Family-owned businesses face distinctive challenges when it comes to succession planning. For example, it’s important to address the distinction between ownership succession and management succession.
When a nonfamily business is sold to a third party, ownership and management succession typically happen simultaneously. However, in the context of a family business, there may be reasons to separate the two.
From an estate planning perspective, transferring ownership of assets to the younger generation as early as possible allows you to remove future appreciation from your estate, thereby minimizing estate taxes. Proactive estate planning may be especially relevant today, given changes to the federal estate and gift tax regime under the Tax Cuts and Jobs Act.
For 2023, the unified federal estate and gift tax exemption will be $12.92 million, or effectively $25.84 million for married couples. That’s generous by historical standards. In 2026, the exemption is set to fall to about $6 million, or $12 million for married couples, after inflation adjustments — unless Congress acts to change the law.
However, when it comes to transferring ownership of a family business, older generations may not be ready to hand over the reins — or they may feel that their children aren’t yet ready to take over. Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the company. Providing heirs outside the business with equity interests that don’t confer control may be an effective way to share the wealth.
Several tools may allow you to transfer family business interests without immediately giving up control, including:
Owners of smaller family businesses may perceive ESOPs as a complex tool, reserved primarily for large public companies. However, an ESOP can be an effective way to transfer stock to family members who work in the company and other employees, while allowing the owners to cash out some of their equity in the business.
Owners can use this newfound liquidity to fund their retirements, diversify their portfolios or provide for family members who aren’t involved in the business. If an ESOP is structured properly, an owner can maintain control over the business for an extended period even if the ESOP acquires a majority of the company’s stock.
When it comes to succession planning, older and younger generations of a family business may have conflicting objectives and financial needs. If any of the strategies mentioned here interest you, or you’d like to discuss other aspects of succession planning, please contact us.
What do you do with your financial statements when your auditor delivers them? Resist the temptation to just file them away — they’re more than an exercise in compliance. With a little finagling, you can calculate key financial ratios from line items in your company’s financial statements. These metrics provide insight into historical trends, potential areas for improvement and how the business is likely to perform in the future.
Financial ratios are generally grouped into the following four principal categories:
Operating ratios — such as the gross margin or earnings per share — evaluate management’s performance and the effects of economic and industry forces. Operating ratios can illustrate how efficiently a company is controlling costs, generating sales and profits, and converting revenue to cash.
This analysis shouldn’t stop at the top and bottom of the income statement. Often, it’s useful to look at individual line items, such as returns, rent, payroll, owners’ compensation, interest and depreciation expense.
2. Asset management
Asset management ratios gauge liquidity, which refers to the ability of a company to meet current obligations. Commonly used liquidity ratios include:
It’s also important to consider long-term assets, such as equipment, with the total asset turnover. This ratio tells how many dollars in revenue a company generates from each dollar invested in assets. Management must walk a fine line with 1) efficient asset management, which aims to minimize the amount of working capital and other assets on hand, and 2) satisfying customers and suppliers, which calls for flexible credit terms, ample safety stock and quick bill payment.
Coverage ratios measure a company’s capacity to service its debt. One commonly used coverage ratio is times interest earned, which measures a firm’s ability to meet interest payments and indicates its capacity to take on additional debt. Another is current debt coverage, which can be used to measure a company’s ability to repay its current debt.
Before a company that already has significant bank debt seeks further financing, it should calculate its coverage ratios. Then it should consider what message management sends to potential lenders.
Leverage ratios can indicate a company’s long-term solvency. The long-term debt-to-equity ratio represents how much debt is funding company assets.
For example, a long-term debt-to-equity ratio of five-to-one indicates that the company requires significant debt financing to run operations. This may translate into lower returns for shareholders and higher default risk for creditors. And, because the company needs to make considerable interest payments, it has less cash to meet its current obligations.
Basis of comparison
Ratios mean little without appropriate benchmarks. Comparing a company to its competitors, industry averages and its own historical performance provides perspective on its current financial health. Contact us to help select relevant ratios to include in your analysis. We can help you create a scorecard from your year-end financial statements that your in-house accounting team can recreate throughout the year using preliminary financial numbers.
