When gifting minority interests, it’s critical to engage either or both an estate planning attorney and business valuation expert to ensure proper planning, reporting and validation to decrease audit risk while maximizing tax exemptions and deductions.
While the Tax Cuts and Jobs Act (TCJA) didn’t repeal gift and estate taxes, it significantly reduced the number of taxpayers subject to them by raising exemptions. It’s important to note that the changes made to many of the income taxes and, more specifically, to the lifetime exemption amount for the gift taxes will expire at midnight Jan. 1, 2026, dropping the exemption from $12.92 million in net assets per person during 2023 back down to $5 million, adjusted for inflation. Still, factoring taxes into your estate planning is important, considering the sunsetting lifetime exemption.
Gift Tax Exemptions, Exclusions
A gift tax exclusion allows individuals to transfer assets to others without incurring a tax liability. For 2023, that limit is $17,000 per recipient. However, there is also a lifetime gift tax exemption, which is set at $12.92 million per person. This means an individual can transfer up to $12.92 million over their lifetime without incurring a gift tax liability.
Any gifting above these values will be subject to a gift tax rate of up to 40 percent, paid by the gift giver. The $12.92 million figure may sound familiar as exemptions for gift tax and estate tax were unified as of January 2013.
Business Valuations in Lifetime Gifting
Business valuations are critical to a successful tax strategy and involve a thorough understanding of the business, its market and its standing within the industry or market. A business valuation substantiates the interest’s fair market value for gift or estate tax exemption reporting and audit protection. A valuation also determines if the interest to be transferred is a minority or majority interest.
If a minority interest is transferred, discounts for lack of control or lack of marketability may be taken from the fair market value. In 2016, Treasury regulations were introduced to eliminate discounts for lack of control and lack of marketability. The regulations to eliminate discounting were withdrawn in 2017 but may be reintroduced.
Methods Used to Value Businesses
When it comes to valuing businesses for estate tax purposes, there are three predominant methods used to determine fair market value:
Income Approach: This focuses on the potential income the business can generate and considers the expected future earnings, cash flows and risk associated with the business to arrive at its value.
Market Approach: This looks at recent sales and transactions of similar businesses to determine a fair market value, relying on market data and considering the prices of comparable businesses that have been bought or sold.
Net Asset Value Approach: This focuses on the underlying assets and liabilities of the business. It considers the value of tangible and intangible assets, as well as any debts or obligations, to estimate the business’s worth.
Each method provides a different valuation perspective and can be used in combination to arrive at a comprehensive and accurate assessment of a business’s value for estate tax planning purposes.
Benefits of Gifting Minority Interest
Gifting minority interests in a business can be an effective way to transfer wealth to heirs while maximizing the lifetime estate tax exemption. The gift tax measures the portion of the asset that the recipient receives, and the estate tax measures the value of what remains at the death of the donor.
When you transfer a minority interest in a company, it is typically valued at a discounted amount due to minority interest holders not having the same rights to make decisions or vote on important issues relevant to the company. A marketability discount is appropriate when the interest given cannot readily be turned into cash. Generally, a gifted minority interest cannot be readily sold in the marketplace allowing such a discount. A lack of decision-making power is the reality for someone owning less than 50 percent of a business interest; such a minority interest is discounted appropriately.
A good business valuation makes lifetime gifts of business interests easier and may set the stage for additional discounts upon the death of the business owner.
Thomas R. Ohlgren, CPA is a partner with Baker Tilly. You can reach him at firstname.lastname@example.org.
Janette Brooks, CPA is founder of D4 Fiduciary and Business Advisory Services. You can reach her at email@example.com.