Millions of successful business owners are contemplating the next chapter in their company and personal legacies. This comes just as generous estate and gift tax exemption limits are on the verge of being cut. Careful gift and estate tax planning can be the difference between creating generational wealth and squandering it. Gifting private business interests to children can be an effective and tax-efficient way for your clients to maximize wealth transfer and achieve their succession planning goals.

Unfortunately, many business owners are unaware of the benefits of donating interests in their businesses rather than cash.

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Business interests have the potential to appreciate over time, especially if the business is well managed and successful. By donating shares of a business that is expected to grow in value, your client can transfer more wealth to his heirs while using less of the lifetime estate tax exemption. Conversely, donating cash or other non-appreciating assets may not give them the same long-term value.

This gifting strategy works based on the components of how the federal gift and estate tax is calculated:

Gift and Estate Tax = (Fair Market Value (FMV) of lifetime gifts and estates – exemption) × 40%

Gifts are valued at the date of gift, while residual property is valued at the date of death. By targeting appreciated assets, your client can essentially “lock in” a lower value than would be included in a client's estate. Here are three examples of how this works:

Example 1: Bob, 60, is single with one child, Roberta. Bob owns 100% of ABC Co., a small but growing manufacturing company with a 2023 FMV of $10 million and no debt. Bob actively leads the company as CEO. He is debating between transferring cash or an interest in ABC Co. to his daughter as part of his estate planning.

Let's assume that the federal estate exclusion for singles is $13.61 million today (none of which Bob has used to date) and the exclusion amount increases by 2.5% each year for inflation. So 10 years later, that exemption would be roughly $17.4 million. (Note: This is for illustrative purposes and may not be the case under current laws, more on that in a minute.) The remainder of Bob's estate consists only of a $10 million bank account, which remains constant over the 10-year period. Also, let's assume that ABC Co. it is valued at a rate of 5% per year.

Bob elects to gift $10 million in cash to Roberta in 2023. He pays no gift tax on that transfer because of his unused exemption. When he dies 10 years later, his exclusion will be $7.4 million ($17.4 million – $10 million used), and his taxable estate will be $16.3 million (ABC Co. as assessed). Bob's estate will then owe $3.6 million in federal estate tax (40% more than his estate exceeds his remaining exclusion).

Use it or lose it

Valuation is a perennial fact pattern in estate tax planning; however, we are currently faced with a transitory opportunity.

The current lifetime estate tax exemption is historically high. As you know, it is set to expire at the end of 2025 and may be subject to change. But The Internal Revenue Service has indicated that it will honor gifts made before 2026 using the increased exclusion amount going forward even after the exclusion amount is lowered.

By gifting now, clients can effectively “use” it before it is “lost” after 2025 with their lifetime estate tax exemption. This potentially significantly reduces the client's overall estate tax liability. Barring new legislation, at the end of 2025 those thresholds will be halved (indexed for inflation). So we're talking roughly $7 million for an individual and $14 million for a married couple, subject to inflation. These thresholds are similar to pre-2017 levels.

Example #2: Let's go back to Bob's ownership plan. We projected $3.6 million in tax savings by donating 100% to ABC Co. to his daughter today instead of a cash donation strategy. However, if the exemption limit is halved as expected on 1 January 2026, then the numbers are very different. Bob will have no exemptions at the date of his death and, therefore, the entire estate of $16.3 million will be exposed to the estate tax of $6.5 million.

Minority discount

While we've discussed the concept of valuation and the imminent reduction of the exemption, there are other factors to consider.

When you give away shares of a business, your client can take advantage of minority discounts. These discounts reflect the fact that a minority interest in a business is usually less valuable than a controlling interest in a business, due to the lack of control and marketability. By applying a minority deduction to the value of the donated shares, a client can effectively transfer more wealth to their heirs without using as much of their lifetime estate tax exemption.

A gift strategy should consider all factors with a deep understanding of the valuation and tax issues at play. Example 3 shows an effective strategy for Bob:

Example #3: Returning to Bob and ABC Co., again, let's assume that nothing has changed about Bob's initial situation. But this time Bob chooses a more nuanced gift strategy in which he transfers his interest in ABC Co. to Roberta in the minority blocks as follows:

By using this gifting strategy, Bob accomplished three important things:

• He effectively distributed about 90% of his use-or-loss exemption (approximate tax savings of $4.9 million).
• He targeted minority gifts effectively to use the deductions (approximate tax savings of $1.3 million).
• It lowered his potential estate tax (estimated tax savings between $1.6 million and $2.8 million, depending on a number of factors).

Bob accomplished all of this while incurring only $60,000 in gift tax.

Time is of the essence

By donating appreciating assets, owners can lock in lower valuations for gift tax purposes while allowing remaining assets to grow outside of their taxable estate. This is especially helpful with the current estate tax exemption limits set to be cut in roughly half after 2025. A well-planned gift strategy that takes into account minority interest deductions, gift timing and projected appreciation can save business owners millions of dollars in taxes. However, this type of planning requires a strategic and long-term approach led by experienced valuation professionals.

Anthony Venette, CPA/ABV is a senior manager, business valuation and advisory, with DeJoy & Co., a BDO Alliance firm headquartered in Rochester, NY He provides business valuation and advisory services to DeJoy's corporate and individual clients.