Business Valuations in the Context of the Estate Tax Exemption
The Federal Estate Tax Exemption:
High net worth individuals benefit from a Federal estate tax exemption, currently at $11.7 million. This exemption is in the cross hairs of the Biden administration. Will there be legislation in the near future that drastically reduces this exemption? If such legislation is enacted into law will it be retroactive to the beginning of the year? One can only guess.
What many individuals may not realize is that even if nothing is done legislatively, the gift Federal gift tax exemption is set to “sunset” on December 31, 2025. On January 1, 2026 the exemption is scheduled to return to what it was prior to 2018, adjusted for inflation. This new Federal gift tax exemption amount is projected to drop to approximately $6 million.
Based on the above, an individual with a net worth of $11 million who dies towards the end of 2025 should not owe a Federal estate tax. However, if this individual were to die just a few days later, at the beginning of 2026, the story would be drastically different.
Because of these political concerns coupled with the sunsetting of the Federal estate tax exemption, business owners are again paying special attention towards gifting minority interests in their closely-held business to family members.
Business Valuations of Closely Held Businesses:
When gifting minority interests of a closely-held business, a carefully articulated business valuation must be performed to determine the Fair Market Value of the gift. Fair Market Value is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” 1
Revenue Ruling 59-60 requires the qualified business appraiser to consider the following eight factors:
- the nature of the business and the history of the enterprise from its inception;
- the economic outlook in general and the condition and outlook of the specific industry;
- the book value of the stock and the financial condition of the business;
- the earning capacity of the company;
- the dividend-paying capacity;
- whether or not the enterprise has goodwill or other intangible value;
- sales of the stock and the size of the block of stock to be valued;
- the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
When performing the business valuation, the valuator must consider each of the three accepted valuation approaches, i) the income approach, ii) the asset approach, and iii) the market approach. The business valuator has the discretion of using any combinations of these three approaches that he/she deems relevant to the subject company.
Discounts used in arriving at Fair Market Value must be calculated and supported by recognized market data. The two most common discounts are the discount for lack of control (minority discount) and the discount for lack of marketability. The minority discount has been in the news lately in that there have been rumors that future legislation may curtail or even eliminate this sought-after discount.
Business valuations for gift tax purposes should not be viewed as a one-size fits all exercise. The valuator should preferably be credentialed and produce a report that carefully articulates his / her conclusions, both qualitatively and quantitatively.
There is a three year statute of limitations that commences once the complete gift tax return is filed. Not including a business valuation report (or including a deficient business valuation report) with a gift tax return where the donor is gifting an ownership interest in a non-public company may represent an incomplete filing. This could jeopardize the statute of limitation clock from even starting.