Valuation Discounts in Estate Planning: Are They Right for Your Business?

“The whole is greater than the sum of its parts.” This well-known saying is the reasoning behind valuation discounts, a tool that can be used to reduce the value of a business interest for transfer tax purposes, including estate tax, gift tax, and generation-skipping transfer tax. How do valuation discounts work, when are they used, and are they right for your business? If you are the owner of a closely-held business whose estate will be subject to estate tax, they might be.

How Valuation Discounts Work

By fragmenting the ownership of your business, the value of each interest is reduced. Let’s say you own a bakery. You know that if a cookie breaks coming out of the oven, you can’t sell it for the same price as a whole, unbroken cookie. Valuation discounts work in a similar way.

Here’s how valuation discounts would work in the bakery scenario. Instead of retaining the entire business, you would create a family limited partnership (FLP) and transfer (sell or give) a percentage interest to family members. For instance, if you were married, you might keep a 35% interest, transfer a 35% interest to your spouse, and transfer a 10% interest in the business to each of your three adult children, Andrew, Billy, and Christa.

The family still owns the business, but no one owner has a majority interest. A buyer who was interested in buying into the bakery probably wouldn’t be interested in paying 30% of the bakery’s value for 30% of the stock if that didn’t translate into 30% of the voting rights. As a minority shareholder of a closely-held business, the buyer couldn’t control the company’s decisions, nor could they sell their stock on a stock exchange.

The only thing that might make buying that 30% interest more palatable to a prospective buyer is if the cost were discounted to reflect the fact that the buyer doesn’t have control of the company and cannot easily resell their interest.

Because the fractional interests are worth less from the standpoint of fair market value (FMV), the value of the estate is lowered, reducing any transfer taxes that might be owed. In this way, a family business can be passed to the next generation at a lower cost. To revisit the cookie analogy, Andrew, Billy, and Christa will eventually end up with the whole cookie either way, but it will cost less (in terms of transfer tax) to give them a few crumbs now and some bigger pieces later.

The Downside to Valuation Discounts

From the description above, it sounds like valuation discounts are a good way to reduce transfer taxes without substantially altering the control of your small business or family farm. But transfer taxes are not the only kind of tax an estate might pay. There’s also a capital gains tax.

A lifetime transfer of an asset does not result in a step-up in basis like a transfer at death does. (In a lifetime transfer, the recipient assumes the transferor’s basis in the asset.) Consequently, valuation discounts of business interests can lead to an increase in taxable gain on the sale of the business. In our example, if Andrew, Billy, and Christa sell the bakery after you and your spouse die, they could pay more in capital gains tax.

You might decide that’s a risk worth taking if it means avoiding a hefty estate tax. As things stand at this writing, the lifetime exemption from gift and estate tax is $11.7 million dollars per person, or $23.4 for a married couple. If your estate, including the bakery, is worth less than that, it may not make sense to discount the value of the business through fractional interests. You would gain no estate tax advantage, and your children might pay more in capital gains tax if they sell the business.

Estate Tax Changes on the Horizon and Valuation Discounts

Right now, the lifetime exemption amount is high, thanks to the Tax Cuts and Jobs Act (TCJA) enacted in the last presidential administration. However, the amount is due to “sunset” back to its previous level after 2025, and the amount could reduce even sooner under President Biden’s proposed tax changes. That means that more estates could be exposed to estate tax, and valuation discounts might make sense for more family businesses.

If you are interested in learning more about estate tax planning strategies, there are many options available, including SLATs and completed-gift domestic asset protection trusts. We invite you to contact Gudorf Law to learn more about strategies for your family or business situation.