As a business owner, you’ve invested years into building and growing your business, but have you thought about what will happen to your business when you’re no longer here to run it? The right business structure and a comprehensive estate plan are crucial not only for the future of your business but also for ensuring that your family and heirs can avoid unnecessary financial burdens, such as hefty estate taxes. With the sunset of the current estate tax exemption set to occur at the end of 2025, now is the time to take action and protect what you’ve worked so hard to build.
Understanding Your Business Structure and Estate Taxes
When it comes to estate planning, your business structure can significantly impact how your estate is taxed. Whether you run a closely held corporation, family limited partnership (FLP), or sole proprietorship, the value of your business could form a significant part of your estate. The IRS closely scrutinizes business valuations for estate tax purposes, and one key aspect of that valuation is whether you can apply discounts that reduce the taxable value of your business.
Two critical valuation tools that can help business owners lower their estate tax liability are the minority discount and the lack of marketability discount:
- Minority Discount: If you own less than 50% of your business, you may qualify for a minority discount. This reflects the reduced value of owning a non-controlling interest in the business.
- Lack of Marketability Discount: This discount applies to closely held businesses that do not have a readily available market for their shares. Since there’s no easy way to sell shares in a closely held business, the IRS recognizes that these shares are worth less.
An important U.S. Tax Court case, Estate of Andrews v. Commissioner, serves as a reminder that the IRS carefully scrutinizes the application of minority and lack of marketability discounts. In this case, the petitioners attempted to significantly reduce the value of the decedent’s interest in four closely held corporations for estate tax purposes by applying both a minority discount (due to the decedent’s 20% ownership stake) and a lack of marketability discount (because the corporations were closely held with no public market for shares). The IRS, however, argued that the stock was vastly undervalued, proposing much higher values for the decedent’s shares—amounts significantly above what the estate had reported.
Specifically, the estate valued the stock interests at around $127,390 in total, while the IRS argued that the correct valuation should be closer to $1.01 million. The IRS applied less aggressive discounts and focused more heavily on the corporations’ net asset values, given that these companies held valuable real estate.
The Tax Court ultimately ruled that both the minority discount and the lack of marketability discount were appropriate, but it did not fully accept either party’s valuations. The court emphasized that a hypothetical willing buyer would consider both the earnings potential of the corporations and their underlying asset values. After weighing the factors, including the management of the businesses and the illiquidity of the shares, the Tax Court adjusted the values but still applied substantial discounts, reducing the estate’s tax liability compared to the IRS’s original assessment, though not to the extent the petitioners had proposed.
This case underscores the importance of proper business valuation in estate planning and demonstrates how courts differentiate between the lack of control and marketability discounts when determining the fair market value of closely held businesses.
The Imminent Sunset of IRC Section 2010(c): What Business Owners Need to Know
Currently, the federal estate tax exemption under IRC Section 2010(c) is at a historically high level. In 2024, an individual can exclude approximately $13.61 million from their estate before estate taxes are owed, which means married couples can shield over $26 million. This large exemption has allowed many business owners to pass significant wealth—including businesses—to their heirs tax-free.
However, this favorable exemption is scheduled to sunset at the end of 2025, meaning that the exemption could drop dramatically—likely back to pre-2018 levels, which were roughly half of the current amount. For business owners, this shift could result in a substantial increase in estate tax liability.
Here’s why this is crucial:
- Larger Estates Could Be Taxed: If your business pushes your estate’s total value above the reduced exemption, your heirs could face significant estate taxes.
- Planning Opportunities: If you take action before the sunset, you can lock in the higher exemption by making strategic gifts or other transfers that fall under the current rules.
Steps to Take Now to Protect Your Business and Family
Given the upcoming changes, business owners need to focus on a few key areas:
- Review and Update Your Estate Plan: If you haven’t updated your estate plan in recent years, now is the time. Ensure that your business interests are included and that your plan reflects your current wishes. Consider working with an estate planning attorney who specializes in business succession planning.
- Explore Gifting Strategies: With the higher estate tax exemption in place through 2025, many business owners are taking advantage of gifting strategies to reduce their taxable estates. This could involve gifting shares of your business to your heirs now, while the exemption is still high, or placing business interests in trusts.
- Consider Your Business Structure: If you’re running a closely held business or family limited partnership, make sure your business structure is optimized for estate planning purposes. Some structures may allow for greater use of discounts (like the minority and lack of marketability discounts) to reduce your estate’s taxable value.
- Valuation of Your Business: Accurate and defensible business valuations are critical for estate planning. Work with a qualified appraiser to ensure your business is valued appropriately and that you’re taking advantage of available discounts.
- Plan for Liquidity: Estate taxes are due nine months after death, and without sufficient liquidity, heirs may be forced to sell business assets or even the business itself to cover the tax bill. Consider insurance or other financial tools that can provide the liquidity needed to cover estate taxes.
Don’t Wait—Act Before 2025
With the sunset of the current estate tax exemption approaching, business owners have a limited window to take advantage of the favorable tax landscape. If you delay, your business and your heirs could be facing an estate tax environment with much higher tax exposure. By taking proactive steps now—revising your estate plan, considering gifting strategies, and preparing your business for transition—you can help ensure that your family and heirs are not saddled with an unexpected tax burden.
In summary, your business structure and estate plan are not just about planning for the future—they’re also about preparing for the unexpected. With changes to the estate tax on the horizon, it’s essential to work with your financial and legal advisors to craft a strategy that protects both your business and your loved ones. Review our Business Succession Planning page and Contact Us Today to get your plan started.