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DEADLOCK-George W. DuRant, CPA/ABV, ASA
To the extent deadlock cannot be broken and harm has or will likely occur, a shareholder may seek judicial dissolution of the corporation under the corporate code. Even though dissolution is sought, a court may order the purchase and sale of an opposing shareholder's shares at fair value when dissolution is not economically advantageous. Generally, it is not advantageous to dissolve a profitable going concern because intangible assets such as work protocols, a trained workforce, name recognition, customer lists, etc. become wasted.
In the often cited case of Hendley v. Lee, 676 F.Supp. 1317 (D.S.C. 1987), two equal 50% shareholders were deadlocked and both sought an order setting the fair market value of the company's stock and compelling the opposing shareholder to sell his shares. In the alternative, each shareholder sought an order for dissolution of the corporation. At the outset of the litigation and throughout the trial, neither shareholder was assured of his status as buyer or seller. And, neither could be certain that the court would not order dissolution. Ultimately however, the court concluded that dissolution would be disadvantageous and ordered a buy-out.
In deciding which shareholder would be the buyer and which would be the seller, the Hendley court considered each shareholder's (a) financial wherewithal, (b) ability to compete with the corporation, (c) ability to operate the business, (d) strategic advantage as the continuing owner, (e) ability to become otherwise gainfully employed, and (f) tax burden upon sale. In addition, due consideration was given to the potential for future litigation resulting from choosing one shareholder over the other as buyer or seller. Accordingly, the buyer was the shareholder having (a) the greater financial resources to effect the buy-out, (b) the most opportunity to compete with the corporation if he were the seller, (c) the ability to operate the business, (d) the highest strategic interest in the business, apart from just employment, (e) the most tax burden upon sale, and (f) the greater potential for litigation if not chosen as the buyer.
In determining the buy-out price, the Hendley court distinguished fair value (an equitable concept of value) from fair market value (a market concept of value). The court observed that some pricing issues normally considered by willing buyers and willing sellers in a market transaction are not necessarily applicable when neither party is willing (as in a judicially ordered buy-out). For example, market pricing between willing buyers and sellers is affected by the degree of corporate control conveyed by a particular stock interest and how quickly the stock can be resold. Because investors prefer control and liquidity, willing buyers and sellers discount the market price of stock lacking those qualities.
However, the Hendley court did not allow market price discounting; even though neither shareholder could control the corporation and even though the stock was illiquid. Instead, the court focused on fair value - a determination of value based on perception of fairness after considering case specific facts and circumstances. According to the court: "discounts properly apply to the total value of the company in a ?willing buyer/willing seller' context, but do not apply at all when neither party is willing and the transaction is between insiders."
Experienced CPAs appreciate and expect judicial unpredictability in valuation cases. In deadlock cases, there is more than the usual uncertainty since the parties can not be certain that the corporation will not be dissolved, and if not dissolved, of their status as buyer or seller. Furthermore, valuation uncertainty increases when courts apply or do not apply accepted valuation methodology on a case-by-case basis in the interest of fairness. The lesson for CPAs is that there are no absolutes in the courtroom. The careful CPA will study the relevant case law and closely coordinate valuation advice with his or her client's legal counsel.
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George DuRant’s Business Value
Views From The United States Tax Court
Last month, Judge Laro of the United States Tax Court shared some of his valuation insights at the AICPA's Business Valuation Conference in Las Vegas. Among the most interesting of his comments are the following:
Guidance on valuation discounts in the family limited partnership (FLP) area is forthcoming from the Tax Court. Expect key decisions early during year 2000. Judge Laro referred to the ACM Partnership case in prefacing his remarks as to what can be expected. The facts of ACM Partnership, indicate that the taxpayer followed tax regulations precisely in structuring major tax saving transactions. Unfortunately, the court agreed with the IRS that the transactions had no business purpose other than tax savings. In Judge Laro's words, "if there is no useful non-tax purpose for doing something, then it is not going to work. So when you do a family limited partnership, one would think it would be a good idea to have business purpose." For those of us working in the FLP area, take heed, business purpose for forming an FLP may become the hotbed of controversy. (IRS Letter Ruling #199950014, September 15, 1999 should be consulted in this regard, also)
Read Mandelbaum (Bernard Mandelbaum, et al. v. Commissioner. T.C. Memo. 1995-254.); particularly if your valuation case is before Judge Laro and the controversy involves determination of a lack of marketability discount. I discussed this case in the Spring 1997 issue of this newsletter. Mandelbaum is important in business valuation because Judge Laro discusses 10 factors that he believes should be considered in assessing a discount for lack of marketability. The opinion goes to great links in explaining those factors and the type of analysis that Judge Laro believes appropriate so as to achieve some level of consistently in deciding marketability discount controversies by the 16 Tax Court judges.
