Valuation Discounts for Gift and Estate Tax Savings

CAPTRUST wealth advisor Veronica Karas offers her insight with a crash course in valuation discounts for gift and estate tax savings. Read on for a breakdown of what valuation discounts are, how they work, and what makes them an important part of a comprehensive gift and estate tax savings strategy.

Valuation discounts, which are commonly used for business appraisals for private investment partnerships, minority interests in LLCs, and family limited partnerships (FLPs), are immensely beneficial for gift and estate tax savings. In fact, applying discounts can reduce valuations for estate tax purposes while at the same time allowing you to gift your children a percentage of the business, LLC, trust, or FLP at a reduced rate.

It’s important to know that the standard of valuation for gift and estate tax purposes is defined as fair market value. This is the price at which the business, LLC, trust, or FLP would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Fair market value is the sale price a hypothetical buyer and seller would reach, not the price that the actual owner would agree to or the price an actual buyer might be willing to pay.

Part of Every Gift and Estate Tax Savings Strategy

An Individual may choose to split up ownership of their business, LLC, trust, or FLP, especially for family-owned or closely held assets, to be eligible to receive valuation discounts. Although it is best practice to craft an estate strategy based on your assets during your lifetime, these same valuation discounts would apply to someone’s estate. In the event that someone passes away still owning their business and leaves all of their assets to their six children, all six children would be entitled to many of the discounts.

Common Valuation Discounts

The most common valuation discounts are those for lack of marketability, lack of control, minority share, and future interest discounts. These discounts can range from 10 percent to 45 percent depending on several factors:

Lack of marketability. This refers to the discount that can be applied when valuing a company that is not publicly traded. This often refers to calculating the value of closely held businesses or restricted shares of public companies. The idea is that a discount exists between a stock that is publicly traded (and therefore has a market) and a privately held stock, which often has little, if any, marketplace. In other words, because a privately held stock does not have clear market value (the way that a publicly traded stock does), it deserves a discount.

Lack of control. The reduction in a company’s share value due to a shareholder’s lack of ability to exercise control over the company is a discount for lack of control. In this circumstance, a business interest is considered to be worth less than a controlling interest in a company, since business decisions, like determining compensation, setting policies, deciding to sell or liquidate, and declaring dividends, are all out of the shareholder’s hands. Thus, when noncontrolling or nonvoting shares are valued for a private company, a discount for lack of control is often applied.

Minority share. You can obtain minority interest discounts by making each gift of an interest in the business small enough to qualify for the minority interest discount. The minority interest discount reflects the notion that a partial ownership interest may be worth less than its pro rata (proportional) share of the total business. For example, ownership of a 30 percent share in the business may be worth less than 30 percent of the entire company value. This is so because a 30 percent ownership may be limited as to the scope of its control over critical aspects of the business, such as management, financial or accounting oversight, regulatory or legal issues, and even hiring and firing decisions.

Future interest. Future interest discounts are common when setting up trusts like qualified personal residence trusts that entitle the beneficiary to the asset a specified number of years in the future. Since it is a gift of future interest, the asset can be discounted based on an assumed interest rate of growth.

Determining the Discount

Individuals will need a qualified business appraiser or skilled valuation analyst to determine an appropriate discount based on an analysis of the assets held by the entity and their condition, the size of the interest being gifted, and restrictions outlined in the operating agreement.

Valuation Discounts Sidebar

Many factors enter into a business valuation, and specific facts surrounding the transfer will weigh heavily into the discount. These restrictions often significantly limit the power of minority interest holders to vote, participate in management, replace managers, force distributions, liquidate assets, and transfer or sell their ownership interest.

If individuals are making gifts over a period of years, experts recommend undertaking a valuation with each gift, as closely to the time of transfer as possible.

Current Tax Law and Valuation Discounts

Amidst the flurry of activity around possible tax law changes, valuation discounts are specifically addressed. If the proposed legislation should pass, no valuation discounts would be allowed with respect to interests under common family control.

Under the current tax law, individuals can give $11.7 million per person in gifts over the course of their lifetimes without having to pay gift taxes. However, this provision is set to expire at the end of 2025. Based on the many tax proposals currently being discussed, it is possible that it may be rolled back to a lower number even sooner.

To take advantage of possible grandfathering for transactions completed before the effective date of any proposed regulations, individuals already engaged in transfer planning with family limited partnerships and LLCs should complete the process in a timely manner, while those seeking to rely on existing laws should begin planning immediately.

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