How California wine business property transfer rules will change in 2021

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Starting in mid-February law changes will tighten rules which currently allow parents to transfer California real estate to the next generation without triggering reassessment. This is stimulating interest in year-end transfers of wineries and vineyards within families.

“I see families in the wine business demonstrate keen awareness that they must consider and plan for taxes, doing what they can to avoid property tax reassessment and to minimize estate tax if they want to give their heirs the best odds for success,” said Lauren Galbraith, an estate and tax planning attorney with Farella Braun + Martel.

“My clients were generally relieved to see Prop. 15 fail but are now thinking about what they can do now in light of the narrow passage of Prop. 19,” she said.

Lauren Galbraith (courtesy photo)
Lauren Galbraith (courtesy photo)

Proposition 15 would have amended the California State Constitution to require commercial and industrial properties, except those zoned as commercial agriculture, to be taxed based on their market value. Proposition 19 allows homeowners over 55, disabled, or wildfire/disaster victims to transfer primary residence’s tax base to replacement residence, changes taxation of family-property transfers and establishes fire protection services fund.

Discussing the state law shift, Galbraith said it substantially changes the rules that apply to transfers between parents and children (or grandparents and grandchildren if the children’s parents are deceased). Currently, the law allows, without reassessment, transfer of a principal residence of unlimited value from parents to children. It also allows, without reassessment, transfer to children of up to $1 million per parent of assessed value of other property, such as second homes, vineyards and wineries.

Effective Feb. 16, 2021, the only direct transfers of California real estate between parents and children that won’t trigger reassessment are transfers of a primary residence or farm if the child also uses it as his or her primary residence or farm. Moreover, if the difference between the assessed value and current market value exceeds $1 million (indexed for inflation), then the primary residence or farm would be partially reassessed.

According to Galbraith, these anticipated changes are causing people to consider transfers sooner than they might otherwise. At the same time, when it comes to making gifts of assets other than California real estate, the sense of urgency has subsided somewhat following the election, with the composition of the U.S. Senate still to be decided.

“I do think that the urgency has fizzled, and estate and gift tax changes effective retroactive to January 1, 2021, at this point seem highly improbable,” she said. “Those who are on the margins in terms of whether they want to make significant gifts now may be best advised to hold off and take a wait-and-see approach.”

For some winery estate owners, however, it is an obvious time to begin to transition ownership through gifts and sales.

“When we are talking about sales to third parties, some people are considering that capital gains rate may increase in the future,” Galbraith said. “If the business will stay in the family, people are looking to make gifts to absorb the record-high gift tax exemption, or intrafamily sales which capitalize on the exceedingly low interest rates.”

Regardless of the tax landscape, certain aspects of planning for business transition remain the same.

“Winery owners should seek counsel early when thinking about transferring ownership of their business. There are a variety of types of professionals who can lend their expertise. More time to plan generally allows for more options and well-considered decisions,” said Galbraith.

Sometimes business owners come up with their own creative solutions to their business transition concerns. Galbraith said one of her clients was thinking about turning the business over to two children but is building a second winery property to offer each child some autonomy from the other and help avoid a controversy over future ownership and the division of real assets.

“An assessment of family members’ ability to manage the business must be part of advance transition discussions,” she said. “In many cases, heirs may have been groomed to take over and have experience, while others may not or do not wish to continue the family business. Still other winery owners may not have children, but want to sell, take a minority ownership position to obtain capital from new partners or retain outside management while still staying involved in the enterprise. Each choice comes with its own pros, cons and considerations that should be addressed.”

She emphasized that it is always wise at the beginning of transitional discussions to involve professionals, as well as family members and others who own wineries or have gone through M&A transactions in the past, in the decision-making process.

Can the next generation handle it?

Robert Nicholson (Youngblood Photography)
Robert Nicholson (Youngblood Photography)

Robert Nicholson, a principal with International Wine Associates, said one of the first questions he asks those thinking about transferring ownership of a winery to their children is whether they are qualified and can they handle it. He said he knows full well this is a deeply personal and sensitive issue that can evolve over time.

This is the prime factor when it comes to staying in business, Nicholson said, especially when owners were responsible for building up their assets, making this one of the main items on his checklist of things to talk about.

“Is it better for the second generation to do such transactions themselves with the right M&A and legal team, or is it best for the current owners to initiate and manage the process?” Nicholson asked.

He favors the latter approach since it was owners who increased the estate’s value over the years as they grew the business.