As with most other tax valuation issues, fair market value is the appropriate standard of value for estate and gift tax matters. Fair market value is defined as the price at which property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having a reasonable knowledge of relevant facts. According to Judge Laro, the willing buyer and the willing seller are hypothetical buyers and sellers and the specific interests of an actual buyer or seller is irrelevant. Furthermore, having reasonable knowledge of relevant facts means more than conducting a limited inquiry of an investment (therefore, appraisals must be thorough) and should not rely upon sales made by persons not reasonably informed about value.
The first thing Judge Laro looks at in a business valuation report is the credentials of the appraiser to determine if the report is written by a real expert. According to the judge, the answer lies with credentials - does the appraiser have the training and the experience? has he or she written about the subject? The second thing Judge Laro looks at are the assumptions - are they reasonable?
Finally, a set of truisms about business valuations: Although past cases offer guidance as to acceptable methodology, each valuation case is unique. There are no absolutes, only general guidelines. There are no irrefutable right answers. And, experts will and do differ.
Business Valuation Key Case Update for 1999
Estate of Jameson, T.C. Memo. 1999-43. Jameson involved a timber holding company having built-in capital gains. Following the rationale of Estate of Davis, 110 T.C. 530 (1998) the court held that a hypothetical willing buyer would take into consideration the net present value of the build-in capital gains tax liability on future timber cuttings. The court also stated that the asset approach was "most reasonable in a case like this one, where the corporation functions as a holding, rather than operating company and earnings are relatively low in comparison to the fair market value of the underlying assets.
Estate of Alice Friedlander Kaufman, T.C. Memo 1999-119. Judge Laro rejected the taxpayer's reliance upon two sales as evidence of value for several reasons: (1) the sales occurred two months after the valuation date, (2) the sales were isolated and the blocks sold were dissimilar to the taxpayer estate's stock, (3) neither seller was "reasonably informed" as to the facts relating to the stock's value. The case hold that appraisers should (a) explain why comparative companies are comparable, (b) develop value indication under all three broad methods (market, income and asset based methods) or at least explain why a method is not used, and (c) follow the precepts of Mandelbaum.
Estate of Richard R. Simplot, 112 T.C. No. 13, 1999. In this case a superpremium was accorded voting stock. But the big decision in this case was 100% deduction of the potential capital gains tax on marketable securities worth $182 million (basis of $13 million) at the date of death. In last year's Davis case only ½ was taken off.
Estate of Smith, T.C. Memo 1999-368, 1999. This case involved valuation of large-asset, low-return company (a farm corporation). IRS wanted to focus only upon underlying asset value; the court required consideration (weighting) of earnings power and dividend paying capacity of the farm. The stipulated pro rata net asset value per share was $1,818. The court allowed a combined 76% discount for lack of marketability and lack of control based on supported valuation conclusions of the taxpayer's experts.
Estate of Harriet R. Mellinger, 112 T.C. 26 (January 26, 1999). Harriett Mellinger, the decedent, was the widow of the founder of Frederick's of Hollywood, Inc. She died owning Frederick's of Hollywood shares in her revocable trust and in a QTIP trust established by her late husband. The court held that the shares of stock should not merge or be aggregated for federal estate tax valuation purposes. As a result, Mellinger's estate was left with two blocks of minority shares in Frederick's of Hollywood. The court allowed a 25% blockage discount (a discount to reflect the depressing effect of marketing a large block of stock). Each case must be decided on its own facts, for a 3% blockage discount see Estate of Foote, T.C. Memo 1999-37.
