With the current economic downturn causing dislocations and struggles for businesses of all sizes, family-owned businesses may find their values diminished along with their immediate prospects. But with these challenges come opportunities for succession planning. Because closely held businesses may now be worth less than formerly, this might be a good time for tax advisers to explore with owners a chance to minimize estate and gift taxes by gifting shares to younger family members involved in the business.
Example. Mr. Senior owns 80% of Deflated Inc. His son and daughter who work in the business own 10% each. Deflated was worth $3 million in 2007. By the end of 2008, it was worth $2.5 million. Senior talks to tax counsel and, after exploring the tax strategies and planning tools discussed below, decides to give each child shares worth $500,000 representing 20% of the business. Now each child owns 30%, and Senior owns 40% of the business. The tax advantages are:
The
stock gifted to each child was previously worth $600,000. If Deflated
Inc. goes back up in value once the economy recovers, Senior has in
effect transferred $200,000 to his children ($100,000 each) free of
estate and gift taxes. At a current marginal estate tax rate of 45%,
Senior’s family can save $90,000 (45% x $200,000).
The gifts still leave each child with a minority interest in
Deflated Inc. Estate and gift tax valuation practices can include
discounts for a lack of controlling interest as well as for a lack
of marketability due to the limited market for such shares. Advisers
should be aware, however, that these discounts are often contested
by the IRS, and their success often depends on factors that include
the types of assets underlying the business interest and the method,
experience and qualifications of the appraiser. See, for example,
Appeals Coordinated Issue Settlement Guideline UIL 2031.01 and Tax
Court cases summarized in “Valuation
Discounts for Estate and Gift Taxes,” JofA, July 09,
page 32. Also, be aware that Congress could limit this tax strategy.
President Barack Obama’s fiscal 2010 budget blueprint includes a
proposal to disregard such discounts for restrictions that will
lapse or may be removed by the transferor or family. Also, a bill to
reform the estate and gift tax (HR 436) currently in the House Ways
and Means Committee would forbid minority interest discounts for
assets “not used in the active conduct” of a trade or business.
While these proposals have a long way to go before they could become
law, they’re worth watching.
In some cases, discounts for minority interests and lack of marketability can be 25% or more (for a recent example of a large family farming operation successfully claiming a 25% discount for lack of marketability and a significant discount for lack of control, see Litchfield v. Commissioner, TC Memo 2009-21). If Senior is able to claim a similar discount, the gift of each $500,000 would be reduced by another $125,000. At a current marginal estate tax rate of 45%, Senior’s family can save another $112,500 (45% x $250,000).
Outright gifts of stock are eligible for the annual done exclusion
of $13,000. In addition, Senior has a wife who will join in this
gift, which will allow for a second $13,000 exclusion. So the
taxable gift to each child is reduced by another $26,000. Additional
savings to the family are $23,400 (45% x $26,000 x 2 children).
If
Senior makes no further gifts and dies with his reduced ownership
interest of 40%, his estate can claim the minority interest and lack
of marketability discounts against his remaining shares. Suppose
that Senior dies in a future year, after Deflated inflates in value
to $4 million. His family might be able to take a 25% lack of
marketability or minority interest discount, saving them another
$540,000 (45% x [$1,600,000 value of 40% interest at date of death -
$400,000 discount]).
Bottom line . Mr. Senior can take advantage of the lousy economy, the discounts for lack of marketability and minority interest, plus the annual donee exclusions with a spousal joinder to save his family a sizable amount of estate and gift taxes. Of course, actual results depend on the facts for each client, and this example doesn’t take into consideration state inheritance taxes.
By Steven J. Fromm, Esq., LL.M. (taxation), Philadelphia. This article is adapted from “The Silver Lining of a Bad Economy: Gifting Shares of Stock in a Closely Held Business” at Fromm’s Estate and Tax Blog (frommtaxes.wordpress.com). His e-mail address is sjfpc@comcast.net.
