Valuation’s Aren’t Just for Businesses

Whether you’re in the process of making a retirement or estate plan or you intend to donate property to charity, you’ll need to know the value of your assets. For many hard-to-value items, such as closely held business interests, real estate, art, and collectibles, an appraisal may be necessary.

Retirement and Estate Planning

To enjoy a comfortable retirement, you’ll need to calculate the income that can support your lifestyle when you’re no longer working. This means understanding the value of the assets you own. Once you have this information, you may decide to move your retirement date up or back.

Knowing the value of your assets is also necessary to assess whether you’ll potentially be subject to gift and estate taxes. It also allows you to identify strategies for minimizing or eliminating those taxes. In addition, without appraisals of hard-to-value assets, it’s nearly impossible to divide your overall property equally among your children (if that’s your wish).

Appraisals may also be necessary to avoid running afoul of tax basis consistency rules. The rules are intended to prevent heirs from arguing that estate property was undervalued, which would raise their basis for income tax purposes. According to these rules, the income tax basis of inherited property equals the property’s fair market value as finally determined for estate tax purposes. Appraisals can help ensure that your heirs receive the basis they deserve.

Gifts and Charitable Giving

The IRS has an unlimited amount of time to challenge the value of gifts for gift and estate tax purposes, unless they’re “adequately disclosed,” which generally binds the IRS to a three-year statute of limitations. A qualified professional appraisal with a timely filed gift tax return is the best way to disclose the value of a gift of a hard-to-value asset.

Charitable gifts of property valued at more than $5,000 (other than publicly traded securities) must be substantiated with a qualified appraisal by a qualified appraiser. This means that the appraiser meets certain education and experience requirements.

Know What You Have

Without appraisals of your hard-to-value assets, it’s difficult to develop a realistic financial plan, to create an estate plan that will achieve your desired results and to avoid unwelcome tax liabilities. Asset values can fluctuate dramatically over time, so make sure you get updated appraisals periodically.

Self-Directed IRAs Provide Both Flexibility and Risk

Traditional and Roth IRAs can be relatively “safe” retirement-saving vehicles, though, depending on what they’re invested in, they limit your investment choices. For more flexibility in investment choices but also more risk, another option is a self-directed IRA.

Gaining More Control

A self-directed IRA is simply an IRA that provides greater control over investment decisions. Traditional and Roth IRAs typically offer a selection of stocks, bonds and mutual funds. Self-directed IRAs (available at certain financial institutions) offer greater diversification and potentially higher returns by permitting you to select virtually any type of investment, including real estate, closely held stock, limited liability company and partnership interests, loans, precious metals, and commodities (such as lumber, oil and gas).

A self-directed IRA can be a traditional or Roth IRA. The tax-free growth Roth accounts offer makes them powerful estate planning tools.

Navigating Tax Traps

To avoid pitfalls that can lead to unwanted tax consequences, exercise caution when using self-directed IRAs. The most dangerous traps are the prohibited transaction rules. These rules are designed to limit dealings between an IRA and “disqualified persons,” including account holders, certain members of their families, businesses controlled by account holders or their families, and certain IRA advisors or service providers.

Among other things, disqualified persons can’t sell property or lend money to the IRA, buy property from the IRA, provide goods or services to the IRA, guarantee a loan to the IRA, pledge IRA assets as security for a loan, receive compensation from the IRA, or personally use IRA assets.

The penalty for engaging in a prohibited transaction is severe: The IRA is disqualified, and its assets are deemed to have been distributed on the first day of the year in which the transaction took place, subject to income taxes and, potentially, to penalties. This makes it very difficult to manage a business, real estate or other investments held in a self-directed IRA. Unless you’re prepared to accept a purely passive role with respect to the IRA’s assets, this strategy isn’t for you.

Considering the Option

If you’d like to invest in assets such as real estate, precious metals, or other alternative investments, a self-directed IRA may be worth considering. But it’s critical to understand the risks.

