Most businesses impacted by the COVID-19 pandemic haven’t yet fully recovered. Depending on the type of business and industry, it may take a long time for certain businesses to bounce back to pre-pandemic levels or to reinvent themselves, shift to a new business model or change market strategies.
Businesses remained afloat in 2020 through 2021 thanks to PPP loans and other forms of government assistance, but many are still hindered by the lingering effects of COVID-19 closures and related mandates. The many uncertainties that still linger, including what might happen to the gift and estate tax exemption level, create a rare planning opportunity by allowing business owners to transfer a greater portion of business assets at still lower values and reduce their taxable estate. But because of the looming tax changes that may take effect in 2022, the window of opportunity is narrowing, and there’s no better time than the present.
As we end 2021 and more than a year after the COVID-19 disruption, following is a recap of a few highlights in business valuation applicable in a gift and estate tax context.
Marketability Discount in Privately Held Businesses
How do you estimate a COVID-19 discount for lack of marketability (DLOM) for interests in privately held businesses? For gifting fractional interests in privately held businesses, layering the DLOM with a “COVID-19 marketability discount” is appropriate, as this process helps to organize thinking and provide support for professional judgment. A suggested methodology for determining an appropriate “COVID-19 marketability discount” is based on weighing factors such as those used in Mandelbaum v. Commissioner, TC Memo 1995-255 (in a landmark decision, Judge Laro provided a framework for evaluating discounts for lack of marketability in minority interest cases) and the Internal Revenue Service DLOM Job Aid. However, the categories would be modified to fit the current situation, such as the effect of the shutdown and stay-at-home orders, employee issues, supply chain issues, PPP loans or other support. Because the process gathers far more qualitative information than quantitative data, significant professional judgment is required, and findings will always fall within a wide range. A caveat to this method, as with any discount, is double counting a risk that’s already been accounted for in the discount rate, the cash flow multiplier or other discounts.
Businesses Impacted by COVID-19
For businesses impacted by COVID-19, a scenario-based analysis is reasonable and appropriate. Typically, this involves a slightly complicated detour from the plain vanilla discounted cash flow (DCF) method and developing a multiscenario DCF and a weighting for each DCF scenario.
For instance, a best case scenario will be a short recessionary period and a slightly adverse impact on financial performance; a base case or middle case scenario will be a one-year recessionary period and a modestly adverse financial impact; and a worst case scenario will be a two-year recessionary period and a severely adverse financial impact. Depending on the distribution of projected net cash flows and percentages used for the probabilities of each scenario, the result will be either symmetrical or skewed. If symmetrical, the probability-weighted value will be the same.
There are various opinions regarding the application of a multiscenario DCF, and it’s more important to factor the impacts into the benefit streams rather than in the risk factor. Also, the time frame isn’t limited to a five-year DCF—it can be two years, three years or whatever is reasonably appropriate. In a multiscenario DCF, a valuation analyst can examine whether the subject firm can even survive over a certain time frame; determine whether the firm can improve and to what extent; and estimate some level of normalized operations post-pandemic. It’s also helpful to determine or consider using different risk rates for different discrete time periods.
A caveat to this method is that even with adjustments to cash flows for the extra risks of COVID-19, projections will still have less reliability than before. Therefore, the discount rate will have to reflect some of the extra risks. In addition, it may also be appropriate to consider the use of ranges for an opinion of value, as opposed to one single number.
Is the Market Approach Still Relevant?
Many valuation experts point out that guideline merger and acquisition (M&A) transactions during COVID-19 need special scrutiny. The target firm may be particularly strong, or there may be some powerful synergies in the deal. Also, the use of market-based multiples is problematic, as the values in the numerator and denominator may not reflect the impact of COVID-19.
Although there are various techniques for adjusting the guideline public-company multiples and guideline M&A transaction multiples to address the impact of COVID-19, some valuation experts offer alternative market-based methods for valuation dates occurring after mid-February 2020. One method is considering the following for the guideline M&A method. If the purchase price of the target reflects the impact of COVID-19 (affected purchase price) but the earnings used in the calculation of multiples don’t (unaffected earnings):
- Calculate the multiples based on the affected purchase price and unaffected earnings of the target. This calculation will provide the affected M&A multiples.