Many construction businesses are structured as C corporations. If that’s the case for your company, you’re probably aware that C corporations usually prefer to classify payments to owners as tax-deductible wages because it lowers corporate taxes. However, as you’re likely also aware, if the IRS believes that an owner’s compensation is excessive and unreasonable, it may claim that payments are disguised dividends — and deny deductions for them. Earlier this year, in Clary Hood, Inc. v. Commissioner , the U.S. Tax Court found that a construction company owner wasn’t entitled to the deductible amounts he’d claimed in two tax years and that he was subject to a penalty. But there was some good news for the taxpayer. Deductions redetermined The company involved in the case primarily provided land grading and excavation services for construction projects in the South Carolina region. The owner founded the business with his wife and, together, they served as the sole shareholders and members of the board of directors. Using a multifactor test, the Tax Court found that the taxpayer failed to adequately establish how the deductible amounts being claimed for each of the two tax years were both reasonable and paid solely as compensation for the owner-founder’s services. However, the court didn’t deny the deductions. Rather, it redetermined the deductible amounts of compensation that the owner-founder could claim. The taxpayer could still deduct up to the redetermined amounts — which were less than what he’d originally claimed but still more than what the IRS was arguing for. The court noted various factors were most relevant and persuasive in reaching its conclusion. These included: The taxpayer’s distribution history, How the owner-founder’s compensation was set in the years at issue, and His involvement (day-to-day activities) in the business. The court also heard testimony from an expert, who included compensation for surety bond guaranties in his analysis and provided a well-reasoned salary comparison against industry standards. Penalty applied Another interesting aspect of the case was whether the owner-founder should be subject to the accuracy-related substantial understatement penalty for both tax years. To wit, the court didn’t uphold the penalty against the construction company and its owner-founder for the first of the two tax years. Although the taxpayer’s understatement was substantial for both years, the evidence demonstrated reasonable cause and reasonable reliance on professional advisors for the first year. Notably, the taxpayer showed that the company’s advisors were competent professionals with sufficient expertise to justify reliance and no inherent conflicts of interest. The owner-founder also provided evidence that the advisors were given all relevant information and that he relied on their advice. However, the court upheld the accuracy-related substantial understatement penalty for the second year. This is because the taxpayer provided almost no evidence regarding professional advice received in calculating the deduction amount. Although the owner-founder alternately claimed substantial authority for his position and the use of a certain test to determine the deductible amount, he failed to prove substantial authority to claim the amount. A strong defense As this case shows, the IRS will challenge deductions for owner compensation that it deems unreasonable. However, as the case also demonstrates, thorough documentation and expert advice can help owners of C corporations defend themselves. We can assist you and your construction company’s co-owners in determining reasonable compensation amounts. Clary Hood, Inc. v. Commissioner , No. 3362-19, March 2, 2022 (U.S. Tax Court) © 2022
When valuing a business using the discounted cash flow method, residual (or terminal) value is a key component. The International Valuation Glossary — Business Valuation defines residual value as “the value as of the end of the discrete projection period in a discounted future earnings model.”
Business valuation experts typically consider the capitalization of earnings method and the market approach when estimating residual value. Either (or both) may be appropriate, depending on the nature of the business, purpose of the valuation, reliability of the company’s financial projections and availability of market data.
The capitalization of earnings method is based on the assumption that cash flow will stabilize in the final year of the projection period. However, this is also the time period that’s subject to the greatest margin for error because it’s the furthest into the future.
Under the capitalization of earnings method, residual value equals expected future cash flow (the numerator) divided by a capitalization rate (the denominator). The long-term sustainable growth rate is used in the numerator to determine cash flow in the final projection period. Then it’s used again in the denominator because the capitalization rate equals the discount rate minus this growth rate.
Because it’s in both the numerator and the denominator, the long-term sustainable growth rate can have a significant effect on residual value. A minor change in this rate can have a major impact on business value.
