Lower Business Values Strengthen the Case for Gifting
August 20, 2020 by Hannah Thoms, CPA, M.S.F., CFP
Estate planning action to consider in 2020
Amidst the COVID-19 pandemic that has caused financial damage to businesses and our global economy, owners and investors may have seen a dramatic decline in the value of their equity holdings and other assets. Despite the downturn, investors can realize potential tax saving opportunities through professional consultation and well-calculated estate planning strategies. This article seeks to inform readers of these strategies and rationale in the broad sense, beginning with an overview of estate and gift taxes before presenting the case for gifting assets in our current climate. Gordon Advisors is here to be of service in your estate planning needs, among a wealth of other related services.
An Introduction to Estate and Gift Taxes
Since 1916, the United States has taxed the estates transferred to descendants, known as the estate tax. The tax, now 40% at the top level, applies only to the portion of the estate’s value that exceeds $11.58 million, the current exemption level in 2020. The estate tax applies to a decedent’s estate, which generally includes all assets, both financial (e.g. cash, stocks, bonds and mutual funds) and real (e.g. land, homes and other tangible property). It also includes their share of jointly owned assets and life insurance proceeds from policies owned.
In 1932, Congress enacted the gift tax to prevent avoidance of the estate tax by transferring wealth towards the end of one’s life. The estate tax’s current lifetime exemption of $11.58 million per donor in 2020 is the same amount that applies to the gift tax. Beyond the exemption amount, donors pay gift tax at the same 40% rate as the estate tax. Both tax rates are integrated, as gifts reduce the amount available for estate tax purposes.
It’s important to note that the exemption level can be “shared” between spouses, which means the effective exemption for married couples is currently $23.16 million, or twice the exemption amount of $11.58 million for individuals. However, proactive planning would ensure that the $23.16 million is properly utilized.
An additional amount each year, referred to as the annual exclusion, does not count towards the gift and estate taxes and is granted independently for each recipient. In 2020, the exclusion amount is $15,000. For example, a married couple with two children could gift them a total of $60,000 (each child receiving $15,000 from each parent) without paying taxes or counting towards the lifetime exemption amount.
Estate Planning – The Time for Gifting May Be Now
As mentioned, a dramatic decline in the value of investment holdings presents a timely estate planning opportunity for those considering estate tax strategies. Combined with already known and inherent “discounts,” this pandemic-related market value depreciation is the icing on the cake for estate planning. A common estate planning strategy to house and manage accumulated wealth, particularly amongst family members, is a limited partnership or limited liability company. These are meant to hold family businesses, investments, real estate and other assets with future appreciation potential. They are essentially a holding company owned by two or more family members and are meant to protect against creditors and reduce exposure to gift and estate taxes, or bypass it altogether.
For an equity interest to receive valuation discounts, it has to be noncontrolling (typically done through a shareholder or operating agreement). Since a noncontrolling interest is being transferred, the gifting party can retain management control and determine cash distributions and compensation.
Certain contractual and legal restrictions, combined with the unique investment characteristics of each underlying asset of the business, are the starting point for business appraisers to determine discounts for lack of control and lack of marketability. These discounts are based on fair market valuation of asset values and range from 20% to over 40%. Historically speaking, they allow and encourage senior members of the family group to gift their interests in the business at significantly lower values than the group as a whole for the same interest. This strategy is very common in efforts to minimize estate tax liability.
Considering the above-mentioned asset gifting strategy, one can see why recent decreases in appraised values for businesses and real estate can have real implications. Depreciated values in our current economic environment (termed “market discounts”), help to maximize discounts and bypass future gift and estate taxes by avoiding the tax threshold. Therefore, some have deemed this time period as a great time to gift!
Note the calculation is simplified in the example. A business venture valued at $10 million in December of 2019 may today be valued at $7 million, due to current economic factors. After discounts for lack of control and lack of marketability of 20%, the discounted fair market value becomes $5.6 million for the respective time period. This represents a 44% decrease in the fair market value of the business; over $1.7 million dollars of estate tax savings.
A similar decline in value is being seen in many asset classes and encourages senior members to gift business interests and other potentially appreciating assets to younger generations, to avoid future estate taxes, as well as benefit recipients from appreciation in value of the assets gifted as the economy improves.
Low Hanging Fruit – The Estate and Gift Tax Exemptions
As the US government continues spending on COVID-19 related efforts like stimulus money, vaccines and other forms of relief, a growing concern revolves around the question, “How is this money going to be recouped?” As the gift and estate tax exemption threshold is currently at its all-time high (and growing to account for inflation), some experts see the $11.58 million for single donors and $23.16 million for married couples as an easy target. Any lowering of these figures will expose billions of dollars to taxation.
As recent as 2017, the estate tax exemption amount was less than half of its current amount, at $5.49 million per individual. The amount has been at least $5 million since 2010. Those with large stakes in business or other combined assets currently should revisit their estate plans. Combined with now-enticing lower valuations, the uncertainty of where the “new” estate tax exemption could end up means it may be time to unload certain assets in the form of gifts to take advantage of the potential estate tax savings.
Our Estate Tax Specialists Are Here to Help
Gordon Advisors Estate and Trust Services specialists provide council every day to our clients, including estate and trust tax filing requirements, estate planning, and for peace of mind that your wishes are honored. Simply put, we are here to help you leave a legacy. Contact us today to begin a discussion.