Did you know taxable estates are projected to increase significantly in the coming years? As a business owner, you have a lot on your plate. Keeping up with the latest estate tax laws may not be at the top of my mind. With the estate tax exemption decreasing after December 31, 2025, now is the time to act.
Estate planning can seem overwhelming, especially when valuing complex assets like a private business. It also involves making some tough choices about how to allocate assets to family members, charitable organizations, non-profits, friends, and even employees. As the Senior Manager of Business Valuation at DHJJ, I help clients understand the value of their business, which can be key for effective estate planning and managing taxable estates.
In this article, I’ll dive into what business owners with taxable estates need to consider, offer guidance on navigating these complexities, discuss valuation issues in estate planning, and share tips on how to make the most of current exemption limits before they change.
Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act (TCJA) introduced substantial increases to estate and gift tax exemptions, also known as the unified tax credit. Under the TCJA, the unified tax credit, which represents the total amount an individual can transfer during their lifetime or at death without incurring estate or gift taxes, was essentially doubled.
Before the act, the exemption amount stood at approximately $5.49 million per individual. However, beginning in 2018, the exemption increased to $11.18 million per individual and $22.36 million for married couples. As of 2024, this exemption has adjusted upwards with inflation, allowing individuals and couples to shield even more of their estates from taxation.
Despite these favorable terms, the provisions of the TCJA are temporary and are set to sunset after December 31, 2025. Without further legislative intervention, the exemption amounts will revert to their pre-2018 levels, adjusted for inflation, which is estimated to be around $6-7 million per individual.
For individuals and couples with significant estates, especially those locked in illiquid private businesses, this creates a crucial opportunity for strategic planning. Gifting noncontrolling, or minority, interests in a business enterprise could entail added tax savings through discounts associated with lack of control and lack of liquidity.
As we approach the 2025 deadline, it is important to consider your options for efficiently transferring generational wealth. If estate planning has not been on your radar, the period until December 31, 2025, offers a valuable chance to get ahead and make the most of these exemptions. Individuals with significant estates should work closely with tax professionals, financial planners, and estate planning attorneys to evaluate their options.
Current and Future Exemption Limits
As of 2024, the estate and gift tax exemption is $13.61 million per individual or $27.22 million per couple. Starting January 1, 2026, this exemption will be reduced to approximately $7 million per individual or $14 million per couple.
Key Figures:
- Current Exemption (2024):
- Individual: $13.61 million
- Couple: $27.22 million
- Expected Exemption (2026):
- Individual: Approximately $7 million
- Couple: Approximately $14 million
Impact: Estates exceeding these thresholds will face estate taxes, potentially leading to substantial liabilities.
Estate Planning Considerations
When it comes to estate planning, everyone has unique needs and goals based on their assets, liabilities, future income requirements, and how they want their assets allocated after they’re gone. A great starting point is to work with a financial planner to determine your future income needs and to get a clearer picture of what you might require for the rest of your life. A financial planner can also assist with planning for healthcare, insurance, and long-term care.
Once you have a handle on your needs, you can begin to explore how to transfer any excess assets in a tax-efficient way. Partnering with an estate planning attorney can provide you with expert guidance on the best strategies for asset transfer. They can help you set up tools like irrevocable trusts, Grantor Retained Annuity Trusts (GRATs), family limited partnerships, or Intentionally Defective Grantor Trusts (IDGTs), all of which can help pass on wealth to the next generation while managing tax costs and maintaining control over your assets during your lifetime.
Strategic Gift Planning Before the Sunset
To fully utilize the current higher exemption amounts, business owners may consider making lifetime gifts before the 2025 deadline. This strategy allows them to reduce the size of their estate and avoid future estate taxes on the gifted assets. Additionally, any appreciation on these assets will not be subject to estate tax if transferred before the exemption decreases.
Gifting portions of a privately held business increases the complexity, requiring a valuation of the ownership interest in the privately held business to establish the gift amount. In a valuation analysis for IRS reporting purposes, a valuation analyst using professional judgment will issue a conclusion of value on the gifted interest.
What to Expect in a Business Valuation
Understanding the value of these assets can be challenging, especially when there is no active market. IRS regulations define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. This standard directly influences how we assess and interpret the subject company during a business valuation.
Under fair market value, we don’t consider a specific buyer such as a strategic buyer. A strategic buyer may offer additional consideration above fair market value due to its ability to provide synergistic value through the efficiencies of combining the businesses, for example, eliminating administrative redundancies. For this reason, fair market value is often considered a floor value when establishing the value of a business in the event of a sale or merger and acquisition activities.
