Is it time to consider estate planning moves?

Businesses and the financial markets have incurred major losses in the first half of 2020 due to the novel coronavirus (COVID-19) crisis. But there’s an upside: Low asset values and favorable tax laws could create opportunities for wealthy individuals to gift certain assets, including business interests and intangible assets, to family members and charities. But this opportunity won’t last forever.

Favorable tax laws

The Tax Cuts and Jobs Act (TCJA) doubled the federal gift and estate tax exemption per individual from $5 million to $10 million, with annual indexing for inflation. For 2020, the inflation-indexed exemption is $11.58 million, or effectively $23.16 million for a married couple. Unfortunately, these generous exemptions are set to expire on December 31, 2025. And they could be reduced sooner if Congress needs revenue to fund expenditures.

Chances are good that most business owners will outlive today’s generous gift and estate tax exemption. But, the fair market value of gifts of business interests to family members, loyal employees or charities made in 2020 may count toward the owner’s lifetime exemption — which means they would be tax free.

In addition, for 2020, taxpayers can transfer $15,000 per recipient under the annual gift tax exclusion free of federal gift tax without tapping into their lifetime federal gift and estate exemption.

Suppose an unmarried business owner gifts private stock valued at $1,150,000 to ten family members in 2020. After the annual gift tax exclusion is applied to $150,000 of gifts, the lifetime exemption can shelter the remaining $1 million from gift tax. That leaves an available estate tax exemption of $10.58 million (assuming the business owner hadn’t tapped into her lifetime exemption in a previous year).

No clawbacks

The IRS issued proposed regulations in 2018 that would prevent these gifts from being “clawed back” and hit with estate taxes if the exemption is lower when they die. Under the proposal, the applicable exemption amount is the greater of:

  • The exemption amount used to shelter gifts made from 2018 through 2025, or
  • The exemption amount that’s applicable in the post-2025 year of death.

If the IRS proposal is finalized, a qualified business appraisal can help maximize the exemption amount used up before the expanded exemption limit expires.

Warning: Some states impose estate or inheritance tax at a lower threshold than the federal government does. So, learn the rules in your state to avoid an unexpected tax liability or other unintended consequences of an asset transfer.

Fair market value

A business valuation is essential to determine how many ownership interests in a private business can be gifted without incurring gift tax — or how much can be deducted for a charitable donation. It also helps business owners formulate a long-term strategy for transferring their wealth.

Do-it-yourself appraisals may raise a red flag with the IRS. Instead, consider hiring a business valuation professional to determine fair market value. Under IRS Revenue Ruling 59-60, valuators consider eight factors when valuing a private business:

  1. Its nature and history,
  2. The outlook for the industry and economy,
  3. The company’s book value and financial condition,
  4. Its earnings capacity,
  5. How much dividends the company could (or does) pay out,
  6. The value of goodwill and other intangible assets,
  7. Prior sales of the company’s stock and the size of the block, and
  8. The price paid in comparable stock transactions.

In addition, smaller ownership interests may be eligible for discounts for lack of control and marketability. Valuation experts use real-world empirical data to support their analyses, rather than gut instincts or industry rules of thumb.

Strike while the iron is hot

It’s important for private business owners to monitor the value of their interests and meet regularly with estate tax professionals to discuss estate planning options. Gifting (or donating) ownership interests while values are low and tax rates are favorable can dramatically lower exposure to estate tax. Contact your valuation advisor for more information.

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