Gross, T.C. Memo 1999-254, 1999. One of the principal disagreements in this case was whether S corporation earnings should be tax affected when using the income approach to valuation. The court said no; to do so would add a fictitious tax burden to corporate earnings. The court observed that the company had a history of making cash distributions to shareholders that nearly equaled its entire income; the court thought it was reasonable to assume the company would continue this practice.
The professional standards for business valuation appraisal have risen steadily over the past few years. The Tax Court's expectations for expert valuation reports and opinions have also increased dramatically. The Mandelbaum case cited previously and Hendrickson, T.C. Memo 1999-278 cases are clearly evidence of the Tax Court's increased sophistication and expectations in this area. In the Hendrickson case, Judge Begae rejected use of the discounted cash flow method because the withness failed to include a small stock premium in the computation of the discount rate (read this case for a pretty good discussion of the capital asset pricing model (CAPM).
Treasury Releases Final Adequate Disclosure Regulations For Gifts
A gift must be adequately disclosed on a gift tax return in order to commence the running of the period of limitations on assessment with respect to the gift. Recently issued regulations (effective December 3, 1999) provide guidance on what constitutes adequate disclosure. The required information must completely and accurately describe the transaction and include: the nature of the transferred property; the identity and relationship of the parties involved; the value of the transferred property; and how the value was determined, including any discounts or adjustments used in valuing the transferred property. In addition, the new regulation requires the taxpayer to submit a statement describing any position taken that is contrary to any temporary or final regulations or any revenue ruling published at the time the transfer occurred.
Adequate disclosure even if no gift tax is due is vital to begin the running of the period of limitations on assessment. Once the period of limitations expires, the amount of that gift as reported on the return may not be adjusted for purposes of determining future gift and estate tax liability, or other related income tax issues.
S.C. Court of Appeals Weighs-In on Stock Valuation
Shareholders dissenting from certain corporate actions such as a merger or sale of all corporate assets are entitled to receive fair value for their shares under South Carolina's Dissenters' Rights statutes.
In Belk of Spartanburg, S.C., Inc. v. Carolyn T. Thompson and Mary E.S. Hannahan, the court broadly specified the valuation methodology acceptable in dissenters' rights cases in South Carolina. The Belk case is recommended reading for those who believe the term fair value means the same as fair market value. In an article to be published in a forthcoming issue of South Carolina Lawyer, attorney Fred Crawford and I explore why the definition of fair value in South Carolina courts may be to some extent "whatever the court thinks is fair, is fair." The article also contains a pretty good explanation of valuation methodology which the court called a "Santee Analysis."
Empirical Data For Valuation of Limited Partnership Interests
Partnership Profiles, Inc., published its 1999 annual re-sale discount study of publicly-registered limited partnership interests in the Partnership Spectrum, May/June 1999 issue. That study compared the prices at which investors purchased limited partnership units in the secondary market during April and May 1999 to the liquidation net asset value of such units. As in past studies, the 1999 study indicates that the two most important factors considered by secondary market buyers in pricing units of real estate partnerships are (a) whether the partnership is consistently paying periodic distributions and (b) the degree of debt financing utilized by the partnership. A summary of the results of the study is reflected in the table below.
Partnership Category Discount From Net Asset Value Yield
Equity-Distributinglow or no debt)25% 8.8%
Equity-Distributing
(moderate to high debt) 35% 6.9%
Equity-Non-distributing 46% 0%
Undeveloped Land 46% 0%
Triple-Net-Lease 14% 9.5%
Insured Mortgages 14% 11.8%
George W. DuRant, CPA/ABV, ASA
This newsletter contains abbreviated discussions of complex topics and does not constitute advice to be applied to specific situations. No valuation, tax or legal advice is expressed or implied herein. ©Copyright 2000, DuRant, Schraibman & Lindsay CPAs. All Rights Reserved. Written Permission Required To Quote, Reference Or Reproduce (By Any Means) In Whole Or In Part.
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So You're Starting a Business
Have you ever said, "I think I'll start my own _______ business" or, "I could do that for a living." However, that is as far as it goes. It could be because you are unsure of how to go about the process of starting a business. Maybe it's the fear of not knowing what to expect. As you continue reading, you will find the basic steps and information you need to turn that entrepreneurial idea into reality. Topics that will be covered are: creating a business plan, business types, methods of accounting, tax deductions.