Buy-Sell agreements Require Careful Planning

Does your business have multiple owners? If so, you need a buy-sell agreement. This type of binding contract determines how (and at what price) ownership shares of a privately held business will change hands should an owner depart. There are also potential tax consequences to consider.

Unique Challenges

Unlike public companies, private ones have no ready or established market on which to sell ownership shares. This can create difficult circumstances for businesses when something unexpected happens. Say an owner suddenly dies. The owner’s shares may pass on to heirs, but how much are those shares worth and to whom can the heirs sell them? A buy-sell agreement will remove uncertainty by stipulating that remaining owners will buy the ownership interest at a price determined by the stated valuation method. Plus, the agreement will help to
prevent an unfamiliar and perhaps unwanted owner from suddenly joining the business.

Setting Parameters

A buy-sell agreement sets up parameters for the transfer of ownership interests following any of a number of “triggering events,” such as an owner’s:

  • Death,
  • Long-term disability,
  • Loss of professional license,
  • Retirement,
  • Bankruptcy, or
  • Divorce.

The agreement will also specify a valuation method for appraising the departing owner’s interest at the appropriate time. In choosing a method, you and your fellow owners should carefully define buyout terms and specify the financial data to be used in the agreement. For example, a sound buy-sell agreement will spell out a required end-date for the financial statements that must be used to appraise business interests following a triggering event. Some also mandate a particular level of assurance (compilation, review or audit) regarding those financial statements.

Different Approaches

In most cases business owners don’t have the cash readily available to buy out a departing owner. So most buy-sell agreements include insurance policies to fund the agreement. This is where different types of agreements come into play. Under a cross-purchase agreement, each owner buys life or disability insurance (or both) on each of the other owners. Should one owner die or become incapacitated, the other owners collect on their policies and use the proceeds to buy the deceased or incapacitated owner’s shares.

Another type is a redemption agreement. Here, the company (not each owner) buys the insurance policies and acquires the deceased or incapacitated owner’s shares. This approach can help businesses with a lot of owners, because fewer policies are needed. In some cases, a company will create a hybrid buy-sell agreement that combines aspects of the cross-purchase and redemption approaches. These agreements may stipulate that the business gets the first opportunity to redeem ownership shares. And, if the company is unable to buy the shares, the remaining owners are then responsible for buying the departing owner’s interests. Alternatively, the owners may have the first opportunity to redeem the shares.

Tax Consequences

The life insurance used to fund buy-sell agreement can also have undesirable tax consequences without proper planning. Life insurance proceeds generally are excluded from the beneficiary’s taxable income, whether the beneficiary is a corporation, another shareholder or a separate entity. An exception is the transfer-for-value rule, under which proceeds will be taxable if an existing policy was acquired for value by someone other than the insured or a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder.

This issue often arises when structuring or changing a buy-sell agreement using existing insurance policies. It’s important to structure the agreement so that the transfer-for-value rule won’t have an impact; otherwise, the amount of after-tax insurance proceeds will be reduced.

This issue often arises when structuring or changing a buy-sell agreement using existing insurance policies. It’s important to structure the agreement so that the transfer-for-value rule won’t have an impact; otherwise, the amount of after-tax insurance proceeds will be reduced.

You may be able to manage this problem by revising your buy-sell as a cross-purchase agreement. Under this approach, owners will buy additional shares themselves, increasing their basis. But there are downsides. If owners are required to buy a departing owner’s shares but the company redeems the shares instead, the IRS may characterize the purchase as a taxable dividend. Your business may be able to mitigate this risk by crafting a hybrid agreement that names the corporation as a party to the transaction and allows the remaining owners to buy back the stock without requiring them to do so.

Complex but Important

Buy-sell agreements can help closely held businesses ensure a smooth transition when an owner leaves the business. But they also require careful planning to be effective, including properly addressing potential tax issues.

Minimizing Capital Gains Tax on Sale of a Home

If you’re looking to sell your home this year, then it may be time to take a closer look at the exclusion rules and cost basis of your home to reduce your taxable gain on the sale.

