Article:

Most business owners pay close attention to the taxes that are assessed on gross revenue, taxable income, and payroll. A more significant tax is lurking as the profitability and stability of the closely-held business is established. Over time this tax liability may become so significant as to alter the ability of the business owner to transfer the business to the "next generation." This tax is the estate tax. And, unlike most other taxes that are assessed on the economic results of operations, the estate tax is based on the value of the company as a whole.

Estate taxes are due in a relatively short period of time. Most small businesses are "for sale" for more than a year. Yet, estate taxes are due in a matter of months from the date of death of the business owner. To the extent the business is the most significant, or only, asset in the estate, liquidating that asset to pay the taxes can cause a huge economic loss through a "fire sale" of an asset that otherwise would sell for much more.

Unintended Consequences

Another significant issue in estate planning is the attempt by most to "equalize" the estate among children. Consider this example: An estate consists of a business, a personal residence, marketable securities and cash. There are three children and the estate documents state that one sibling is to get the business, another the home, and the rest of the estate to the third sibling with a cash payment made to equalize the estate value. It sounds simple - the estate is split equally among the three children. This is a very common scenario. It may make a lot of sense when the planning documents are established.

However, the practical result is often quite complex and problematic. One possibility is that the cash and marketable securities are depleted by professional fees and taxes. That leaves two siblings with valuable but illiquid assets. Another possibility is that the sibling with the business has the asset that is substantially more valuable than any of the other assets but is the least marketable. Since there is insufficient cash in the estate and/or the business, the only practical solution is to split up the ownership of the business to equalize the estate. This raises considerations of management control and profit allocation among the siblings. Valuing the partial interests becomes a difficult and cumbersome process.

Five Key Steps

The above illustrates some of the complexities involved in owning a small business at the time of death. The challenge is not just estate taxes but also succession of ownership in such a way that the business is not disrupted. The following are five key steps to consider when preparing a comprehensive estate plan involving a closely-held business ...

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Trade secrets are defined under the law in varying ways depending on the legal jurisdiction. There are three factors that tend to cut across all definitions: it is information that is generally not known that confers economic benefit on its holder, and is the subject of reasonable efforts to maintain its secrecy. The value of the secret derives specifically from the fact that it is not known, not just from the value of the information itself. If a company takes no steps to protect the information there is a weakened ability to claim trade secret status.

Businesses generally protect secrets through the use of non-compete and non-disclosure contracts with vendors, customers, employees, and others who have access to the information. This places the theft of secrets into a framework of violating a written agreement in addition to the actual misappropriation and misuse of the information. Once a company suspects that its secrets have been stolen there must be an effort to identify not only who took the secrets, but how they are being used. This generally requires an extraordinary effort to obtain (often, secret) communications, data download histories, relationship clues, and interviews/cooperation from individuals (recipients of the secrets) who are not motivated to assist in the investigation.

The most common case of trade secret theft is when an employee resigns or is terminated. It is common in trade secret cases to discover that the departing employee was recruited by a competitor business and offered employment and compensation for changing employment and bringing secrets with them. Resolving these cases is often dependent on sophisticated data tracking systems that retain emails and date/time stamped records of data dumps from servers and hard drives.

Once the case has been made that secrets were stolen the decision is made whether to pursue criminal prosecution, civil remedies, or both. The criminal penalties are severe and can include jail time for the persons involved. Under federal law, companies involved in theft of trade secrets can be fined the greater of $10,000,000 or three times the value of the stolen trade secret.

Civil litigation can result in a range of penalties including injunctions, a reallocation of profit earned from the secret by the party who benefitted from the theft, reimbursement of actual damages, and punitive damages. In some jurisdictions, the award can include a multiple of actual damages. Actual damages can be calculated as lost profits or by placing a value on the information that was stolen. To the extent the information was stolen and destroyed (published widely, for example) the extent of damage was the value of the information right before it was destroyed.

Valuation of intellectual property, including trade secrets, is ultimately based on the projected income stream generated by the information discounted to present value at an appropriate risk rate. The valuation of trade secrets is difficult because of the need to isolate the historical income stream associated uniquely with the information that was protected as secret. The valuation expert must be able to identify income, direct expenses, and allocated indirect expenses associated with the information. That data is then used to project future net cash flows. In some cases where the information is stolen, used by a competitor, and cannot be recovered the value of damages is calculated based on the marginal benefit derived by the competitor from the stolen information.

As noted above, accurate and relevant estimates of damages are based on reliable historical accounting information. Additionally, the use of an experienced account and valuation expert is required to properly use the historical information as a basis to opine as to the value of the trade secret and/or the damages caused by the theft of the trade secrets.

The Forensic Accounting practice is headed by partner Chris L. Hamilton, CPA, CFE, CVA. Mr. Hamilton is a Certified Public Accountant, Certified Fraud Examiner, and Certified Valuation Analyst. He is a licensed life and disability insurance agent and a General Securities Representative. Mr. Hamilton has published articles in several publications, and has made presentations at national conferences, training institutes and seminars on topics including forensic accounting, fraud and business appraisal.

Speeches:

Chris Hamilton's upcoming presentations include:

November:

• "Calculating and Explaining Damages" presented to NACVA, Chicago, IL
• "Market Approach to Valuation" presented to NACVA, Chicago, IL
• "Special Purpose Valuations" presented to NACVA, Chicago, IL
• "Income and Asset Approaches to Business Valuation" presented to NACVA, Chicago, IL
• "Laws, Courts, and Dispute Resolution" webinar

December:

• "Valuing Earnouts and other Performance Based Contracts" presented to NACVA, Las Vegas, NV
• "Trial Preparation: Direct Examination" webinar
• "Deposition and Trial Testimony" webinar
• "Advanced Business Valuation" presented to NACVA, Las Vegas, NV

If you are interested in asking Mr. Hamilton to speak at your organization's upcoming meeting, please feel free to contact him.