strategic estate planning could save your clients millions.
by anthony venette, cpa/abv
we stand at the precipice of the largest wealth transfer in american history. 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.
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that being said, many business owners are unaware of the benefits of gifting interests in their businesses 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 is expected to increase in value, you can effectively transfer more wealth to your heirs while using less of your lifetime estate tax exemption. in contrast, gifting cash or other non-appreciating assets may not provide the same long-term value.
take bob for example. 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 of $10 million in 2023 and no debt. bob actively runs the company as ceo. he is debating between transferring cash or an interest in abc company 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 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 ten years later, his exemption will be $6.5 million ($16.5m – $10m used) and his taxable estate will be $16.3 million (abc as appreciated). his estate will then owe $3.9m 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 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 $6.5m ($16.5m – $10m used) and his taxable estate (which now excludes abc) will be $10 million (i.e., 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, you can effectively transfer more value to your heirs without using as much of your lifetime estate tax exemption.
let’s use the example of bob and abc co. again, but this time abc co. has a fair market value of $15 million in 2023 with $5 million of debt and a fair market value 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 ten years, his exemption will be $6.5m ($16.5m – $10m) and his taxable estate will be $23.4 million (abc as appreciated and with a reduction in debt). his estate will then owe $6.8m 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 ten 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, you 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, you can effectively transfer more wealth to your heirs without using as much of your lifetime estate tax exemption.
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 fair market value of $8.8 million) because of his unused exemption. when bob passes away in ten 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 is 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 for married couples, it is $25.84 million. 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, you can effectively use it before you lose it with your lifetime estate tax exemption. this potentially reduces your 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.
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 upon 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 $700,00. 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.
conclusion
in summary, gifting appreciating business interests can be a powerful estate tax planning strategy that offers a range of benefits. however, it is important to work with an experienced valuation consultant, tax professional and legal advisor to ensure your gifting strategy aligns with your broader estate planning goals and objectives. an unfiled or improperly filed gift tax return (including those with an unqualified appraisal) can expose taxpayers to permanent audit risk, penalties and interest.
more about anthony venette
anthony venette, cpa/abv is a senior manager, business valuation & advisory, with dejoy & co., a bdo alliance firm based in rochester, new york. he provides business valuation and advisory services to corporate and individual clients of dejoy.
this article is for illustrative purposes only. it should not be construed as legal, financial or tax advice. always consult your advisor before making any important decisions about your business or family finances.