By Robert W. “Bob” Evans
Principal at Blue & Co., LLC
The interest rate changes that occurred in 2022 and 2023 have created a window of opportunity for certain business owners who are looking to gift their business to the next generation.
Based on recent signals from the Federal Reserve Board (“Fed”) and on the formulas used to value small-to-medium sized businesses, this window will begin to close shortly, so time is of the essence if one is to receive the maximum benefit of this opportunity.
About the Unified Credit
In 2024 individual taxpayers have a combined gift tax and estate tax exclusion, called the unified credit that provides $13.61 million that can be used to offset taxable gifts and estates that otherwise would be subject to tax at 40 percent.
A married couple has a combined unified credit of $27.22 million. The unified credit can be used at any time, and any unified credit not used during a person’s lifetime to offset gift tax is available to offset estate tax. Assuming that there are no changes in the current tax law and inflation is at the Fed’s target rate of three percent, effective January 1, 2026, the unified credit, which is indexed for inflation, will be reduced to approximately $7.22 million or $14.44 million for a married couple. At that time, any unused unified credit above approximately $7.22 million will be lost and gifts previously made will reduce the new, lower, exclusion. Prior gifts more than the new, lower, unified credit and less than the current unified credit will remain tax free.
How Interest Rates Affect Business Valuation and the Unified Credit
Ownership interests in closely held companies gifted to family members must be valued by a qualified appraiser. The most common valuation approach used to value profitable closely held companies is the Income Approach, where “normalized” cash flow is discounted by a rate that is determined in part by interest rates, specifically the Prime Rate and Treasury Bond yields.
As interest rates rise, the discount rate also rises, which reduces the multiple applied to the normalized cash flow, which then lowers the business’ value. While the exact impact differs from company to company, we have seen the 2022-2023 interest rate increases reduce values determined by the income approach by about 25 percent. So, in essence, a gift made today would be valued at about 25 percent less than a gift made at the end of 2021 and would consume about 25 percent less of the donor’s unified credit.
If inflation remains at or near the Fed’s three percent target and interest rates come down in 2024, the reverse will happen. The discount rate will decrease, the normalized cash flow multiple will increase, the business value will increase, and more of the unified credit will be used by the gift.
How Interest Rates Move
Beginning in March 2022 and ending in July 2023, to bring down increasing inflation the Fed increased its Federal Funds Rate 11 times, from 0.25 percent to 5.25 percent. Since July, the Fed has signaled that it did not expect any additional increases and recently projected that it would cut the Federal Funds Rate three times in 2024. Some market watchers predict even more reductions in 2024.
While the Fed only controls the Federal Funds Rate, many other interest rates, including the Prime Rate and Treasury Bond yields that affect business valuations, quickly move to match the Fed’s actions. The expected reductions in interest rates have no announced timeline. When the reductions occur, this will indicate that the window of opportunity is closing, and the benefit will be reduced.
Estate Planning Opportunity
It is important to preserve as much of the unified credit as possible, as estate tax applies to a person’s entire estate, including but not limited to cash, investments, real and personal property, life insurance and intangible assets. It is not just the value of the business.
If you are a business owner considering gifting all or part of your business, this can be an opportune time to do so and will allow you to make the most efficient use of your unified credit.
Editor’s Note: This article is based in part on historical precedent, current tax law, and on forward-looking statements made by members of the Federal Reserve Board through January 23, 2024. However, the financial markets are complex, and events and circumstance may not occur as expected, and the differences may be material. We have no responsibility to update this article for events occurring after this article was written.