Major Changes to Federal Estate and Gift Tax Threatens the Continuation of Businesses

The hope for many privately held business owners whether the company is in its first generation of ownership or already a multi-generation company is to create a legacy that is ongoing.

Unfortunately, the odds of a business surviving multiple generations have never been greater. Decades of statistics tell us that there is less than a one-third survival rate for companies transitioning from a first to second generation of ownership and less than 15% success rate for a company to survive from a second to third generation. Of course, the statistics become dramatically worse for generations beyond.

Although there are many reasons why successful companies don’t remain successful and are ultimately forced to liquidate, often at a steeply discounted sales price, this article will focus on a present and clear threat to many business owners – the federal estate and gift tax.

Specifically, the estate tax, imposed on assets transferred at passing death and the gift tax, imposed on assets transferred at life unplanned for can be the death knell for many businesses.

The federal estate tax was enacted in 1916, as a way to redistribute wealth in the United States. There was a real concern that too few controlled too much of our country’s wealth and via the federal estate tax, that wealth after being taxed at death would be redistributed for the common good.

What was once designed to zero in on the extreme elite, eventually became a required tax paid also by the ‘non extreme elite.’ Although statistically, only a very small percentage of United States citizens actually will pay the estate tax because of asset exemption amounts, many individuals who own businesses, real estate and other asset classes would be ravaged by the estate tax, as their assets exceed exemption amounts.

Bad news on the horizon

The good news is that as this article is written in 2023, the amount of assets that can be exempted from federal estate and gift taxes is the highest in the history of the United States. The individual amount is $12.92 million and the amount for married couples is $25.84 million.

The bad news is the high exemption amounts will be substantially reduced beginning January 1, 2026. This means that if a married couple died in 2023 with an estate value of just under $26 million they could escape owing federal estate taxes entirely. The same married couple, with the same $26 million estate, dying in 2026 means that there will be millions of dollars due in federal estate taxes.

Yes, you’ve read that correctly. A coming change in tax law will have the dramatic impact of going from $0 being owed in taxes to millions of dollars being owed. The tax rate over the exemption amount is 40%.

The federal estate tax has always been fluid. The exemption levels have ebbed and flowed. For example, from 1987-1997, the exemption was a mere $600,000 with a top marginal tax rate of 55%. In 2010, there was a one-year complete repeal (the federal estate tax has been repealed several times, and has always reappeared), and between 2011 and 2021, the exemption amount ratcheted up, and the tax rate remained a flat 40% for every taxable dollar.

This historical perspective can be confusing and it’s just one of the many reasons why we always insist SEAA members and other clients be proactive with their planning.

It’s possible for business owners to prepare

Like the fluidity of the history of the federal estate tax, owning a business in the construction market, can be similar. Things are always changing. Some things we react to and others we need to prepare for.

The federal estate and gift tax is something that business owners can prepare for. The federal estate tax is due, in cash, within nine months after date of death of the business owner (or any U.S. citizen that owns assets that exceed the exemption amount). If married, the tax may be deferred, via utilization of the unlimited marital deduction, until the second spouse passes away.

If you own a business that you want to pass down to the next generation or other successors, you must be cognizant of the federal estate tax and the impending significant change.

• Determine if you’re comfortable giving away substantial assets. If the answer is “no” then regardless of tax savings retain the asset(s).

• If the answer is “yes” it is vital to have the company valued by a valuation specialist to quantify the lowest IRS acceptable value and discount rate.

• Choose who will receive and what amounts will be gifted. Reducing the amount owed or eliminated in taxes is always a good thing, right? The commonsense answer, of course is “yes” although not necessarily when it comes to reducing the amount owed in future estate and gift taxes. First, an individual must decide if they are comfortable in parting with the asset. If someone doesn’t want to give away an asset, regardless of tax savings, more than likely the asset should be retained.

Importance of asset valuation

Some people have the incorrect assumption that they can “sell” a highly valued asset at a deep discount. Example, a $1,000,000 property “sold” to a son or daughter for a $1 is nothing more than a $999,999 gift. That doesn’t mean that there aren’t ways to capitalize on discounting strategies when transferring an asset by gift or sale.

It is critical to have a valuation specialist (typically credentialed as a CVA or ASA) value a privately owned business at its fair market value adhering to IRS Revenue Ruling 59-60. Once that number has been established it is common to have a combined discount rate of 30-40%, sometimes more, for gifting a business interest that is a minority ownership position because of lack of control and no true market for the recipient to sell to.

Who gets the asset

It is recommended when giving away ownership percentages in a privately held or family-owned business to only give ownership to active participants. Giving ownership to many family members, when not all are working in the company can be a set up for future family dissension. This does not mean that those not involved in the business be disinherited as there are many proactive asset equalization strategies that will allow everyone to be treated fairly.

Proactively planning for a future tax may help you reduce or possibly eliminate the tax entirely. There are planning strategies out there that will allow your dream to be realized if proper steps are taken. Don’t let your thriving business become the one that goes up for sale at a discounted rate, bringing all the good you’ve done in your community and for your family come to a screeching halt. •