COVID-19 Distress May Present an Estate Planning Opportunity – Why Now May be the Time to Gift Business Interests

Blog
July 29, 2020

The COVID-19 pandemic has exerted significant downward pressure on the value of many businesses. Since the S&P 500 bottomed out on March 23, 2020, the public equity markets have rebounded significantly. On Friday June 19, 2020, the S&P 500 closed at 3,100, which is 38% higher than the bottom, and only about 8% off its February 20, 2020 high of 3,373. Despite this historic comeback in the public equity markets, many U.S. businesses continue to struggle due to record unemployment, low consumer confidence, and continued shutdowns as the COVID-19 pandemic continues on. For some business owners considering a transfer of ownership interests (e.g., into trusts for the benefit of their heirs), this presents an estate planning opportunity. To the extent the business recovers in the future, there may be significant tax savings in transferring interests in the midst of the pandemic as opposed to a post-recovery transaction.

Trust and estate planning is inherently a complicated and ever-changing area of law, and we recommend seeking legal counsel before undertaking such a transaction. Likewise, the actual impact of the pandemic on any business can be complex and nuanced. Here we will simply present a couple of back-of-the-envelope case studies from a valuation perspective to illustrate the potential for federal tax savings.

Case Study A: Moderate decline, full recovery

Facts:

Business Owner A owns 100% of Business A. As a result of the COVID-19 pandemic, Business A sees moderate declines in revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) between December 31, 2019 and June 30, 2020 that, along with declines in the relevant markets, pushes the value of Business A down. By June 30, 2021, Business A has experienced a complete recovery. The table below summarizes selected financial and valuation information pertaining to Business A. Dollar amounts are in thousands.

Analysis:

The total equity value of Business A was $24.0 million on December 31, 2019, but declines to $19.2 million at June 30, 2020 under pandemic pressure. At June 30, 2021, the total equity value of Business A recovers to its pre-pandemic value of $24.0 million.

Assume Business Owner A wishes to transfer a 25% ownership interest in Business A into Trust A for the benefit of her heirs. Further assume that a composite valuation adjustment (i.e., discount for lack of control and/or lack of marketability) of 33% is appropriate based on the facts and circumstances. If Business Owner A transfers a 25% ownership interest at June 30, 2020, she would transfer $3.2 million into Trust A at the $19.2 million total equity value.

If Business Owner A waits twelve months and transfers a 25% ownership interest at June 30, 2021, she would transfer $4.0 million into Trust A at the $24.0 million total equity value. Business Owner A would have missed an opportunity to remove $800,000 from her taxable estate.

Case Study B: Steep decline, partial recovery

Facts:

Business Owner B owns 100% of Business B. As a result of the COVID-19 pandemic, Business B sees steep declines in revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) between December 31, 2019 and June 30, 2020 that, along with declines in the relevant markets, pushes the value of Business B down. By June 30, 2021, Business B has experienced a partial recovery. The table below summarizes selected financial and valuation information pertaining to Business B. Dollar amounts are in thousands.

Analysis:

The total equity value of Business B was $24.0 million on December 31, 2019, but declines to $16.8 million at June 30, 2020 under pandemic pressure. At June 30, 2021, the total equity value of Business B recovers to 90% of its pre-pandemic value, or $21.6 million.

Assume Business Owner B wishes to transfer a 25% ownership interest in Business B into Trust B for the benefit of her heirs. Once again further assume a composite valuation adjustment of 33%. If Business Owner B transfers a 25% ownership interest at June 30, 2020, she would transfer $2.8 million into Trust B at the $16.8 million total equity value.

If Business Owner B waits twelve months and transfers a 25% ownership interest at June 30, 2021, she would transfer $3.6 million into Trust B at the $21.6 million total equity value. While the underlying assumptions are different, Case Study B also illustrates a missed an opportunity to remove $800,000 from the taxable estate.

Post-Mortem

As the simplified case studies above illustrate, there may be an inverse relationship between the amount of pandemic-related stress a business is experiencing and the potential estate planning opportunity for its owners (provided that the business eventually recovers). From a tax strategy perspective, business owners typically want to gift interests at a reasonably low valuation, such as when the business is under pandemic-induced distress. With the upcoming elections this Fall, some may also be motivated by potential future tax law changes. Thus for business owners expecting a post-pandemic rebound, and who plan to transfer ownership during their lifetime, doing so before a lifetime pandemic subsides may be a smart move.

As always, Aronson’s team of tax advisors and valuation specialists is available to help you navigate complex valuation and tax planning situations. Contact 240.364.2580 to connect with our team.