date is unclear, but would appear to apply to sales or exchanges from September 13, 2021 (including the binding sales contract exception).
At this point, it is best to complete: (1) gifts; or (2) sale to a non-grantor trust where a lack of control or DLOM discount is applicable.
Company specific risk
The company specific risk premium (CSR) used to develop an appropriate discount rate has been a topic of interest, particularly in the aftermath of COVID-19. The Appraisal Foundation seeks to develop guidelines to promote greater consistency in practice in estimating CSR for fair value for financial reporting.
Currently, there are no empirical studies, magic formulas or computer algorithms to accurately determine CSR in a private company. Assessment is not a precise science and professional judgment is required. In the era of COVID-19, many experts recommend spending more time on the numerator (cash flow) of the valuation equation and less time on the denominator, which includes the cost of capital.
Another area in the development of the discount rate that has emerged recently is the size effect. Many finance veterans conclude that the small business effect doesn’t exist, after all. Russell’s indices show that the factor is “at best mitigated”, and sophisticated statistical work confirms this. Several recent articles suggest that taking a DLOM and a size premium can double the illiquidity factor. Stay tuned.
There is no magic formula to doing business valuations for gift and estate tax purposes in the COVID-19 era. Today we take a fundamental approach with a much greater dose of professional judgment and deepen the impact of COVID-19 on operations, modifying the DCF, adjusting pre-COVID-19 market multiples, analyzing and by layering additional risks and more. .