The Ticking Time Bomb for High Net Worth Clients

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced monumental tax reform for individual and business taxes. While the TCJA had widespread, sweeping tax effects, one area targeted in particular was the gift and estate tax lifetime exemption.

The gift and estate tax lifetime exemption allows an individual to gift a certain amount tax exempt during life or at death. Before the TCJA, the lifetime exemption began at a tax base of $5 million adjusted for inflation ($5.6 million), adjusted annually for inflation.

Following the TCJA, that same exemption doubled to $11.2 million, adjusted annually for inflation. However, this was only enacted as a temporary change, and the increased lifetime exemption is set to expire on January 1, 2026. Any change to this expected sunset date requires an act of Congress.

The Future of Lifetime Exemption

So, what is the future of the lifetime exemption? As mentioned, come 2026, the exemption reverts to its former base level of $5 million, adjusted for inflation.

The IRS further clarified that individuals who take advantage of the temporary $10 million base will not be penalized in the future once the exemption reverts back to the $5 million amount. Therefore, the exemption amount available to individuals will be the full amount of the increased exemption with a $10 million base if used prior to 2026, or only the amount of the decreased exemption with a $5 million base available after the start of 2026.

The reduction of the exemption is a seismic change that will impact high net worth individuals. As a practical matter, it means that putting off estate and gift tax planning could lead to millions of dollars more in an individual’s estate becoming taxable at the high rate of 40%. What a taxpayer does now matters not only to the estate, but also to the taxpayer’s families and loved ones.

What can be done in the near term?

A colleague once described the estate and gift tax as an optional tax. No taxpayer is required to pay this tax because they could simply give all their assets away until they reached the lifetime exemption and give the rest to charity.

In 2023, the lifetime exemption is $12.92 million. Keep in mind, this is a per individual amount, so a married couple has the combined exemption of $25.84 million. The 2023 annual gift tax exclusion amount increased to $17,000, which is the amount that can be freely gifted to another individual without tax ramifications. This amount will change in 2024, and similarly will be adjusted for inflation.

To fully take advantage of these high exemption amounts, retain a knowledgeable estate attorney, tax accountant, and valuation specialist now.

Gift and Estate Tax Mechanics

The gift and estate tax are both taxed according to a rate schedule that quickly reaches 40% on the value of the property transferred.

  • If the transfer occurs during a taxpayer’s lifetime, the transfer is subject to gift tax and Form 709 may be filed.
  • If remaining at the taxpayer’s death, then the transfer is subject to estate tax and Form 706 may be filed.

The Gift and Estate tax system applies these exclusions and exemptions at the individual level. However, married couples can combine their exemptions and exclusions.

Lifetime Gifts

To thoughtfully plan for estate taxes, a taxpayer must consider what he or she can give away during his or her lifetime. It is important to understand the taxability of gifts and the exemptions available. These exceptions have layers as seen here:

  • Gifts excluded from the gift tax include those to:
    • A spouse if a U.S. citizen
    • A government entity, charity, or certain exempt organizations
    • Medical expenses paid directly to the medical establishment
    • Tuition paid directly to the educational institution
  • Annual Exclusion – For 2023, gifts up to $17,000 per person are not subject to gift taxes. Gifts up to this exclusion can be given to an infinite number of people at any time. Married couples can split a gift, meaning a married couple can effectively gift $34,000 per person with the annual exclusion.
  • Lifetime Exemption – The final exemption applied is adjusted for inflation annually, but for 2023 it is $12.92M. As previously mentioned, the lifetime exemption was temporarily doubled, yet taxpayers can still take advantage of the larger credit before 2026 when it is lowered. The final regulations explain the calculation to arrive at the applicable exclusion, which applies the higher of the exclusion amount applicable to gifts made during the taxpayer’s life or the exclusion applicable on the date of death. Therefore, the next few years are critical to estate planning.

Estate Taxability

At date of death, an estate is valued for the estate tax. The gross estate includes all property owned or controlled by the decedent, which can include personal, tangible, or intangible property.

Valuation of certain interests, such as a closely held business or partnership, can be complex, which is why a credible valuation team is vital. Furthermore, certain transfers during the decedent’s life in contemplation of death or with a retained interest could be included in the gross estate and must be valued.

