The current estate tax exemption under the 2017 Tax Cuts and Jobs Act, which is set to expire on Dec. 31, 2025, presents a unique opportunity for tax-free transfers of family wealth.
In 2024, the lifetime estate tax exemption is $13,610,000 for individuals and $27,220,000 for a married couple. In 2025, that amount is projected to increase to approximately $14 million for individuals and approximately $28 million for married couples before the exemption sunsets on Jan. 1, 2026. At that point, the exemption is set to revert to pre-2018 levels, currently estimated to be approximately $7 million for individuals and approximately $14 million for married couples.
This looming 50% decrease in the amount that can be transferred tax-free has created urgency for wealthy families to determine the viability of transferring valuable assets — including private company stock — to children and grandchildren by the end of 2025.
Understanding the Estate Tax Exemption
The estate tax is a federal tax imposed on the transfer of property upon one's death. It applies to the fair market value of an individual's assets at the time of death. Generally speaking, the estate tax rate is 40% of the value of assets subject to the federal estate tax. However, not all estates are subject to estate tax. The U.S. government provides an estate tax exemption, which is the amount of assets that can be passed to heirs without incurring estate tax liability.
For families with significant shares of stock in private companies, the estate tax exemption presents an opportunity to transfer wealth to their children or grandchildren without triggering estate tax liabilities, provided the total value of the transferred assets falls within the exemption limit. In addition to the benefit families can recognize by gifting stock to younger generations, the IRS recently clarified that individuals taking advantage of the increased gift and estate tax exclusion amounts in effect from 2018 to 2025 will not be adversely impacted if their death occurs after 2025, when the exclusion amount is scheduled to revert to pre-2018 levels.
Taking Advantage of Recognized Discounts
Another significant benefit available to individuals seeking to use the estate tax exemption to gift private company stock is the valuation discount methods applied to private companies. In order to properly gift stock in a private company by use of the estate tax exemption, the person making the gift must first have the stock valued and will then be required to file a form 709 Gift Tax return with the IRS verifying its value.
When valuing a private company, most valuation specialists apply significant discounts to the reported valuation where the transfer involves a minority interest in the company's stock. These discounts are known as the lack of marketability and the lack of control discounts. They are applied because there is no public market for stock in a private company and because minority shareholders do not have the power to control the future strategic decisions of the company. Depending on the circumstances, the discount rate used by the valuation expert can be significant, extending a further additional benefit to the individual making the gift.
A Case Study
Jim and Kate Smith are the founders of a food production business that operates in six states (“Foodco”). They own all 1,000 shares of the outstanding stock in Foodco and have two children. A recent third-party appraisal of Foodco estimates its fair market value at $40 million. The Smiths intend to continue operating Foodco for another 10 years but would like to transition some of the ownership to their children while retaining majority ownership in the company. What are their options?
Because the Smiths (as husband and wife) together can make a tax-free gift of up to $27,220,000 in 2024, they can transfer up to 49% (or 490 shares) to their two children, divided equally among them. Using the recent $40 million fair market valuation of Foodco, the Smiths can request an updated valuation for the transfer of a non-controlling and non-marketable interest in Foodco. A typical valuation result would apply somewhere in the range of a 20% to 35% discount for the transfer of a non-controlling, non-marketable interest. So, for purposes of filing a Form 709 Gift Tax return, the transfer of 490 shares (which would be valued at $19,600,000 before application of a discount) may be reduced by as much as $6,860,000 to $12,740,000. Using the 2024 estate tax exemption for a married couple of $27,220,000, the Smiths would then transfer 245 shares of Foodco stock to each of their children on a tax-free basis, and still maintain majority control of Foodco.
Key Questions
We recommend working closely with your attorney and accountants to evaluate the following steps and factors when considering using the estate tax exemption to gift private company stock:
- Do the company's organization documents permit a transfer to your children or grandchildren, or would it trigger a buy-sell provision (or require the company's consent)? If a prohibition exists, an amendment to a governing document and/or third party consent must be secured to permit the transfer.
- Is the gift consistent with your estate plan or will it require an amendment?
- Does the company have a shareholder agreement that will prohibit the recipient of the shares from transferring the stock? If not, we recommend that the shareholder agreement be modified to prohibit such a transfer before the shares are gifted.
The use of the estate tax exemption for passing stock in a family-owned company from parents to children is a powerful wealth planning tool that can help families preserve and transfer wealth across generations. By relying upon the exemption through gifting strategies, families can minimize estate tax liabilities while ensuring the orderly transfer of assets to the next generation. However, it's crucial to approach these strategies with careful planning and consideration of the unique circumstances and objectives of each family.