BUSINESS PLANS:
The first (and the last) thing that probably jumped into your mind, when thinking about a new business, was, "Where do I start?" or, "That won't work." At this point you become overwhelmed. Don't! There is a simple tool you can use to help determine whether your idea is worth exploring. It's called a business plan. The object of a business plan is to help discover the strengths and weaknesses of your idea. Writing a plan will enable you to capitalize on your strengths and minimize your weaknesses. A business plan does not have to be a treatise worthy of Homer's Odyssey. It is important to get your idea down in writing, to give yourself a road map to go by. Having a written plan, while not ensuring success, will give you a greater chance at achieving it.
Your business plan should cover some basic areas begining with a simple mission statement that defines:
· What your business does.
· Who your customers are.
· How your business is different from other competitors.
· What you expect to be making a year to five years from now.
An example might be, "I will have a portrait painting business that specializes in people's pets that will be grossing $12,000 the first year and $50,000 by the end of five years." In order for you determine what makes your business different from others; you will have to do a little legwork. Look in the yellow pages. Read the local newspaper ads. Go talk to your potential suppliers and potential customers. Take an informal survey of people you know and see what they would like to see, what they would or wouldn't buy and how much they would be willing to pay.
Then, decide how you will reach your target customer and how much marketing will cost. Set goals for converting prospects to clients. Don't get hung up on the traditional marketing methods; be creative. I've heard of a travel agent who made a collection of pictures from beautiful tropical islands, burned them onto a CD, and placed it on people's windshields. This gave the potential customer a virtual vacation tour of the tropics. If true, the CD was a lot more effective than flyers. Use your family and friends as sources of marketing ideas and help in driving business through your door. I highly recommend reading Guerrilla Marketing by Jay Levinson. It's full of creative and inexpensive ways to get to your product in front of your prospective customer.
Now comes the fun part: pricing. You need to determine what your prices will be and what your terms will be. Some craftsmen require a 50% deposit up front with the remainder due upon the customer's final approval. Some businesses have 30-day payment terms. You should develop a simple invoice or contract that you can use as a template. A good way to determine what the "best pricing practices" are is to ask your potential competitors or people who are in a similar business.
Now the next area that needs to be discussed is one that most people hate: budgeting. Budgeting is not as hard as it sounds. First you need to determine those items that you will need to have. Do not be afraid to take educated guesses. At this stage, list everything you can think of that you would potentially need. You can always shorten this list later. It's better to overestimate your budgeted costs than to come up short with funding.
Some of the more common costs are: supplies, workspace rent and other costs (electricity etc), marketing costs, phone, computers and self-employment and income taxes (more on this later). Also, don't forget to pay yourself. Some of these items you may have, like a computer. Others may cost you very little, such as a phone. A little tip for you: the best thing to do is to break your costs up by one-time costs and monthly costs. Once you know what your expenses will be, then you can easily determine how much money you need to start with and how much you need to sell to at least break even.
For a simple example, let's say that you figured that you need supplies and a computer to get going and it will cost you $2,500. Your other monthly cost are $1,500. In addition ,figure on your gross draw to be $500 a month (I'm a generous employer). You have $5,500 to contribute to your business venture (this could be from your savings, money borrowed from the bank, relatives or friends). Your pet portraits sell for $500. You will need to sell more than 3 portraits a month to keep in business.
The following is a sample of a monthly budget using broad expense categories:
|
|
Jan |
Feb |
March |
|
Beginning cash |
$ -0 |
$ 1,900 |
$ 1,400 |
|
Sales |
-0 |
1,500 |
1,000 |
|
Owner Cash |
5,500 |
-0 |
-0 |
|
Total cash available |
5,500 |
3,400 |
2,400 |
|
|
|
|
|
|
Less expenses: |
|
-0 |
-0 |
|
Owners draw |
500 |
500 |
500 |
|
Marketing |
500 |
500 |
500 |
|
Supplies |
1,000 |
900 |
900 |
|
Computer |
1,500 |
-0- |
-0- |
|
Utilities |
100 |
100 |
100 |
|
Total expenses: |
4,100 |
2,000 |
2,000 |
|
|
|
|
|
|
Ending Cash |
$ 1,900 |
$ 1,400 |
$ 400 |
That is what a business plan is about: Planning for how to get business, how much to charge, what your cost will be and how much you will have to sell to stay in business. Some business people have written term paper size reports and others have written them on napkins. Use whatever method works best for you. Almost all successful entrepreneurs have written a plan of some kind, so that they have a good understanding of where they are now, where they are going, and how they will get there.