Applying the market approach
Another way to estimate residual value is to assume that the business could theoretically be sold at the end of the discrete period in an arm’s length transaction. Using the market approach, a business valuation expert considers comparable public stock prices and sales of comparable private businesses. Although the market approach sounds straightforward, it can sometimes be difficult to find comparable transactions, especially for small private companies.
Comparable market data also might serve as a sanity check. For example, a valuation expert might compare:
There may be cause for concern if, say, a company’s residual value generates a price-to-revenue multiple of 5.0 and comparable transactions during the last 12 months indicate an average price-to-revenue multiple of 1.2. The expert would need to explain the reason for such a discrepancy — or possibly adjust his or her analysis.
Residual value can be a major part of the valuation puzzle, so it’s important to get it right. Like annual cash flows over the discrete projection period, residual value is discounted to present value to arrive at the value of a business under the discounted cash flow method. Contact us to develop a residual value that’s based on reliable projections and objective market data.
Preventing, detecting, and investigating occupational fraud requires a deep understanding of the types of schemes, potential financial losses, emerging threats and risk mitigation strategies. To that end, the Association of Certified Fraud Examiners (ACFE) has published its “Report to the Nations,” the preeminent source for occupational fraud statistics and trends, every two years since 1996.
The 2022 ACFE report covers 2,110 occupational fraud cases in 23 industries and in 133 countries. Surveyed organizations have lost more than $3.6 billion to fraud. The report can help your organization understand and mitigate fraud threats. Here are some of the highlights.
The ACFE divides occupational fraud schemes into three types:
Asset misappropriation. This includes cash theft, fraudulent disbursements, larceny and misuse of inventory and is the most common type of occupational fraud, accounting for 86% of cases. The median loss for these schemes is $100,000.
Financial statement fraud. The least common type of fraud (9% of cases), financial statement schemes generate the highest losses — a median loss of $593,000 in the 2022 report.
Corruption. This falls between asset misappropriation and financial statement fraud in terms of losses and frequency. In the 2022 report, corruption costs resulted in a median loss of $150,000.
Fraud experts who participated in the study estimate that the average organization loses 5% of revenue to fraud each year. This percentage can serve as a starting point for determining your risk of suffering financial harm.
Detection and the role of tips
According to the ACFE report, a typical fraud case generates losses of $8,300 per month and lasts for 12 months. Forty-two percent of frauds in the report were uncovered via tips, with more than half of those provided by employees. Forty percent of tips came via email, 33% via a web-based form and 27% from phone calls.
The volume of email and web-based tips exceeded the number of tips submitted via phone hotlines. However, organizations offering hotlines reduced the median loss of fraud by 50%, from $200,000 to $100,000. Those organizations detected fraud faster and reduced the duration of schemes by 33% — from 18 months to 12 months.
Almost half of the cases analyzed in the 2022 report were determined to occur because the organizations lacked adequate internal controls or managers had overridden existing controls. The report also highlighted a lack of management review and a poor “tone at the top” as primary control weaknesses contributing to fraud.
Not surprisingly, the ACFE found that the existence of antifraud controls can lower fraud losses and accelerate fraud detection. To help organizations understand the impact of internal controls, the ACFE details the effect of 18 common policies on median loss and median duration of fraud schemes. These include hotlines, surprise audits, codes of conduct, antifraud training and proactive data monitoring.
For example, when job rotation or mandatory vacation policies are in place, the median loss from fraud is $64,000. When neither control is in place, the median loss climbs to $140,000. Similarly, when organizations have job rotation or mandatory vacation policies in place, fraud schemes typically last eight months. This duration doubles to 16 months when those controls aren’t in place.
Learn from others
The ACFE report is relevant to organizations of every size and in every industry. Learning about the losses of others can help your company better assess risk and take steps to mitigate fraud. If there’s one overwhelming takeaway from the ACFE reports, it’s that internal controls are essential. Contact us for help assessing your control needs.
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