If H.R. 436 (the “Pomeroy Bill”) does not receive Senate approval, the IRS may propose equivalent (or stronger) regulations that, if enacted, could eliminate or severely curtail the use of valuation discounts. Discounts might be prohibited for passive holding entities (such as Family Limited Partnerships) owning assets such as cash and marketable securities. Discounts would (probably) be permitted for operating businesses. As always, the specifics are impossible to predict, but it is clear that the applicability and magnitudes of allowable discounts are at risk.
What might this mean for business appraisers? At first blush, discount limitations threaten our revenue streams, but I think there is some good news, too!
Right off the bat, there will be questions as to whether a business is a holding or an operating company. Like many others, these will be resolved by attorneys and accountants, not appraisers. I can foresee controversies as to whether real estate acquisition and development companies are deemed holding or operating entities.
Other things being equal – thinking only about valuation discounts – it would be desirable for discountable (operating) companies to have higher assets, earnings, cash flows, and lower liabilities. These would increase their values (that could be discounted). The opposite would be true for non-discountable (holding) companies.
Here is an example of what might transpire. A client owns two entities: an operating company and a real estate holding company. The operating company leases the real estate from the holding company. To maximize valuation discounts, this client should consider things like:
- Lowering the rent. This raises the operating company’s earnings and cash balance, and lowers those of the holding company.
- Increasing holding company debt and distributing the proceeds. This lowers its value.
- Investing the proceeds in the operating company. This raises its value.
- Raising owner compensation from the operating business and lowering it from the holding company.
- Merging the entities (if the merged company would be an operating company subject to discounting).
- Whether “S” or “C” corporation status makes more sense for each entity.
Of course, all of these options have to be considered in the context of what makes good business and prudent financial sense and what is feasible. That is where we come in: rather than doing appraisals, we can offer planning services (i.e. limited calculation engagements) to help such clients explore the financial ramifications of different scenarios.