BUSINESS TYPES:
After you have created a business plan you will need to decide what kind of company (entity) you will be. Your choices are: Sole proprietor, C or S-Corporation, Partnerships or a LLC. There are many factors that need to be considered when making your choice. Are you in business by yourself or do you have a partner? How much liability are you exposed to? How hard are they to operate? What are the implications for your individual tax situation? How easy is it to raise money? The following table meant to give you a comparison of the different entity types and some of the advantages and disadvantages associated with them. They are meant only to give you a broad understanding of the different choices. It is important when making your decision that you consult with your legal or tax advisor.
|
Characteristics
|
Sole-Proprietorship |
Partnerships
|
LLC
|
S-Corporations
|
Corporations
|
|
|
|
|
|
|
|
|
Formation: |
No permission is required |
Partnership agreement. No permission required |
Membership agreement. Permission from state |
Permission from state |
Permission from state |
|
Number of owners |
1 |
Unlimited |
Unlimited |
75 shareholders |
Unlimited |
|
Liability: |
Unlimited |
Unlimited |
Typically members are not liable for debt |
Typically shareholders are not liable for debt |
Typically shareholders are not liable for debt |
|
Tax reporting: |
On individual return-Schedule C |
Form 1065 |
Form 1065, 1120S or 1120 |
Form 1120S |
Form 1120 |
|
Taxation: |
Individual pays all taxes |
Income/Loss are passed through to partner per partnership agreement. |
Income/Loss are passed through to members per membership agreement. |
Income/Loss are passed through to shareholders in proportion to their ownership. |
Company pays all taxes. |
|
Double taxation: |
No |
No |
No |
No |
Yes |
|
Self Employment tax |
Yes |
Yes, if income is from trade or business |
Yes, if income is from trade or business |
No |
No |
|
Raising capital: |
Individual contributes money |
Contributions of partners, or addition of partners |
Contributions of members, or addition of members |
Sell shares of stock |
Sell shares of stock |
METHODS OF ACCOUNTING:
After you have chosen your business type, you will need to decide what method of accounting you will use. The two types of accounting are accrual and cash. Again, please consult with your tax advisor as this decision can have a large impact as to your tax liability.
Accrual accounting recognizes income when earned, regardless when received and expenses when incurred regardless of when paid. The cash method of accounting recognizes income and expense when paid. For example, you finished a pet portrait for a client and they have not paid you. Under accrual accounting you would recognize this as income, even though you have not received any cash. Under the cash method you would not treat this as income until the client paid you. Another example would be if you went to the store and bought materials under credit. Under the accrual method this is an expense. For the cash method this would not be an expense until you paid for it.
Generally, the accrual method is favored for financial reporting purposes because is presents a more accurate picture of financial results. For those who are allowed to use the cash method, it can be favored because of income tax benefits
TAX ISSUES
The discussion of tax issues is never very easy. Most tax professionals have a favorite phrase: "It depends." That is because every situation is unique and the application of the rules can be tricky. It seems that every year there are changes to what and how much can be deducted. Deductions are subject to phase-ins, phase-outs, taxable income and other limitations that are very dependant on individual circumstances. Therefore, it is very important that you discuss tax deductions with your tax advisor and how they interact with your specific situation. The following is a general discussion of tax specific deductions from income.
Self-Employment taxes: Trade or business income from Sole proprietor, partnership and LLC are subject to this tax. This tax is equivalent of FICA and MCR deductions that you see on your normal paycheck times two, which is 15.3%. That's in addition to your income taxes.
