Business owners have always needed strategic wealth-management plans that protect their families and the long-term health of their business. And with market uncertainty, business disruptions due to COVID-19, and possible tax code changes, this is especially true in 2020.
While these unusual circumstances present considerable business challenges, they also offer important opportunities for closely held businesses owners. Many high net worth individuals can see significant tax savings if they “gift” ownership shares to their children rather than waiting to transfer ownership in a will or even gifting several years from now.
This article will discuss why 2020 is the right time for business owners to gift ownership to their children, grandchildren, or both.
Valuation for Gifting Ownership Stakes
When gifting an asset to a child or grandchild, the asset value must be assigned for federal tax purposes. Unlike a cash gift (where the value is inherent and understood), gifting an ownership stake in a business requires that the value of the ownership stake (the “gift”) be determined.
The value of the ownership stake is based on the fair market value of the business. The IRS scrutinizes these gift planning techniques and business valuations intensely. Undervalued gifts may be subject to tax penalties. A valuation that is performed in good faith by a competent, independent third-party appraiser is more likely to have a “reasonable basis” and therefore is less likely to incur an audit, additional tax, or penalties.
Gift Now for Favorable Tax Outcomes
Given the valuation process, several factors make 2020 an optimal time for business owners to give part of their ownership stake to their children and grandchildren.
Tax Laws May Change
As many business owners may be aware, current tax law allows owners to give up to $15,000 to each child or grandchild every year, tax-free. The lifetime maximum is $11.58 million (or $23.16 million for married couples). Staying within this range allows owners to pass down their stake in a business without paying taxes to the IRS.
Because of the 2020 election, it’s possible that tax laws may change for 2021. While there are still many unknowns, plans are currently being proposed to decrease the lifetime maximum to $3–$5 million. If these tax laws pass, owner gifts will be limited. The January run-offs change nothing since the exemption must drop in 2026 under the current law. By engaging in gift planning in 2020, you take all tax threats off the table. If you wait till January, you could get whipsawed with retroactive tax laws and miss the current opportunity.
Some Valuations Are Down, Some Discounts Have Increased
Uncertainty in the economic recovery and market stability has impacted some businesses. In addition, certain valuation discounts (like the marketability discount) have increased to account for fewer buyers and less access to capital.
High marketability discounts and slightly depressed business valuations provide a valuable opportunity for high net worth individuals to transfer an ownership share at a reduced tax burden. These conditions enable business owners to transfer more of their assets without increasing their taxes.
As markets continue to recover and become more stable, valuations will likely go up, and discounts will likely go down. This shift means that owners looking to transfer ownership shares will not be able to transfer as many assets as they can today.
Account for Future Unknowns
There is a saying that the best time to plant a tree was 20 years ago, and the second-best time is now. Business owners should apply similar thinking as they plan for the continuation of their ownership stake. The best time to prepare for the future of a business was 20 years ago, and the next best time is today. As 2020 has shown, the future brings many unknowns. The business owners who take action now can better protect family wealth and prepare the family for long-term business success.
Many business owners gift ownership shares to their children because they want to ensure that the business they’ve created stays in the family. But there are other, more strategic reasons to consider giving ownership shares to your children. For example, we find some owners will gift to charity. The charity may get liquidity from a future transaction or potentially from key people buying into the business. The original owner avoids capital gains tax and gets a charitable contribution deduction. The key person gets the very same stock they would have otherwise acquired from the owner.
Gifting to children may be a more tax efficient way to push future income to children. This method works particularly well when children and grandchildren are in lower tax brackets than the donor. This method can permanently shift future cash distributions and taxable income to children and grandchildren.
We just helped a client transfer a portion of his closely held medical diagnostics business. The transfer included company stock valued at $11.58 million (the full lifetime exemption) to a trust for the benefit of his children and grandchildren. If the lifetime exemption amount is lowered in future years, this money is now outside of his estate.
We assisted a construction contractor equalize ownership through a lifetime gift. You can gift to anybody, not just family. This business had grown and the key person who owned 10% of the business had been promised 50%. After studying the tax and economic costs of a purchase, a decision was made to utilize the lifetime exemption to fund the transfer. No tax to fulfil a long-time intended business promise.
For larger businesses with many family shareholders, an annual valuation can support internal family transfers, executive compensation, and charitable gifting. This annual process also establishes a years long pattern and process which will facilitate estate planning and estate tax settlement and resolutions. Over many years we provided annual valuations to a family board. Some years there were no transactions, but many years included sizable transactions. Recently one family member died and the valuation for the estate is essentially known and complete. A comforting thought for a grieving family.
Business owners need to act quickly to take advantage of these favorable terms and unique circumstances. To incur tax savings, business owners must make the gift transfer before December 31, 2020. The business valuation required to substantiate the gift must be completed prior to filing your 2020 tax returns, which is April 2021 at the earliest or October 2021, the extended filing deadline.
We are currently facilitating many year end 2020 gifts. We have a process in place to accommodate more clients especially for those of you who receive this note. Please contact us swiftly. We anticipate reaching full capacity prior to year-end. There are alternative structures that shift the valuation requirement to 2021, but your transfer must be completed in 2020.
Adams Capital offers a no-cost initial telephone consultation to provide a sounding board to business owners.
Please email us at email@example.com or call us directly at 770-432-0308 to schedule a consultation or to learn more.
David Adams is the President of Adams Capital, LLC. He is an expert in the valuation of businesses, business interests, and tangible and intangible property for mergers and acquisitions, corporate recapitalization, privatization, gift and estate tax planning, bankruptcy proceedings, dissenting shareholders, Employee Stock Ownership Plans, and financial and tax reporting. Frequently counseling business owners and families on methodologies to enhance shareholder value.