Uncertain economic and political conditions can present estate planning opportunities for those who can opportunistically weather the storm to enhance generational wealth and minimize negative future tax consequences.
Sharp Economic Downturn
The current economic downturn is unprecedented in many ways, including the speed of increases in business closures and unemployment claims as well as the rate of decline in overall economic activity. Real GDP declined at an annual rate of 32.9 percent in the second quarter of 2020, which was easily the largest decline in the history of that statistic, dating back to 1947. This economic contraction is drastically reducing revenues and earnings for companies across most sectors of the economy, as shown below.
At the same time, market volatility has increased many of the risk premiums that determine the rates of return that are required by investors and utilized to value business ownership interests and assets. Such increases in risk premiums have a negative correlation with business value.
- The annualized price volatility of small companies, which averaged 17 percent during 2015-2019, has increased to 44 percent in 2020 (through June).
- Average credit spreads on high-yield debt have increased from 3.6 percent in December 2019 to 6.4 percent in June 2020 (after spiking to 10.9 percent in March 2020).
- Industry risk premiums have widened for many industries, particularly some of those that are consumer-sensitive, as shown below.
Larger Impacts to Privately Held Companies and Non-Controlling Interests
Privately held companies, and especially non-controlling ownership interests in those companies, can face greater impacts to their values in times of heightened economic uncertainty. Investors generally require higher returns for smaller, privately held companies, which are reflected in the small-company risk premium and company-specific risk premium designed to address enhanced risks inherent in small and middle-market businesses. Both of these premiums tend to increase as investors become more risk-averse during periods of significant market volatility, thereby further increasing required returns and putting downward pressure on equity values.
Additionally, values of non-controlling ownership interests are typically reduced by a discount for lack of control (DLOC) and/or a discount for lack of marketability (DLOM). These discounts also tend to grow during periods of significant volatility, further depressing the values of private, non-controlling interests.
- During the last economic recession, the median DLOC increased from 15.6 percent in the third quarter of 2007 to 35.6 percent in the second quarter of 2009.
- Based on a standard protective put model, the implied DLOM for small companies doubled from December 2019 to June 2020.
The combination of higher volatility, lower earnings, higher risk premiums and higher discounts could result in significantly lower values for ownership interests in privately held companies. This may apply across a broad scope of business types, including traditional operating businesses, real estate holding companies, and investment holding companies.
Tax Planning Opportunities for Ownership Transfers
Reduced equity values can provide an excellent opportunity for business owners to implement various estate and transfer planning strategies. Ownership interests can be gifted or transferred to future generations, trusts or other planning vehicles at reduced values, thereby reducing gift taxes and/or using less of the owner’s lifetime estate and gift tax exemption. Additionally, the current low interest rate environment increases the attractiveness of certain strategies, including Grantor Retained Annuity Trusts (GRATs), Charitable Lead Trusts (CLTs), intra-family loans and leveraged transfers.
The Tax Cut and Jobs Act (TCJA), signed into law in 2017, doubled the lifetime gift exemption through 2025. However, the 2020 election adds considerable uncertainty to the longevity of the changes effected by the TCJA. One of the released pre-election plans proposes to reverse the lifetime exemption to prior levels or lower and to reduce or eliminate the tax basis step-up on inherited assets. If these changes are enacted, they could have extreme tax impacts on future ownership transfers. Therefore, now could be a great time to discuss gift, estate and tax planning opportunities with your advisors in order to take advantage of potentially reduced business values and currently favorable tax laws. For more information or to speak with an advisor, reach out to us at email@example.com or contact the author(s) listed below.