Rare Valuation & Estate Planning Opportunities – Capitalizing on Record Low Interest Rates

By Ed Street and Brian Foltyn

Increased economic and financial uncertainty can create opportunities to transfer ownership interests in business entities at reduced values. In addition, low interest rates can provide further tax planning opportunities as discussed in this article.

Depressed Values + Low Interest Rates = Tax Planning Opportunities

Typically, stock prices and interest rates are inversely related. Oversimplified, when interest rates rise, borrowing money becomes more expensive and business earnings (net income) decrease due to:

  • Higher borrowing costs for businesses, which directly reduce business earnings and
  • Consumers decreasing spending, which causes business activity and business earnings (net income) to decrease.

Reductions in business earnings in turn cause stock prices to be reduced. And when interest rates fall, typically the opposite happens.

However, there are times when this relationship seems to break down. For instance, we are NOW observing both lower stock prices and lower interest rates, which is creating unique estate tax planning opportunities.

Depressed Values

For investment holding companies, asset values are depressed and for operating businesses, valuations have been negatively impacted by reduced business activity and increased financial and economic uncertainty, ultimately, leading to reductions in current earnings and future earnings expectations. In addition, increased uncertainty tends to decrease earnings based valuation multiples. Further, in the case of minority interests, we are observing an increase in discounts for lack of control and lack of marketability or liquidity in the markets for both holding and operating companies.

Lower overall equity values coupled with higher discounts for minority interests allow acquirers to purchase a greater number of shares and thus potentially enjoy greater future capital appreciation.

Low Interest Rates

The U.S. Treasury Department reduced the mid-term Applicable Federal Rate (AFR) from 1.75% in February to 0.99% in April, 0.58% in May and 0.43% in June.

Mid Term Rates for 2020
January February March April May June
1.69% 1.75% 1.53% 0.99% 0.58% 0.43%

 

The AFR is used as a proxy for private loan rates in estate tax planning. This means that if your client’s estate is large enough to trigger estate taxes when they pass, intra-family loans, sales to grantor trusts, grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs), in addition to outright gifts, are some examples of actions or estate planning strategies that could transfer future appreciation in asset value outside of a taxable estate.

Note: Under certain circumstances, existing intra-family loan balances can be consolidated and replaced with new loans using the current AFR rate.

Hypothetical Example

Assume that Dad sells $10.0 million of company shares at fair market value to his children in exchange for an eight year note. Assuming that the company shares are used to fund interest expense and ultimately repay the note, the below table summarizes the anticipated total return on the shares as of February 2020 and June 2020.

Excel table summarizes a hypothetical example of anticipated total return on sold shares

Note that on both dates, the expected appreciation in the company’s business exceeds the AFR, which allows the children to service the debt, repay the note at the end of the term and still retain ownership in the company. However, the hypothetical June 2020 transfer results in an additional $4.3 million of value (future value in hypothetical example) transferred compared to February 2020.

How REDW Can Help

Right now, it seems that with the country beginning to reopen and an economic recovery looming, the window of opportunity to maximize your client’s transfer of wealth may be small. REDW’s team holds extensive expertise and knowledge in both valuation and tax planning and can assist you and/or your clients to benefit from the current environment. Please contact Ed Street or Brian Foltyn to get started.


Copyright 2020 REDW LLC, CPAs & Advisors. All Rights Reserved. This publication is intended for general informational purposes only and should not be construed as investment, financial, tax, or legal advice.