Estate Planning for Business Owners – Act Soon to take Advantage of Favorable Federal Tax Rules

Year end is always a good time for business owners to reevaluate their estate plans. But the exercise may be particularly important this year because Congress is considering proposals that could make the federal estate and gift tax rules less taxpayer friendly. Here are the pertinent details.

Timing Counts

Under current tax law, the federal gift and estate tax exemption per individual is $10 million, with annual indexing for inflation. For 2021, the inflation-indexed exemption is $11.7 million, or effectively $23.4 million for a married couple. (Beware: Some states impose estate or inheritance tax at a lower threshold than the federal government does.)

Unfortunately, the generous federal gift and estate exemptions are set to expire on December 31, 2025. The exemptions also could be reduced sooner if Congress passes legislation to generate revenue to fund infrastructure expenditures, economic stimulus or other spending.

Earlier this year, President Biden proposed major changes to the treatment of property that’s gifted or is transferred at death. It’s generally believed that any new rules that Congress would adopt would apply prospectively, so there still may be time before year end to make proactive tax moves to take advantage of current rules.

Lower Exemptions, Higher Rates

One proposed change would lower the federal gift and estate exemptions to $3.5 million for estate tax and only $1 million for gift tax. Other proposed changes would replace the current 40% estate and gift tax rate with graduated rates as high as 65% for estates and gifts over $1 billion.

The effects of these changes are significant. Currently, an individual who dies with a $10 million estate would face no estate tax liability. If this proposal becomes law, the estate tax would be more than $2.9 million.

No More Stepped-Up Basis

Under current law, when people inherit appreciated assets, they receive a so-called “stepped-up” basis. In other words, an heir’s basis in an asset is equal to its fair market value at the time of the deceased’s death.

President Biden has proposed eliminating the stepped-up basis and treating the receipt of assets because of death as a “realization event.” Under this proposal, the deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. The amount of the capital gain would be the excess of the asset’s fair market value on the date of death over the deceased’s basis in that asset.

Certain exclusions would apply. For example, payment of tax on the appreciation of certain family-owned and operated businesses wouldn’t be due until the business interest is sold or the business ceases to be family-owned and operated.

Possible Restrictions on Discounts

Under current law, business owners can minimize gift and estate taxes by transferring minority interests to their children or other heirs. These interests are generally entitled to substantial discounts for lack of control and marketability.

Biden’s proposed changes would eliminate most valuation discounts for transfers in which both the transferor and transferee are part of the family that controls the business. So, time may be of the essence when gifting family business interests.

Sidebar: Estate of Jackson: How Much was the King of Pop Worth?

Pop singer Michael Jackson died in 2009. The U.S. Tax Court recently resolved a dispute between Jackson’s estate and the IRS over the fair market value of Jackson’s image and likeness, as well as his interests in two trusts that held interests in certain music catalogs.

An accounting firm had originally valued Jackson’s image and likeness at only $2,105 on the estate’s original federal estate tax return. For trial, the estate hired four valuation experts who determined that, at the time of Jackson’s death, his image and likeness were worth $3 million and his entire estate was worth $5.3 million. The IRS relied on only one expert, who valued Jackson’s image and likeness at $161 million and his entire estate at $481 million.

A significant aspect of the case was the credibility of the valuation experts who testified at trial. The IRS’s expert damaged his credibility by perjuring himself several times at trial. Among other things, he lied when he testified that he’d never been retained by the IRS before.

The court sided primarily with the estate, finding that Jackson’s image and likeness had been severely tarnished by child sexual abuse allegations in the years preceding his death. It valued these assets at $4.1 million using the income approach.

However, the court sided primarily with the IRS regarding the value of unreleased songs in one of the music catalogs, valuing the estate’s interest at $107 million under the income approach — almost $105 million more than what the estate had claimed. Despite this sizable discrepancy between the court ruling and the original estate tax return, the court imposed no valuation penalties because the estate’s valuations of the assets “were not unreasonable.”

Start with a Valuation

As of this writing, it’s uncertain which, if any, of these proposals will be passed by Congress. But, one way or another, today’s taxpayer friendly estate and gift tax rules won’t last indefinitely. A business valuation professional can help determine tax-smart estate planning and gifting strategies for private business owners in light of evolving federal (and state) tax rules.