What to Do When One Employee Holds the Key to Business Value
Author: Ron Soluri Jr.
A company’s earnings and cash flows can suffer significantly when an executive or other critical employee leaves. Small and service-oriented businesses and professional practices are particularly vulnerable to such financial losses.
To account for this risk, professional valuators may apply a key-person discount. These discounts don’t apply to all business appraisals and they’re rarely one-size-fits-all. Thus, a valuator must ask several questions specific to the subject company and its key employees.
Which appraisals are affected?
Choosing when a key-person discount is appropriate can be tricky. Smaller closely held businesses are likely to depend on one or more critical employees, but such risk is often accounted for in a separate “size premium.” Larger closely held companies or public companies usually are able to replace key management personnel and thus minimize potential losses.
In general, businesses that sell products are better able to withstand the loss of a key person than service businesses, which depend to a greater extent on key employees’ knowledge, reputation and relationships. However, a product-based company that relies heavily on technology or intellectual property may be at risk if a key person possesses specialized technical knowledge.
Who are the key people?
Key people provide value in different ways, depending on the roles they play in their companies. For example, a key person might:
- Drive the company’s strategic vision,
- Handle day-to-day management responsibilities,
- Offer technical expertise,
- Lend his or her excellent reputation, or
- Provide access to an extensive network of contacts.
Personal relationships are a critical factor in identifying key employees. If clients, customers and vendors deal primarily with one person, they may decide to do business with another company if that person is gone. On the other hand, it’s easier for a company to retain customer relationships when they’re spread among several people within the company.
A key person may also have a financial impact on the business. It’s not unusual for the CEO or another executive in a closely held business to personally guarantee the company’s debts. Lenders may call in such debts if the key person is no longer with the company.
How deep is the bench?
When determining key-person discounts, valuators must assess the ability of others to fill key employees’ shoes. To survive without a key person, existing management must have the knowledge, skills and business acumen to continue normal operations without interruption.
Another key factor is whether there exists a comprehensive succession plan that formally outlines which individuals assume control after key people leave. In the absence of a plan, the departure of one key person could trigger power struggles or require the company to bring in a replacement who isn’t familiar with the organization.
What’s the impact?
Identifying risks associated with key persons is one thing; estimating the impact of those risks on business value is quite another. Valuators generally use one of three methods to incorporate key-person discounts into their calculations: 1) Adjust future earnings to reflect the risk of losing a key person (typically used when a key person’s departure is imminent), 2) adjust the discount or capitalization rate, or 3) discount calculated value by a certain percentage (similar to a marketability or minority interest discount).
Quantifying the discount can be challenging because little empirical support for across-the-board key-person discounts exists. However, research has shown that, in cases where a discount was appropriate and a departure was reasonably certain, the applicable decrease in value associated with a key person’s loss ranged between 4% and 6%.
Among the many legal contexts in which key-person discounts can arise are marital dissolutions, shareholder disputes, mergers and acquisitions, and tax court challenges. To ensure the best outcome for your client, work with a valuator who has experience estimating such discounts and is capable of defending his or her appraisal methodology in court.
If you have any questions about valuations or any other issue, give us a call at 716.847.2651, or you may contact us here.
Court Determines the Gift Tax Exclusion Applies to FLP
Author: Ron Soluri Jr.
Recently, we discussed a case where the U.S. Tax Court held that gifts of interests in a family limited partnership (FLP) qualified for the federal annual gift tax exclusion. The decision in Estate of Wimmer v. Commissioner came as a surprise to some because, in three previous cases, the same court held that the exclusion didn’t apply to gifts of limited partnership interests.
Keeping it in the family
A married couple formed an FLP in 1996, funding it with publicly traded and dividend-paying stock. The FLP was established in part to restrict nonfamily rights to acquire family assets. The husband and wife made gifts of limited partnership interests in the FLP to various family members.
In 1996, the FLP began receiving quarterly dividends from the stock. To allow the limited partners to pay federal income tax, the FLP made distributions from 1996 through 1998. Beginning in 1999, the FLP continuously distributed all dividends — net of partnership expenses — to the partners when they were received. These were made in proportion to partnership interests. Limited partners were also given access to capital account withdrawals and they used such withdrawals for, among other things, paying portions of their residential mortgages.
After the husband died and his estate filed an estate tax return, the IRS returned a tax deficiency of $263,711. The estate asked the Tax Court to find that the gifts of limited partnership interests qualified for the annual gift tax exclusion.
Annual gift tax exclusions are available for “present interest gifts” only, not to gifts of future interests in property. As the court clarified, a gift in the form of a transfer of an equity interest in a business or property, such as limited partnership interests, isn’t necessarily a present interest gift.
To qualify as a present interest gift, the gift must confer on the recipient a substantial present economic benefit by reason of use, possession or enjoyment of either the property or income from the property. In this case the court decided that, because of the significant transfer restrictions in the FLP’s partnership agreement, the donees didn’t receive the rights to immediately use, possess or enjoy the limited partnership interests themselves.
However, the court found that the estate satisfied three requirements for income from the limited partnership interests to qualify the gifts of the interests as present interest gifts: 1) the partnership would generate income; 2) some portion of that income would flow steadily to the limited partners; and 3) that portion of income could readily be ascertained. The court concluded that the limited partners received a substantial present economic benefit.
Wimmer provides an example of the right way to administer an FLP. It’s possible to put restrictions — which often are used to create valuation discounts — on gifted limited partnership interests while still satisfying the requirements for the gifts to qualify for the annual gift tax exclusion. To ensure your clients’ FLP operating agreements walk this fine line, work with an experienced financial advisor.
If you have any questions about the gift tax exclusion or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.