Knowing the value of one’s ownership in a company is important for a variety of reasons, including looking to the future and making the right decision for your estate. Proper estate planning can result in tremendous cost savings to your estate and loved ones down the road. The outlook is of particular importance considering the current political climate. There are a number of proposed changes affecting the estate tax, and prudent planners should act soon in making proper arrangements. As discussed below, the timing of transfers may be of particular importance now.
An estate tax (sometimes referred to as the “death tax”) is the tax assessed on the value of an individual’s estate either at the date of death or, by election, six months after the date of death. In the political landscape, the estate tax is an easy target for achieving short term fiscal policy results of a given administration, as changing the given thresholds and rates can either raise or lower tax revenues to address budget deficits, without affecting lower income constituents. Estate tax thresholds and rates can, and typically do, vary by administration. Additionally, they could be changed on short notice, and potentially applied retroactively. No one knows with certainty what a final bill will contain, but past bills and congressional actions provide some hints and things to consider.
As of today, the 2021 lifetime estate exemption is $11.7 million for an individual ($23.4 million for a couple), and estate tax rates can reach 40% for estates with values $1 million or higher above the threshold. This exemption is currently scheduled to sunset on December 31, 2025, returning to $5 million, per person (adjusted for inflation). However, the current administration has proposed many changes to tax law. Among these changes is a revision to the estate tax threshold and rates. Thresholds as low as $3.5 million have been proposed, as well as an elimination of the step-up in basis for heirs at the time of death. In plain language, the result of these changes will make more estates taxable and at higher tax rates.
Gifting assets and formation of trusts can be effective methods for transferring valuable assets out of a taxpayer’s estate. When making a gift for which a value is not readily available, such as an interest in a privately held entity, a certified valuation professional can assist in determining the value. The valuation process involves considering the applicability of any available discounts such as “lack of control” and “lack of marketability.” Among changes being proposed is the elimination of these discounts currently available.
A minority interest owner typically has little control over the direction of a company, including but certainly not limited to the riskiness of the assets in which it invests. In addition, there is generally not an established market for buying and selling such interests, making it more difficult to eventually cash in on one’s investment. For example, consider a closely held company with a net asset value of $10 million. It has a restrictive operating agreement, a long-term liquidation horizon, and does not make distributions. Not considering discounts for lack of control and lack of marketability, a hypothetical investor looking to invest $1 million could purchase a 10% interest in the company. Alternatively, he could invest that $1 million in a diversified portfolio of large publicly traded stocks. It is unlikely that a hypothetical investor would pay $1 million for a 10% interest in the closely held company when he is giving up control of the investment portfolio and the ability to easily sell his shares.
The size of such discounts varies, but they can be significant and can impact the amount of an estate or gift greatly. The appropriate discount assigned to a minority interest should be determined by a certified valuation professional.
It should be noted that although tax law is never set in stone, it is wise to consult with an estate planning professional and to consider the idea of gifting as an estate planning measure. Proposed changes have moved estate planning in 2021 to a high priority for many Americans.
This discussion represents only a portion of potential changes to tax law. There are a variety of other changes being discussed, as well as other provisions of the Tax Cuts and Jobs Act that are set to expire at the end of 2025, adding further uncertainty. For further information regarding potential tax law changes, it is recommended that you speak with a certified professional.
Spencer Lamb, CPA, CVA and Colleen Hearne, CVA | Heard mcelroy & Vestal