Once the gross estate has been determined, certain deductions are applied to get to a taxable estate. Allowable deductions include:

  • Marital deduction – This is the value of any property passed to a surviving spouse. Keep in mind, this is more of a deferral than a complete deduction as the property will be included in the spouse’s estate unless transferred.
  • Charitable deduction – A deduction for the value of property passed out from the estate to a qualifying charity or tax-exempt organization is also allowed. Unlike the income tax system, there is no limit on the charitable deduction for an estate.
  • State Death Tax deduction – If there are any state taxes paid related to the decedent’s death, they are deductible for federal purposes.
  • Debts – A deduction for the debts owed by the decedent at the date of death is allowed.
  • Funeral Expenses – Expenses related to a funeral paid by the estate are also deductible.

Once the gross estate has been calculated, the remaining lifetime exemption is applied, and the resulting value is the taxable estate. The taxable estate is then taxed based on the unified tax rate schedule according to Section 2001(c), which quickly reached 40%.

The work may not be complete yet. An alternative valuation date may be beneficial. This would value any property sold or distributed from the estate within six months of date of death at the date of distribution. All remaining property is valued at the date six months after the date of death. The election can only be made if the gross estate is less than the date-of-death valuation.

The gift and estate tax system is complex, which is why at LBMC we have a team of experts partnered with our valuation department ready to educate and assist clients with their estate planning goals.

Strategic Valuation Techniques for Minimizing Gift and Estate Taxes

Due to the gift and estate tax being applied to value rather than cost, an important strategy for lowering the taxes is to lower the taxable value of the transfers.

An effective strategy can lower the taxable value without reducing the real economic value of the underlying assets. If the estate includes a private business entity, and a taxpayer plans to gift an interest in the entity, then the taxpayer will need to engage a valuation professional.

There are two different types of well-known valuation discounts available to minority interests in private business entities, which include the discount for lack of control and the discount for lack of marketability.

A minority interest is generally one that owns less than 51% of the governance rights in a business entity. The discounts applied to the minority interest directly reduce the value of the interest being gifted, and therefore reduce the amount of lifetime exclusion used up by the individual making the gift.

Let’s review a high-level exploration of some of the items considered within these two discounts.

Discount for Lack of Control

The discount for lack of control is applied to an interest that lacks the ability to make unilateral decisions within the business entity. The valuation professional will receive and analyze information from a management interview, the financial statements, and the governing documents of the business entity. The agreement will define the rights for the ownership interest being valued. Items that can affect the discount for lack of control include:

  • Who has control of management?
  • Who dictates both the timing and the amount of distributions?
  • Who is able to initiate the sale of all, or substantially all, of the business?
  • Who is able to negotiate the sale of the business?
  • Who is able to determine the amount of debt that the business takes on?
  • Who has voting rights?
  • Who does not have voting rights?
  • Who can mandate capital calls?
  • Is there another owner(s) who can unilaterally block decisions of the interest?

Of course, this is not an exhaustive list of considerations concerning the discount for lack of control. But each of these items gives significant weight to the discount for lack of control.

Discount for Lack of Marketability

The discount for lack of marketability is a recognition that a non-controlling interest in a private company lacks the same level of liquidity or marketability as stock in a company that is traded on the public stock market. Additionally, closely held businesses may further restrict transferability by putting in place the following:

  • Right of first refusal;
  • Restrictions on admissibility of members/partners; and
  • Restrictions on permitted transfers.

Again, this is not an exhaustive list of items considered for the discount for lack of marketability. Combined discounts for lack of control and discounts for lack of marketability can vary greatly but can reduce the value of a taxable transfer by as much as 40%. Given these discounts result in a significant reduction in value, and therefore, the overall tax being paid, it is important to have a reputable valuation professional completing the work.

January 1, 2026, is quickly approaching. Gift and estate attorneys, tax advisors and valuation professionals are hard at work trying to keep up with current demand.

If any questions arise regarding estate or wealth planning, contact LBMC’s wealth advisors’ team, and we can help build a strategy that will work best for you and your family.

Content provided by LBMC valuation professional, Jessica Barrett, CPA, ABV, CFE, and LBMC tax professional, Shelby Follis, CPA.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.