The IRS home sale gain exclusion rule allows an exclusion of gain up to $250,000 for a single taxpayer or $500,000 for a married couple filing jointly. This exclusion can be used over and over during your lifetime (but not more frequently than every 24 months), if you meet certain ownership and use tests.

Eligibility Requirements

During the five-year period ending on the date of the sale, you must have:

  • Owned the home for at least two years – Ownership Test
  • Lived in the home as your main home for at least two years – Use Test
  • Not excluded gain from the sale of another home during the two-year period ending on the date of the sale.

The Ownership and Use periods need not be concurrent. Two years means 24 months or 730 days within a five-year period, but the months or days need not be consecutive. Short absences, such as for a summer vacation, count in the period of use. Longer breaks, such as a one-year sabbatical, do not.

If you own more than one home, you can exclude the gain only on your primary home. The IRS uses several factors to determine which home is a principal residence: the place of employment, location of family members’ main home, mailing address on bills, correspondence, tax returns, driver’s license, car registration, voter registration, location of banks you use, and location of recreational clubs and religious organizations you belong to.

The exclusion can be used repeatedly every time you reestablish your primary residence. When you change homes, please call the office with your new address to ensure the IRS has your current address on file.

Only taxable gain on the sale of your home needs to be reported on your tax return. Further, you cannot deduct the loss on the sale of your main home, unless a portion of your home is rented out or used exclusively for your business. In that situation, the loss attributable to that portion of your home may be deductible, subject to various limitations. Please call for additional details.

Improvements Increase the Cost Basis

Be sure to consider all improvements made to the home over the years when selling your home. Improvements will increase the cost basis of the home, thereby reducing the capital gain.

Additions and other improvements that have a useful life of more than one year can also be added to the cost basis of your home. Examples of such improvements include the following: building an addition; finishing a basement; putting in a new fence or swimming pool; paving the driveway; landscaping; or installing new wiring, new plumbing, central air conditioning, flooring, insulation, or a security system.

Jack and Mary purchased their primary residence in 2012 for $200,000. They paved the unpaved driveway, added a swimming pool, and made several other home improvements adding up to a total of $75,000. The adjusted cost basis of the house is now $275,000. The married couple sold the house in 2023 for $550,000. It costs them $40,000 in commissions, advertising, and legal fees to sell the house.

These selling expenses are subtracted from the sales price to determine the amount realized. The amount realized in this example is $510,000. That amount is then reduced by the adjusted basis (cost plus improvements) to determine the gain. The gain, in this case, is $235,000. After considering the exclusion, there is no taxable gain on the sale of this primary residence and, therefore, no reporting of the sale on Jack and Mary’s 2023 joint income tax return.

Partial Use of the Exclusion Rules

Even if you do not meet the ownership and use tests, in certain circumstances you may be allowed to exclude a portion of the gain realized on the sale of your home. A partial exclusion may be available if you sell your home because of health reasons, a change in place of employment, or certain unforeseen circumstances. Unforeseen circumstances include, for example, divorce or legal separation, natural or man-made disasters resulting in a casualty to your home, or an involuntary conversion of your home. If one of these situations applies to you, please call for additional details.

Recordkeeping

Good recordkeeping is essential for determining the adjusted cost basis of your home. Ordinarily, you must keep records for three years after the filing due date. However, you should keep documents proving your home’s cost basis for as long as you own your home.

The records you should keep include:

  • Proof of the home’s purchase price and purchase expenses
  • Receipts and other records for all improvements, additions, and other items that affect the home’s adjusted cost basis.
  • Any worksheets or forms you filed to postpone the gain from the sale of a previous home before May 7, 1997

Help Is Just a Phone Call Away

Tax considerations surrounding the sale of a home can be confusing. If you have any questions on taxes related to the sale of your home, please call.

Small Business Financing: Securing a Loan

At some point, most small business owners will visit a bank or other lending institution to borrow money. Understanding what your bank wants and how to approach it properly can mean the difference between getting a loan for expansion or scrambling to find cash from other sources.

