Using the Estate Tax Exemption to Transfer Stock Tax Free

By Bret Pittman and Caroline Van Hook

The current estate tax exemption expansion, which is set to expire for estates and gifts dated after December 31, 2025, presents wealthy families a window of opportunity to transfer substantial assets to descendants tax free. The exemption for 2024 is $13.61 million for individuals and $27.22 million for married couples. In 2025, that amount will increase to 13.99 million for individuals and 27.98 million for married couples.

The 2017 Tax Cuts and Jobs Act (TCJA) provision that raised the exemption amount is set to expire on January 1, 2026, leaving the exemption to revert to its pre-TCJA level, which, adjusted for inflation, will be about $7 million for individuals and $14 million for married couples. However, with the results of the 2024 presidential election, the 2017 TCJA provision will likely be extended with a Republican majority in both the House and Senate. If an extension is passed, it will likely be in effect through the end of 2026.

Taking Advantage of 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. The estate tax is generally 40% of the value of assets in excess of the exemption. Estates valued at less than the exemption for the year of the grantor’s death are not subject to the estate tax at all. The tax rates start at 18% and quickly rise to the maximum of 40%.

For families with significant shares of stock in private companies, the increased estate tax exemption presents an opportunity to transfer greater wealth to descendants of the estate without triggering estate tax liabilities, provided the total value of the transferred assets falls within the exemption limit. Individuals take advantage of the increased gift and estate tax exclusion by gifting assets during their lifetime. This effectively removes the assets from the donor’s gross estate when they pass. Gifts over the annual exclusion reduces the lifetime gift and estate exemption. Moreover, the IRS recently clarified in Treasury Decision 9884 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. In other words, if one gifts the assets while the current rules are in place, but dies after the sunsetting of those rules, the current rules will still apply. This guidance provides additional comfort to individuals planning to take advantage of the opportunity to use the existing estate tax exemption.

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. To properly gift stock in a private company by use of the estate tax exemption, the individual making the gift must first have the stock valued. The individual gifting the stock will be required to file a Form 709 Gift Tax return with the IRS verifying the value of the gifted stock.

When valuing a private company, most valuation experts apply significant discounts to the reported valuation where the transfer involves a minority (non-controlling 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 another benefit to the individual making the gift.

How could this impact your legacy? Let’s consider an example

Jim and Kate Smith are the founders of a food production business (“Foodco”) that operates in six states. They own all 1,000 shares of the outstanding stock. A recent third-party appraisal of Foodco estimates its fair market value at $40 million. The Smiths intend to continue operating the business for another 10 years but would like to transition some of the ownership to their two children while retaining majority owner status.

They can transfer to their two children equal amounts totaling up to 49% (or 490 shares) valued at $19.6 million entirely tax free in 2024 because Jim and Kate (as husband and wife) together have a $27,220,000 exemption to work with. Using the recent $40 million fair market valuation of Foodco, the Smiths can request an updated valuation for the transfer of a non-controlling (or minority) interest in the business. A typical valuation result would apply somewhere in the range of a 20% discount for the transfer of a non- controlling interest such that, for purposes of filing a Form 709 Gift Tax return, the $19.6 million may be reduced by as much as $3,920,000 to $15,680,000.

The total gift of shares valued at $15.68 million is tax free. But if the same transaction occurred after Dec. 31, 2025, about $1.68 million will be subject to tax, assuming no extension to the increased gift tax exemption. This would equate to about $617,000 of tax.

Estate-Specific Practical Planning Considerations

Practitioners should address the following matters with clients who are 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 does it trigger a buy/sell provision (or require the company’s consent)? If a prohibition exists, either 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 shareholders’ agreement that will prohibit the recipient of the shares from transferring the stock? If not, a Shareholders’ Agreement prohibiting such a transfer should be put in place before making the gift.

Conclusion

The use of the estate tax exemption for passing stock in a family-owned company from parents to children is a powerful estate planning tool that helps families preserve and transfer wealth.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.