Valuation Opportunities for Planning Amid a Pandemic
This article is based on a BKD Thoughtware® webinar by the same title presented on April 29, 2020 by Jim and Partners Susan Jones and Shaun Duffin.
The Wall Street Journal headline read, “Stocks Suffer Worst Quarter in 12 years,” and went on to note that “U.S. stocks closed out their worst quarter since the depths of the financial crisis, a stunning blow for the market that few investors could have anticipated at the start of the year. Investors scrambled to flee assets ranging from stocks to commodities to emerging market debt, betting the global economy was headed for a sharp downturn.” The date of the article was April 1, but unfortunately it was no April Fool’s joke. In the first quarter of 2020, the Dow Jones Industrial Average, S&P 500 and Nasdaq were down 23 percent, 20 percent and 14 percent, respectively.
What happened in the first quarter of 2020? With the uncertainty surrounding COVID-19, businesses shutting down and employees being furloughed and laid off, volatility spiked as investors reassessed the state of the economy and stock market. During times such as this, risk gets repriced in the market as market participants re-evaluate future earnings prospects, growth rates and required rates of return. While unsettling, this environment also can create planning opportunities.
When market volatility increases and liquid assets are in high demand, opportunities for higher returns in riskier assets become available. Over the past decade, the market for M&A transactions was ultra-competitive as private equity buyers looked for ways to deploy capital, combined with strategic buyers looking for bolt-on growth opportunities. That cycle finally turned in the first quarter and now offers an opportunity to revisit desired acquisition targets. While short-term uncertainty may cause some deals to get repriced, postponed or canceled, M&A activity is likely to resume as better capitalized investors re-enter the market searching for acquisitions.
Tax Planning Opportunities
Another opportunity as a result of the market downturn is the chance for companies to reassess their structure and tax exposure. When companies undergo tax and legal reorganizations, lower valuations of equity and assets can make such transactions more efficient and achievable. Reassessing where (geography) and how (profits, property, etc.) a company is taxed may present an opportunity to reduce its tax exposure.
Examples include a C corporation meeting appropriate criteria, converting to pass-through entity status and eliminating a layer of corporate taxes. Conversion to an S corporation normally comes with exposure to a 10-year built-in gains tax, but the exposure diminishes when asset valuations are lower. Another example would be a company setting up a manufacturer/marketing and distributor relationship, with each entity set up to earn profit in the most advantageous geographic location, according to its operations. These legal entity structures often involve transfer pricing and must also adhere to the fair market value standard.
Finally, now also is a good time to revisit gift and estate planning and consider transferring property while valuations are lower. For appreciating assets, lifetime gifting is more efficient than transfers at death because future appreciation is outside of a donor’s taxable estate and therefore not subject to estate tax. Ownership interests in privately held companies, real estate and mineral interests have additional advantages related to valuation uncertainty and the potential for fractionalized ownership. Depending on the facts and circumstances, the interest transferred could be subject to minority interest and lack of marketability discounts. More complex gifting structures can provide additional opportunities to leverage the gift and estate tax exemption, including incorporating asset sales to family members, reducing the use of exemptions.
While the downturn in the first quarter of 2020 was particularly painful, planning opportunities are available in M&A and tax. Many companies will likely need to test assets and goodwill for impairment for financial reporting purposes, and while doing so, can also consider the benefits of M&A and tax planning strategies. Planning now and leveraging these opportunities can help companies and investors survive the bear market and be in better position when the bulls eventually return.
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