Auto Deduction: either
Mileage: You can deduct 36 cents from each mile you drive specifically for your business. Commuting and personal mileage are not deductible. Also the IRS requires you to keep records, i.e. keep a separate mileage log, record it in your day timer, personal organizer or PDA to have support for your deduction.
or
Actual: You can deduct actual expenses of operating your vehicle, i.e. fuel, insurance, repairs and maintenance and depreciation. This deduction is limited to the percentage of actual business use and personal use can not exceed 50%.
Meals and Entertainment: Meals and entertainment expenses that are incurred directly to benefit your business are 50% deductible. Club memberships are not deductible, but the actual meals are, but subject to the 50% rule. There are a few more considerations that further complicate this area, so please consult your tax advisor.
Home Office: A lot of business owners decide to run their business from their homes. Certain expense can be deducted in the same proportion as your office is to your home. If your home office is 25% of your home, you can deduct as a business expense: 25% of your homeowners' insurance, utilities, interest, taxes, repairs, and yard maintenance. . Notice I did not include the phone. Telephone expenses are fully deductible if and only if you have a second line. Now some of these expenses are individual deductions, such as home interest and taxes. But, because you deducted them against business income you are able to reduce your business income and reduce self-employment taxes.
You are also able to deduct depreciation of your home in the same ratio. Unfortunately, since you took this as a deduction against ordinary income when you sell this house you will have to recognize the gain, to the extent you could have claimed depreciation, as ordinary income taxed at your highest income tax rate. Normally, as an individual, gains are excluded from income up to $250,000 per individual (Assuming this is your primary residence and you lived there for 24 months out of 60). Notice I underlined the word could. If you decided that depreciation was too much trouble and did not deduct it, the IRS will still treat the sale as if you had. The consequence of which would be that you would have to pay taxes on the income that you never got the deduction for. So ,please consult your tax advisor.
Health Insurance: Starting in 2003 health insurance for self employed individuals (including partners, shareholders of S-Corps and members of LLC's) are 100% deductible to the extent you had income from the business.
Retirement Plans: As a self-employed individual you are eligible to set up a retirement plan and deduct your contributions to it. It can be an IRA, Simple, KEOGH, 401k. Each one has its own set of eligibility and contribution limits. My advice would be to consult with your financial or tax advisor. But you can do it, so it's worth exploring.
SECTION 179 AND BONUS DEPRECIATION: Under Section 179 the government allows you to directly deduct $100,000 of the cost of equipment, furniture and other personal property. In addition, if new, you can deduct an additional 50% bonus depreciation (almost all states do not recognize this bonus depreciation). You can only take the Section 179 deduction to the extent you have income from your business. There is no such rule for the 50% bonus depreciation. A vehicle has to be over 6,000 lbs to be eligible for section 179 and full bonus depreciation. If not, luxury automobile depreciation rules apply. Under those rules it would take a very long time to fully depreciate a vehicle. If you were inclined to buy new equipment for $200,000 you could conceivably deduct $150,000 of the cost in year one, before applying the standard rule of depreciation. Remember you would still have to pay for the vehicle. First you would take the full section 179 of a $100,000, then the bonus depreciation of $50,000. Now there are a lot more ins and outs to the Section 179 and bonus depreciation. Again, I would highly recommend you have a discussion with your tax advisor.
The previous information should have been a good primer to get you started. There are many other resources available for you to use to turn your idea into an actual business. Your local college and public libraries, the Chamber of Commerce, your local SCORE (Service Corps of Retired Executives Association) office and your CPA are excellent resources. In addition there are several excellent websites. Feel free to check out our firms website at www.dslcpas.com
About the author: Bill Arnott is a practicing Certified Public Accountant in South Carolina, with the firm DuRant, Schraibman and Lindsay CPA's. Bill has been helping small business owners in many states, with their accounting, accounting systems and tax needs for 7 years. If you have any questions or comments please feel free to contact Bill at 803-790-0020 or via email bill@dslcpas.com. or by post -4408 Forest Drive, Third Floor Columbia, SC 29206
This newsletter contains abbreviated discussions of complex topics and does not constitute advice to be applied to specific situations. No valuation, tax or legal advice is expressed or implied herein. ©Copyright 2003,
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