Transferring Business Interests to Optimize Estate Taxes as originally published in Trust & Estates on wealthmanagement.com

Millions of business owners are struggling to write the next chapter of their companies and their legacies. Prudent gift and estate tax planning can be the difference between creating generational wealth and squandering it. Gifting privately held business interests to a child or children can be an effective and tax-efficient way to maximize wealth transfer and achieve legacy planning goals.

That being said, many business owners are unaware of the benefits of gifting interests in their business rather than cash. Here are four important reasons why gifting business interests can be advantageous:

Appreciation

Business interests have the potential to appreciate over time, especially if the business is well managed and successful. By gifting shares of a business that’s expected to increase in value, your client can effectively transfer more wealth to their heirs while using less of their lifetime estate tax exemption. In contrast, gifting cash or other nonappreciating assets may not provide the same long-term value.

Example 1: Bob, 60, is unmarried with one child, Roberta. Bob owns 100% of ABC Co., a small but growing manufacturing company with a fair market value (FMV) of $10 million in 2023 and no debt. Bob actively runs the company as CEO. He’s debating between transferring cash or an interest in ABC Co. as part of his estate planning.

Let's assume the federal estate exemption is $12.92 million today (none of which Bob has used to date) and is raised by 2.5% annually for inflation. So, 10 years later, that exemption would be approximately $16.5 million. The remainder of Bob’s estate consists solely of a bank account with $10 million, which remains constant over the 10-year period. Also, let’s assume ABC Co. appreciates in value at a rate of 5% annually.

Let’s say Bob elects to gift $10 million in cash to Roberta in 2023. He pays nothing in gift tax on that transfer because of his unused exemption. When he passes away 10 years later, his exemption will be $6.5 million ($16.5 million - $10 million used), and his taxable estate will be $16.3 million (ABC Co. as appreciated). His estate will then owe $3.9 million in federal estate tax (40% times his estate in excess of his remaining exemption).

In an alternative universe, Bob elects to gift 100% of his interest in ABC Co. to Roberta in 2023. He'd pay nothing in gift tax on that $10 million transfer because of his unused exemption. When he passes away 10 years later, his exemption will be $6.5 million ($16.5 million - $10 million used), and his taxable estate (which now excludes ABC) will be $10 million (that is, the value of his bank account). His estate will then owe $1.4 million in federal estate tax. That’s an effective tax savings of $2.5 million from the scenario in which Bob transferred his cash.

Debt Reduction

As companies pay down debt over time, the value of their equity increases. By gifting shares of a business with a high debt-to-equity ratio, your client can effectively transfer more value to their heirs without using as much of their lifetime estate tax exemption.

Example 2: Let’s go back to Example 1, but this time ABC Co. has a FMV of $15 million in 2023 with $5 million of debt and a FMV of equity of $10 million. ABC works hard to pay down its debt, and by 2033, the total balance is down to $1 million. The rest of the fact pattern is identical.

Let’s say Bob elects to gift $10 million of cash to Roberta in 2023. Again, he'd pay nothing in gift tax on that transfer because of his unused exemption. When he passes away in 10 years, his exemption will be $6.5 million ($16.5 million - $10 million), and his taxable estate will be $23.4 million (ABC Co. as appreciated and with a reduction in debt). His estate will then owe $6.8 million in federal estate tax.

In an alternative scenario, Bob elects to gift 100% of his interest in ABC to Roberta in 2023. Again, he'd pay nothing in gift tax on that transfer because of his unused exemption. When he passes away 10 years later, his exemption will be $6.5 million, and his taxable estate will be $10 million. His estate will then owe $1.4 million in federal estate tax. That’s an effective tax savings of $5.4 million from the scenario in which Bob transferred his cash.

Minority Discounts

When gifting shares of a business, your client may take advantage of minority discounts. These discounts reflect the fact that a minority interest in a business is typically less valuable than a controlling interest in the business, due to the lack of control and marketability. By applying a minority discount to the value of the gifted shares, your client can effectively transfer more wealth to their heirs without using as much of their lifetime estate tax exemption.

Example 3: Going back to Bob and ABC Co., again, let’s assume nothing has changed regarding the business and his decision to transfer cash to Roberta. That scenario still sticks his estate with a $6.8 million tax bill.

This time Bob elects a more nuanced gifting strategy in which he transfers 20% of his interest in ABC Co. to Roberta each year for five years starting in 2023. We'll assume a modest total minority discount of 30%. He’d still pay nothing in gift tax on those transfers (which have a total FMV of $8.8 million) because of his unused exemption. When Bob passes away in 10 years, his exemption will be $7.7 million, and his taxable estate will be $10 million. His estate will then owe $900,000 in federal estate tax, which is an effective tax savings of $5.9 million from the scenario in which Bob transferred his cash.

Use It or Lose It

The current lifetime estate tax exemption is historically high, but it’s set to expire in 2025 and may be subject to change. As mentioned earlier, the exemption amount in 2023 is $12.92 million per person and $25.84 million for married couples. NOTE: The IRS has indicated that gifts made prior to 2026 using the elevated exemption amount will be honored going forward even when the exemption amount is lowered. By gifting now, your clients can effectively “use it” before they “lose it” with their lifetime estate tax exemption. This potentially reduces your client’s overall estate tax liability. Barring new legislation, at the end of 2025, those thresholds will be cut in half (indexed for inflation) so we’re talking approximately $7 million per individual and $14 million for a married couple, again, depending on inflation.

Example 4: Let's revisit our friend Bob with the exemption reduction in mind.

Under Bob’s cash gifting scenario in 2023, he’d owe zero gift tax because of the exemption. He’d also capitalize on the elevated exemption amounts, which is good, because the exemption amount will be reduced to $7 million in 2026. Therefore, his estate would have no remaining exemption on his death in 2033 and would pay $9.4 million on his $23.4 million estate.

When approaching his transfers strategically, Bob has a few options. He could pursue his ratable 20% gifts annually for five years and maximize the use of minority discounts. However, that approach would hit him with a gift tax bill in 2027 of $700,000. Alternatively, he could accelerate his gifts into 2023 through 2025 with larger but still minority blocks of interest. He could make an additional 2025 cash gift for the remaining unused exemption of $5.7 million, knowing that he would “lose it” in 2026. All of those gifts could be accomplished without paying a federal gift tax. Under this scenario, Bob’s taxable estate would be $4.3 million, and he’d have a federal estate tax of $1.7 million. This results in an effective tax savings of $7.6 million from the scenario in which Bob transferred his cash.

This article was originally published in Trust & Estates on wealthmanagement.com.

https://www.wealthmanagement.com/estate-planning/transferring-business-interests-optimize-estate-taxes

Anthony Venette, CPA/ABV is a senior manager, business valuation & advisory, with DeJoy & Co., a BDO Alliance firm based in Rochester, N.Y. He provides business valuation and advisory services to corporate and individual clients of DeJoy.

Contact the author if you would like to learn more about the calculations.

 

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