For the second year in a row, the estate tax exemption has increased to keep up with inflation, offering families, family business owners and affluent individuals with substantial assets the ability to shield a bigger portion of their assets from estate tax.
While debates leading up to the presidential election have had much buzz on health coverage, climate change and infrastructure, candidates are not talking about lower estate tax exemptions, current lower valuations, and allowable valuation discounts. Here are some best practices to consider ahead of 2020 election uncertainty.
1. Take advantage of today’s estate tax environment. If you don’t, you could risk leaving millions of dollars in tax exemptions on the table. As a provision of the Tax Cuts and Jobs Act of 2017, Congress raised the estate tax exemption, now at $11.58 million per individual or $23.16 million per couple. All great news for savvy entrepreneurs and small business owners looking to shield more of their assets from estate taxes. The current threshold is set to sunset at the end of 2025, when it would revert to the pre-2018 exemption level (adjusted for inflation) of $5 million for an individual taxpayer.
2. Gift now. Most business owners are concerned that they cannot use the increased exemption because of their desire to retain the cash flow from the assets that could be given away. However, if the use of the increased tax exemption is delayed, it may not be available later if the increase is eliminated as scheduled in 2026, or earlier, depending on the 2020 election outcome. Today’s favorable estate tax environment is unlikely to come around again.
3. Explore planning alternatives. Ensure your options provide the greatest flexibility in terms of receiving future cash flow and being able to use principal from time to time. Sales, entity freezes and Grantor Retained Annuity Trusts are all methods a taxpayer can use to retain access to some cash flow and transfer future appreciation of the assets out of their estate.
4. Consider transferring appreciating assets. If you have shares in your own business, you can gift them, and the appreciation then takes place out of your estate. The annual gift exclusion is $15,000. Gifts over the annual exclusion start to chip away at that lifetime exemption of $11.58 million, but no gift tax is currently due until the taxable gifts exceed the lifetime exemption.
5. Use, or risk losing, the temporarily increased exemption amount. Back in November 2019, the IRS issued regulations that wouldn’t “claw back” or penalize those who die in the future for past gifts that exceed their exemption at death. This ruling gives taxpayers assurance that any current planning they do for large gifts will hold up. If the exemption is changed by Congress or expires, taxpayers who do not make gifts while this is the law may lose out on a valuable benefit.
6. Optimize the use of estate tax exemptions with current lower valuations and allowable valuation discounts. The use of lower valuations (i.e., before value appreciation due to capital gains) and current allowable discounts allows you to leverage this valuable estate tax exemption amount. An individual willing to use $11.58 million of their exemption, and assuming a 25% discount, can gift $15 million of assets at no current gift tax cost. Look for the lowest valuation of businesses and business interests deemed supportable for tax regulatory purposes. Act now, as the estate tax exemption, current lower valuations and allowable valuation discounts might not be available in the future.
7. Experience matters. To support and defend valuations against regulatory scrutiny takes experience and understanding of the appropriate valuation methodologies and assumptions acceptable to the regulatory authorities, especially what are deemed acceptable in terms of discounts for lack of control (“DLOCs”) and discounts for lack of marketability (“DLOMs”).
8. Know the IRS won’t always prevail. In the last couple of years, the IRS has had some success in eliminating valuation discounts on death with respect to family limited partnership interests held by a decedent. Furthermore, what were considered acceptable assumptions and support by the regulators for DLOCs and DLOMs in years past are not necessarily acceptable in today’s environment.
9. Assemble the right team to execute your strategy. Having advisors experienced in estate tax planning and valuation provides a solid foundation for maximizing your estate and gift tax savings. Gifting now will allow business owners to pass more of their wealth to heirs free of tax. It could also help settle some business issues now, not later, when the owners die.