It’s nearly impossible to discuss anything automobile-related without mentioning the name Henry Ford. Henry Ford established the Ford Motor Company in 1903 and also became one of the founding fathers of the automated assembly line mode for the production of his Model T vehicle. One of the famous quotes attributed to Mr. Ford is that “failure is only the opportunity to begin again.” This adage continues to inspire the auto industry today as it attempts to recover from turbulent economic conditions caused by the COVID-19 pandemic, much like its recovery from the Great Recession just a decade ago.
Three converging factors have this fall shaping up to be the busiest estate planning season since 2012.
While economic recovery is still uncertain as the pandemic continues on and new relief bills are on the ropes, there currently exist potentially attractive estate planning opportunities for auto dealer owners.
Three converging factors have this fall shaping up to be the busiest estate planning season since 2012: 1) potentially depressed valuation of assets and businesses; 2) historically low interest rates; and, 3) uncertainty regarding the political administration going forward. Let’s delve a little deeper into these three factors.
Potentially Depressed Valuations
At its core, the valuation of a business consists of three assumptions: cash flow, risk and growth. Cash flow can be defined as the expected earnings of a business into the future. With no certainty of the future, historical performance and recent performance can serve as a starting point for those future expectations. The second assumption is risk: what are the risks that the company faces to achieve those expected cash flows? Risks can be internal such as labor and management or risks can be external such as the economy or competition. The final assumption to valuation is growth: how are cash flows expected to grow in the future?
All three of these valuation assumptions have been threatened by the pandemic. Recent cash flow has been threatened for most industries, not just the hospitality, retail, and restaurant industries. Certainly, for businesses, operating and economic risks have increased during the pandemic. As far as growth and recovery, we’ve all gotten an education into the alphabet soup of recovery: can the recovery for the general economy be described as v-shaped, u-shaped, w-shaped, k-shaped, or some other letter?
Historically Low Interest Rates
Those familiar with the concepts of finance and valuation also understand the relationship between interest rates and value. Generally, as interest rates (and risk) increase, the value of the asset decreases and vice versa. The pandemic and summer/fall of 2020 has created a unique opportunity regarding interest rates, as the Fed has brought rates to near zero in order to combat the pandemic.
How are interest rates used in estate planning? Attorneys utilize many structures when seeking to transfer family wealth from one generation to the next: Grantor Retained Annuity Trusts (GRATs), Charitable Remainder Unified Trusts (CRUTs), installment sales, interfamily loans, and many other structures. Most of these structures utilize some form of a note/loan between family members. Under current tax law, a family member could not make an interest-free loan to a child or grandchild without that portion of the loan being considered as a taxable gift. To shield that portion of the loan from being a taxable gift, the loan must carry a stated interest rate. The IRS establishes guidelines for these interest rates in the form of Applicable Federal Rates (AFRs), which are determined monthly by the U.S. Treasury. The mid-term AFR rates have been historically low, and below 1% for most of 2020.
The mid-term AFR rates have been historically low, and below 1% for most of 2020.
How do low AFRs assist in estate planning? In addition to satisfying the IRS’ requirement so that the interest portion of the loan will not be treated as a gift, the lower level of AFRs should motivate estate planning this fall. Often, the structures that attorneys use in this form of planning (discussed above) depend on the cash flow from the asset being transferred (perhaps an operational business as an example) to fund the debt service in connection with the loan. In times of lower AFRs, the debt service is reduced, and it’s easier for the cash flow from the asset to cover the debt service. Additionally, the success of these transfer vehicles is usually dependent on the potential growth and appreciation in value of that asset after it is transferred to the next generation. With historically low AFRs and greater expected rates of return on the transferred assets, there are potential arbitrage opportunities on the spread of those returns.
Uncertain Political Climate
The fall of 2020 brings with it the national election season, and along with it, potential political change. Two important tax provisions that affect estate planning are at stake: the estate tax credit and the step-up basis for tax treatment. The current estate tax credit is $11.6 million per individual, meaning a married couple can shield and pass an estate worth $23.2 million ($11.6 million times two) to their heirs without incurring estate taxes. This provision is set to sunset in 2026 and will return to an amount of $5 million-plus inflation adjustments, expected to settle at a figure between $6 – $7 million per individual. At those levels, the unified estate tax credit limit for couples would lower by approximately $9.2 million, resulting in a greater pool of family estates that would be subject to estate taxes. If a new party wins the White House this fall, this provision could be debated and potentially changed sooner than 2026.
Two important tax provisions that affect estate planning are at stake.
A second tax provision that aids in estate planning could also be in jeopardy this fall. Among the pillars of Vice President Joe Biden’s proposed tax plan is the elimination of the step-up basis for taxation. Under current U.S. tax laws, the assets of an estate pass to their heirs at a tax value established at death (or alternate date of valuation). The value is transferred to their heirs at this established value at death or a stepped-up basis. Biden’s proposed tax plan would eliminate this step-up basis. Consider an estate portfolio with a value of $10 million and a tax basis of $2 million. Under the current unified estate tax credit, the portfolio example would not be subject to estate taxes and would transfer to the heirs at a stepped-up basis of $10 million. If the step-up basis was eliminated, the portfolio would transfer to the heirs at a basis of $2 million and would also be taxed on the imbedded capital gains of $8 million. There are also discussions that a change in power in the White House could also lead to increases in the capital gains tax rates, which are currently set at 15-20%. Increased capital gains tax rates and the elimination of the step-up basis could greatly diminish the value of a family’s portfolio at the death of the patriarch/matriarch.
Unique Estate Planning Opportunities in Auto Dealer Industry Today
As discussed above, this fall brings a unique opportunity for owners in the auto dealership industry to capitalize on low interest rates for planning tools and potentially lower valuations of the underlying assets being transferred. Last week’s blog covered the market’s update on Blue Sky multiples. Despite market optimism, valuation and blue sky multiples of auto dealerships are still very specific to the individual dealership and consider their unique conditions including financial performance, competition, and local economic conditions among other factors.
In a previous Family Business Director blog post, colleague Travis Harms also discussed the impact of real estate on estate planning. It’s very common for the operations of the dealership to be contained in one entity and the real estate where the dealership resides to be contained in a separate asset holding company. Often when owners of auto dealerships desire to transfer their wealth/assets to the next generation, they may have children that are active in the business and they may have children that are not active in the business. We have consulted with owners on a strategy to gift interests in the operating business to the active children and interests in the real estate holding company to the non-active children. Owners/parents often view this strategy as equitable to their children and seek to reward/incentivize the active children with a direct interest in the operations of the dealership.
Now is a unique time, rife with estate planning opportunities with potentially lower valuation of assets, historically low interest rates, and changing political winds. Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equally. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation. Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning. Mercer Capital has extensive experience providing valuations for estate planning and valuations specific to the auto dealership industry.