With estate and gift taxes being top of mind for many of our clients and partners, we wanted share some timely information about transferring business ownership to other members of the family through a systematic “gifting” strategy. Doing so can provide significant tax savings to high net worth individuals. Here’s the details and current exclusion amounts:
For both 2020 and 2021, the annual gift-tax exclusion is $15,000 per donor, per recipient – meaning business owners can gift up to $15,000 per year in assets without incurring federal gift taxes or utilizing any of their Lifetime Exemption. With the current Estate and Gift exemption (“Lifetime Exemption”) sitting at $11.7 million per individual and $23.4 million per couple, high net worth individuals can greatly reduce their tax liability by implementing a gift tax strategy that utilizes the $15,000 (adjusted annually for inflation) per receipent per year. So, every year, a husband and wife could “gift” in total $30,000 of cash or cash equivalents to their children or grandchildren without utilizing any of their Lifetime Exemption.
The value for this “gift” is deemed to be “fair market value” at the time of the gift, as defined by the Internal Revenue Service (Revenue Ruling 59-60). At a high level, fair market value is the cash or cash equivalent value between a hypothetical willing buyer and seller both having knowledge of all relevant facts and not being under any compulsion to sell. While this is a very straight forward calculation for cash gifts, there’s an opportunity to apply valuation discounts to gifts of closely-held business interests that do not have a readily observable price. Under the statutory definitions and supported by a tremendous amount of case law, the following are a sample of the most common discounts allowed for a minority interest:
- Discount for Lack of Control – cannot control compensation or distributions, change management, or force a sale of the company;
- Discount for Lack of Marketability – cannot be converted quickly into cash like three days for a publicly traded security; and
- Discount for Lack of Voting Rights – since the shares do not have voting rights, they must be worth less than the equivalent voting shares
There is not set rule or formula for determining the exact valuation discount. It is always a facts and circumstances analysis by the valuation professional. Generally, the steps we see undertaken to maximize valuation discounts by limiting control of the interest being gifted is to recapitalize the company. For an operating company (usually an S-Corporation), recapitalization begins by creating two classes of shares of voting and non-voting stock, both being identical with the exception of voting privileges. The non-voting shares are then gifted to family members (or into trust for their benefit). For holding companies (generally real estate), the same idea is executed by utilizing limited partnership or LLC interest with very restricted operating agreements.
To make this concept real, consider this example of a married couple with three children. In 2021, the couple would like to transfer to them in trust the maximum amount without utilizing any of their Lifetime Exemption. They could make cash gifts of up to $90k for the tax year (3 children x 2 parents x $15k annual exclusion per gift to each child). However, if they were to transfer non-voting shares or limited partnership interest, then $150k of value per tax year could be transferred assuming a modest 40% overall discount (selected discount for illustration purposes only).
Additionally, this type of transfer of ownership not only provides significant tax savings now, it also removes future appreciation and income from your estate – even if your family members choose not to run the company in the future. At Vision Point Capital, we have seen this structure utilized successfully many times when it comes to a future sale of the Company for significantly higher value than the original gift. That said, we know that optics are important, so we recommend the best time to pursue a gifting strategy with significant valuation discounts is before you have a letter of intent in hand.
Summary: In conclusion, a one-time gift or a systematic gifting strategy is still one of the best ways for high-net worth individuals that own a closely-held business to transfer minority ownership to the next generation at a significantly reduced valuation, retain control of the business, and minimize estate and gift transfer taxes. However, it still takes the proper advisory team (attorney, CPA, valuation professional) with the relevant experience to ensure that any strategy not only minimizes any possible transfer taxes but also is in agreement with the client’s overall goals and objectives. Please do not hesitate to contact us to help with any business transition needs.
This article is simply a high-level overview of complex topics and does not constitute valuation, tax, or legal advice. Readers of this article should seek the services of skilled and experienced professionals.
Vision Point Capital focuses its services in three pillars of consulting for business owners: 1) Valuations; 2) M&A Advisory, & 3) ESOP Advisory. Working with business owners and their advisors is in our DNA. Please check out our website at www.visionpointcapital.com for more information about our services and team members.