“For me, the reality is if people come to me in a hurry to enter into a transaction in the wake of the fires, pandemic and economic uncertainty, I usually advise them to pause and see how things go over the next few months,” Nicholson said.

He said in the 2007-2010 recession, the best wine estates decided to stay the course rather than rushing to transact a sale or transfer, realizing they would not get the right value for their investment until later in the recovery. This proved to be the right decision based on the 2011-2012 resurgence and pent-up demand.

Nicholson is not seeing a mega-wave of businesses being transferred today, but pointed to those in other industries, such as restaurateurs, who are having a tough time staying alive.

“Some 50% of restaurants in the U.S. are going out of business or soon will be, according to the National Restaurant Association, and many more expect to shut their doors. I’ve had some quiet conversations with people in this situation and urge them not to panic, but rather to think about their options and look for ways to stay afloat. Some are making adjustments in their supply chains, exploring other strategies and implementing new ideas to keep going.”

For the wine industry as a whole, Nicholson said it can’t rely on international sales to pick up the slack in the U.S.

“One of the first things that should be done is to validate what the business is worth on a cash-flow basis. Those with a good brand and good cash flow have a better chance of success.”

Another factor affecting a decision to sell a property is the tax impact and the ability to take advantage of tax-free or tax-deferred Section 1031 exchanges that offer an opportunity to defer and thus reduce federal capital gains tax helping the seller shield the investment.

“Taxes should not be a driver behind getting a deal done quickly, especially in times like these with so many disasters and uncertainties associated with what COVID-19 could bring. The reality is that good things will come back, and at good prices comparable to the high value transactions seen before the coronavirus.”

Nicholson believes the goal is to have confidence in a sound business plan designed to help weather the storm, while adjusting ways of doing things to adapt to current conditions.

Of the top 20 wine brands in the U.S. today, Nicholson said most wineries are doing very well.

Nicholson said his firm has transacted over $175 million in transactions so far this year, and most of those took from nine to 12 months to complete. One took over three years, while the shortest time taken to do it right still took six months.

At the core of the marketplace malaise

Mario Zepponi (courtesy photo)
Mario Zepponi (courtesy photo)

Mario Zepponi, founder of Zepponi & Company, a merger and acquisition advisory firm that provides transaction advisory services to the global beverage alcohol industry, said he has not seen winery property values rise significantly.

“It is an illiquid marketplace presently, with a lack of transactions due to the unstable environment created by the pandemic and the recent wave of wildfires that have adversely impacted the industry,” Zepponi said. “At the core of this malaise in the marketplace, sellers are not being driven to sell out of economic duress and buyers are not feeling compelled to make acquisitions due to market needs.”

Decisions should be made on sound rational thinking, rather than fear, he said.

“We are in a state of industry flux, but we’re not in crisis mode and can’t let what is happening around us influence us to make quick moves — unless wineries are running out of cash, forcing some to think about selling,” Zepponi said. “But even then, there may be opportunities to look at capital partnering to get back ahead of the curve.”

Zepponi said a Silicon Valley Bank wine industry study released in 2008 forecast that 51% of wineries would be dealing with transitions in ownership over the next decade, and that change is always a factor in the wine industry, as with any privately owned business.

He noted that if, for example, a winery owner desires to retire and sell the business, he or she should be realistic with their expectations of value and market pricing if they have an urgency to close a transaction sooner rather than later.

If, on the other hand, an owner has the luxury of time within which to sell their business, then they will have a higher probability of achieving their desired market value. In the current environment, there is a much stronger correlation between desired market value and the profitability of a winery’s business.

Silicon Valley Bank’s latest annual wine report, written by Rob McMillan, executive vice president and founder of the wine division, predicted that “the wine industry will be challenged over the next five years and is in the midst of a consumer reset, which requires every winery to reimagine how they sell and market wine.”

Part of this reset is attributed to the decline in total wine sales volume, the decline in premium wine growth rates and the difficulty in passing price increases on to consumers as boomers buy less wine and millennials have yet to replace them and realize their full buying potential.

McMillan observed that based on early results, there are winners and losers today, with about 25% of the businesses struggling, while the upper quartile of wineries is delivering record years. He noted that the wine industry is slow to evolve.

”The wine industry is past the tipping point and starting a phase of declining growth in volume,“ McMillan wrote. ”The lack of engagement by the youngest consumer is both the greatest concern and greatest opportunity. Wine companies with the best management teams are still performing well, but in this era of diminishing demand by volume, any growth is coming at the expense of other wineries.”

Correction, Dec. 2, 2020: International Wine Associates has closed over $175 million in transactions.

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