By Miranda Aavatsmark

In case you had not heard, never watch the news, or do not regularly check your Twitter, the estate and gift tax exemption doubled from about $5.5M to $11.2M starting in 2018. This change was included in The Tax Cuts and Jobs Act of 2017 that was passed on December 22, 2017. As with many of the recent changes to the tax laws, the estate and gift tax exemption is set to revert back to pre-2018 levels (including increases for inflation) after December 31, 2025. What does this mean and how does this affect taxpayers?  What does estate planning look like now for clients?  And more importantly, will this change be short-lived, or continue beyond the 2020 presidential election?  Regarding the latter, your guess is as good as mine. As with all changes to the tax laws, CPAs can only plan based on what we know the tax laws to be for certain right now. That being said, let’s dig into the background of estate taxation.

What is an estate and gift tax exemption?

The modern estate tax was enacted in 1916 and has been phased in and out and repealed at various times over the years. In 1916, the estate and gift tax exemption was $50,000 and, over a 100 years later in 2019, the exemption has increased to $11.4 million per person ($22.8 for a married couple). Unlike the federal income tax, the estate tax is based on value, not income.  Most simply put, the estate tax is a tax on the value of a person’s assets at the time of their death.

The gift and estate tax exemption is synonymous with what is referred to as the lifetime exemption. The lifetime exemption is the amount that can either be gifted during a person’s lifetime or excluded from their taxable estate upon death.  For example, if a person passes away in 2019 and the value of their estate is $10M but during their lifetime they gifted $5M, then their lifetime exemption of $11.4 would be reduced by the $5M of gifts. Therefore, the taxable estate would be $3.6M ($10M + $5M – $11.4M). If the value of the person’s estate is instead $10M but they did not make any gifts during their lifetime, then they do not have a taxable estate since the value is less than the exemption.

On the topic of gifts, there are many considerations, such as whether a gift is a “generation-skipping gift.” A generation-skipping gift most often occurs when a grandparent bypasses their own child to make a gift to their grandchild. There are many special rules and nuances with these types of gifts and although beyond the scope of this article, CPAs should be aware of their client’s specific situation and whether this would apply.

Tax Cuts and Jobs Act of 2017

Although there was some talk of repealing the estate tax completely, most professionals in the community weren’t betting their Derby money on it. And rightfully so, since what we ended up with instead was something like what happened with the alternative minimum tax (AMT). CPAs were hopeful that the AMT tax would be repealed, but Congress decided alternatively to increase the exemption, thereby eliminating the tax for many taxpayers. The doubling of the estate tax exemption essentially accomplished the same, in that now many wealthy taxpayers may no longer need to worry themselves with the “death” tax.

Business Valuations and Estate Planning

Not all, but many Americans build a wealthy estate over the course of their lifetime through business ownership. CPAs in the estate planning field deal largely with business owners who are very much concerned with preserving their wealth and businesses, even beyond the grave.  To mitigate or reduce estate taxes, business owners will want to organize their affairs and develop a strategic plan.

One of the strategies for reducing potential estate taxes is by gifting some or all a company’s ownership from the business owner to their children or a family member during their lifetime.  By gifting ownership, business valuators can utilize discounts to reduce the value of the business. The following are some of the discounts available for use when determining values for gifting purposes.  This is not an exhaustive list or a detailed map for valuing a business.

Marketability Discounts

A marketability discount is a discount allowed for reducing the value of the business due to lack of “marketability.” If the company is a closely-held business, finding the right buyer may take a substantial amount of time and effort, therefore the value of the business can be reduced for these factors. Unlike publicly traded stocks, which can be easily bought and sold on a whim, a family-run business is not as quick and easy to buy and sell.

Minority Discounts

A minority discount is available when only a small percentage of a company is transferred. For example, if a dad owns 100% of the company, and transfers 10% to his son, then the small percentage is not as valuable to the son because of lack of control. If the son only owns 10% of the company, he may not have any ability to vote on important issues or make executive decisions.  As such, a minority discount is allowed since the son is not really enjoying a relatively equal 10% share of the pie.