Understand the Basic Principles of Banking

It is vital to present yourself as a trustworthy businessperson, dependable enough to repay borrowed money, and to demonstrate that you understand the basic principles of banking. Your chances of receiving a loan will greatly improve if you can see your proposal through a banker’s eyes and appreciate the position that the bank is coming from.

Banks are responsible to government regulators, depositors, and the community in which they reside. While a bank’s cautious perspective may irritate a small business owner, it is necessary to keep the depositors’ money safe, the banking regulators happy, and the community’s economy healthy.

Each Bank Is Different

While banks in general have a cautious attitude toward lending, they differ in the types of financing they make available, interest rates charged, willingness to accept risk, staff expertise, services offered, and attitude toward small business loans.

Selection of a bank is essentially limited to your choices from the local community. Typically, banks outside of your area will be more reluctant to make loans to you because of the higher costs of checking credit and of collecting the loan in the event of default.

Furthermore, a bank will typically not make loans, regardless of business size, unless a checking account or money market account is maintained at that institution. Ultimately your task is to find a business-oriented bank that will provide the financial assistance, expertise, and services your business requires now and is likely to require in the future.

Building Rapport

Establishing a favorable climate for a loan request should begin long before the funds are needed. The worst possible time to approach a new bank about a loan is when your business is in the throes of a financial crisis. Devote time and effort to building a relationship and goodwill with the bank you choose and early on get to know the loan officer you will be dealing with.

Bankers’ overriding concern generally is minimizing risk. Logic dictates that this is best accomplished by limiting loans to businesses they know and trust. One way to build rapport and establish trust is to take out small loans, repay them on schedule, and meet all loan agreement requirements in both letter and spirit. By doing so, you gain the banker’s trust and loyalty, and the banker will consider your business a valued customer and make it easier for you to obtain future financing.

Provide the Information Your Banker Needs

Lending is the essence of the banking business, and making mutually beneficial loans is as important to the bank’s success as it is to the small business. This means that understanding what information a loan officer seeks and providing the evidence required to ease normal banking concerns is the most effective approach to getting the financing you desire.

A sound loan proposal should contain information that expands on the following points:

  • What is the specific purpose of the loan?
  • How much money is required?
  • What is the source of repayment for the loan?
  • What evidence is available to substantiate the assumptions that the expected source of repayment is reliable?
  • What alternative source of repayment is available if management’s plans fail?
  • What business or personal assets, or both, are available to collateralize the loan?
  • What evidence is available to substantiate the competence and ability of the management team?

You need to do your homework before making a loan request because an experienced loan officer will ask probing questions about each of these items. Failure to anticipate such questions or providing unacceptable answers is damaging evidence that you may not completely understand your business and are incapable of planning for its needs.

What To Do Before You Apply for a Loan

  1. Write a business plan.Your loan request should be based on and accompanied by a complete business plan. This document is the single most important planning activity you can perform. A business plan is more than a device for getting financing; it is the vehicle that makes you examine, evaluate, and plan for all aspects of your business. A business plan’s existence proves to your banker that you are doing all the right activities. Once you have put the plan together, write a two-page executive summary. You will need it if asked to send “a quick write-up.”
  2. Have an accountant prepare historical financial statements.You cannot discuss the future without accounting for your past. Internally generated statements are OK, but your bank wants the comfort of knowing an independent expert has verified the information. Also, you must understand your statement and be able to explain how your operation works and how your finances stand up to industry norms and standards.
  3. Line up references.Your banker may want to talk to your suppliers, customers, potential partners, or team of professionals. When a loan officer asks for permission to contact references, promptly answer with names and contact information; do not leave the officer waiting for a week.

Walking into a bank and talking to a loan officer will always be stressful. Preparation for and thorough understanding of this evaluation process is essential to minimize the stressful variables and optimize your potential to qualify for the funding you seek.

Seek Advice from a Tax Professional

The advice and experience of a tax and accounting professional are invaluable. Do not be shy about calling the office.