- If COVID-19 has affected the earnings of the subject company (affected earnings), adjust the affected earnings to quantify the unaffected earnings of the subject company.
- Apply the affected M&A multiples to the unaffected earnings of the subject company to estimate the value of the subject company as affected by COVID-19 (COVID-19 value).
Valuation Date—Timing the Gifting Date
Between 2020 through 2021, there were many opportunities for gifting at low valuations, especially for businesses impacted by COVID-19. A valuation done pre-COVID-19 may be obsolete and should be updated post-COVID-19 to factor in the impacts of the pandemic.
Many business owners ask: How do you do projections when you don’t know how long COVID-19 will last? That’s one of the million-dollar questions, but note that assumptions should be backed by reliable sources. Valuation experts point to sources such as the Congressional Budget Office (CBO) and McKinsey, which have done analyses about economic recovery periods. The June 1, 2020, CBO report says that, as a result of the global pandemic, it will take 10 years before the country’s real gross domestic product matches the office’s projections from January. According to McKinsey, in a muted recovery, it could take more than five years for the most affected sectors to get back to 2019 levels.
If a pre-COVID-19 valuation date is being prepared in a post-COVID-19 environment and the impact of the virus wasn’t known or knowable as of the valuation date, the valuation shouldn’t take COVID-19 into account but a subsequent events section should be added to the valuation report. The American Institute of Certified Public Accountants (AICPA) recently put out a subsequent events toolkit that includes frequently asked questions and sample disclosure language. It reminds valuation analysts who adhere to the AICPA’s valuation standards that the disclosure of a subsequent event isn’t required, and it’s up to the valuation analyst to decide whether it’s appropriate to make the disclosure.
New Tax Law in 2022?
Uncertainty remains regarding a new tax law under the current presidential administration. On Sept. 12, 2021, the House Ways and Means Committee released the text of a proposed bill to fund the Build Back Better Act. This bill contains extensive tax law changes targeted to reduce tax planning opportunities for high-net-worth private clients. Below are a few highlights of some of the proposed changes that have valuation implications:
- Exemption amount is reduced from $11.7 million to approximately $6.02 million effective Jan. 1, 2022.
- Valuation discounts for gift tax and estate tax purposes are eliminated except with regard to entity assets used in an active trade or business effective for transfers made after the date of enactment.
- The top tax rate for long-term capital gains is increased from 20% to 25%. The effective date is unclear but would seem to apply to sales or exchanges on or after Sept. 13, 2021 (includes binding sales contract exception).
At this time, it’s best to complete any: (1) gifting; or (2) sale to a nongrantor trust where a discount for lack of control or DLOM are applicable.
The company-specific risk (CSR) premium used in developing an appropriate discount rate has been a topic of interest especially in the wake of COVID-19. The Appraisal Foundation is seeking to develop guidance to promote more uniformity in practice in estimating CSR for fair value for financial reporting.
At the moment, there are no empirical studies, magic formulas or computer algorithms that can determine with precision the CSR in a privately held company. Valuation isn’t a precise science, and professional judgment is required. In the COVID-19 era, many experts recommend spending more time on the numerator (cash flows) of the valuation equation and less time on the denominator, which includes cost of capital.
Another area in developing the discount rate that’s come to light recently is the size effect. Many financial veterans are concluding that the small-company effect doesn’t, after all, exist. The Russell indexes show that the factor is “muted at best,” and sophisticated statistical work confirms it. Several recent papers imply that taking a DLOM and a size premium may be double counting the illiquidity factor. Stay tuned.
There’s no magic formula for doing business valuations for gift and estate tax purposes in the COVID-19 era. We take a fundamental approach nowadays with a much greater dose of professional judgment and dig deeper into the impact of COVID-19 in the operations, modifying the DCF, adjusting pre-COVID-19 market multiples, analyzing and layering in the extra risks and more.