Key Person Discount

A key person discount is a discount used to take into consideration personal goodwill. A company that is heavily dependent on the reputation and skill of the owner is probably not worth as much in the hands of another person. Although, the owner can certainly transition their work, inevitably, some customers may not be loyal to the new owner.

The advantage of using discounts is best explained with an example.

Let’s say Mr. Rich owns 100% of the shares in an S-Corporation, Riches, LLC. An initial business valuation is performed, as a baseline, and determines that 100% ownership of the business is worth $10M. However, Mr. Rich wants to gift ownership of the company to his son, Brock, but he is not ready to give up control of the business at this time, so he decides to gift 40% to Brock initially. Based on the baseline value of $10M, the value would appear to be $4 million for the 40% interest. But, due to the fact that Brock will not be in control and the stock lacks liquidity, a business valuator would discount the 40% interest. Assuming the valuator determines a 35% combined discount is appropriate, the interest would only be worth $2.6 million for gift tax purposes.

When the 40% interest in the business is transferred to Brock, Mr. Rich will be required to file a gift tax return. The value listed on the gift tax return will only be $2.6M, thereby reducing Mr. Rich’s lifetime exemption by this amount, instead of the original value of $4M.  On the other hand, if Mr. Rich dies while still owning the company, the $4M value will likely be used for estate tax reporting purposes. Assuming Mr. Rich has other assets that push him over the estate tax exemption, the $1.4M discount from the gift to Brock has the potential to produce a savings of up to 40% in estate taxes, or $560,000.

Furthermore, provided that a gift is adequately disclosed on the gift tax return, the three-year statute of limitations clock begins to tick. Business valuators have a checklist of the required disclosures and documentation required by the IRS to support the valuation of the business. After the three years have passed, the IRS generally cannot open the gift tax return for audit and challenge the value of the gift.

Business Valuations Post-Mortem

After the passing of a business owner, there are two considerations for business valuators. One, valuing the business for purposes of reporting and paying estate taxes and two, valuing a business for purposes of the step up in basis. Most likely, the second consideration is the more important of the two, considering the increase of the estate tax exemption. When an individual dies and the assets are transferred to their heirs, the heirs acquire a brand-new basis in the asset. The assets are valued as of the date of death and the value becomes the heir’s basis. If the beneficiary decides to sell the asset, they may not realize much or any gain on the sale and therefore pay minimal or no income tax. Alternatively, if the assets were transferred to the beneficiary as a gift before death, the donor’s basis generally becomes the donee’s basis. In this case, if the asset is later sold, there may be significant gains subject to income tax.

If the value of the business, along with the taxpayer’s other assets, is well below the estate tax exemption, there may not be a need to gift ownership during the taxpayer’s lifetime. The value of the business, as determined upon death, may be more beneficial to the heirs because of the step up in basis. Effectively, reducing income tax in the hands of the beneficiary becomes the main goal in this situation.

On the contrary, if the taxpayer’s business and other assets are near or above the estate tax exemption, then gifting before death could be beneficial to reduce estate taxes. Gifting before death allows the use of some of the discounts mentioned above and an overall reduction of estate taxes. As a side note, the IRS clarified late last year in IR-2018-229 that the increased gift and estate tax exemption would not adversely impact estates post-2025. To explain this, supposed an individual dies in 2026 and this person gifted assets of $10M between 2018 and 2025, but the estate tax exemption reverted back to $5.5M. The estate is permitted to use $10M as the exemption instead of $5.5M, and not be penalized by the large gifts made during the time frame that the estate exemption was much higher.

Conclusion

The doubling of the estate tax exemption may certainly eliminate estate taxes for most taxpayers, but estate planning for high net worth clients and business owners remains a critical task for professionals. Determining the value of a business as part of planning can provide a wealth of information to use as a guide. With the volatile nature of tax laws and the uncertainty of the current political climate, knowing the value of a business can be useful to make necessary estate planning changes as needed. As discussed earlier, the current estate tax exemption is set to revert back to pre-2018 levels after December 31, 2025. Barring any extensions or changes prior to this, at the very least, estate planning will need to be re-evaluated as this date grows closer.

This article was originally published in The Kentucky CPA Journal.