IRS Revenue Ruling 59-60 (RR 59-60) issued in 1959 provides an outline of the methods and factors to be considered in the valuation of a privately held business. Factors provided in RR 59-60 include:
- The history and nature of the business
- The economic outlook in general and the condition and outlook of the specific industry in particular
- The book value of the subject company’s stock and the financial condition of the business
- The earning capacity of the company
- The dividend-paying capacity of the company
- Whether or not the firm has goodwill or other intangible value
- Sales of the stock and size of the block of stock to be valued
- The market price of publicly traded stocks or corporations engaged in similar industries or lines of business
When valuing a business, it is crucial to evaluate all relevant aspects, including the company’s outlook, industry trends, the broader economic environment, and any legal rights or restrictions associated with the ownership interest.
Revenue Ruling 59-60 states, “A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”
To address these factors comprehensively, a valuation analyst must conduct a thorough analysis of the company’s historical financial performance, benchmarking it against industry peers. Additionally, the analyst should assess management’s outlook and risk evaluation for the company while considering broader industry trends. It is also important to factor in both national and local economic conditions, as macroeconomic influences can significantly impact the business’s prospects.
In the event of an IRS challenge, taxpayers risk substantial penalties and professional fees. Therefore, a valuation analyst must address the factors outlined in RR 59-60 when determining the fair market value of a privately held business. Crafting a thorough analysis and carefully documenting the assumptions and reasoning in a valuation report raises the likelihood that the valuation is accepted by the IRS.
For business owners, transferring non-controlling or minority interests in a business can come with additional discounts for lack of control and lack of marketability. A minority interest typically involves a discount due to the inability to influence strategic decisions, hire management, and set distribution policies. Additionally, a minority interest in a privately held business often faces discounts due to its illiquidity or lack of market. By utilizing lifetime gifts, a business owner can transfer an interest in a privately held company to certain trusts, maintaining control during their lifetime while setting goals for the trust after their death. As the business value appreciates over time, this appreciation will not be taxable to the estate but will benefit the trust’s beneficiaries.
Regulations to Note: The IRS has issued guidance to prevent a “clawback” of the increased exemption amount. If you make gifts under the higher exemption amount and pass away after the exemption reverts to $7 million per individual, your estate will benefit from the full exemption used at the time of the gift.
Example: If a married couple gifts $27 million in 2024, and the exemption decreases to $14 million in 2026, their estate will benefit from the $27 million exemption used at the time of the gift. This strategy could significantly reduce their estate tax liability, potentially saving them $5.2 million at the current 40% estate tax rate.
Benefits of Making Lifetime Gifts
- Reduce Estate Size: Lowering your estate’s value through strategic gifts can significantly decrease potential estate taxes.
- Avoid Future Tax Increases: Assets gifted before the exemption reduction will not be subject to estate taxes, even if their value increases.
- Utilize Current Exemption: Take advantage of the higher exemption limits available now to maximize your tax savings.
Preparing for the Tax Cut and Jobs Act Sunset
While estate planning may seem like a burdensome task, it doesn’t have to be. Working with trusted advisors to help you create and execute a plan can alleviate the burden on your time and significantly enhance your chances of success. Throughout your lifetime, you’ve become an expert in your field, built a successful career, and established a thriving business. With the window for increased estate tax exemptions closing and no guarantee of new legislation, future estate taxes may rise. Now is the time to understand the value you’ve created and explore how to transfer this wealth to future generations in a tax-efficient manner.
Selecting the right team for estate planning is crucial. The first step involves consulting with an estate planning attorney and a financial advisor to explore your options. The next step is to understand the value of your business. Working with valuation professionals to help you plan for your eventual estate transfer will help optimize your strategy and ensure that the plan meets compliance standards, retirement needs, and the needs of your family.
Large accounting or valuation firms may offer a comprehensive range of services but can sometimes lack attention and an individualized touch. Smaller firms might lack the broad expertise required to develop and execute a robust estate plan, leading to a piecemeal approach and potential miscommunications. Partnering with firms that combine top-tier expertise with a family-oriented approach is essential. This helps ensure a cohesive and customized strategy for creating and executing your estate plan effectively.
Sources:
- https://www.taxpolicycenter.org/sites/default/files/briefing-book/how_did_the_tax_cuts_and_jobs_act_change_personal_taxes_1.pdf
- https://ceritypartners.com/thought-leadership/irs-guidance-on-clawback-of-gift-estate-tax-exemption/
- Mercer, Z. C. (2022). What Revenue Ruling 59-60 says (and does not say) about fair market value: Analysis and review of this seminal ruling from business and valuation perspectives.
