More On Tax Planningfrom The Advisor's Professional Library
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
Valuing minority interests in a family-owned business can present a significant challenge to owners looking to take advantage of today’s high gift tax exclusion. Even after obtaining a professional appraisal of the business’ value, frequent IRS challenges to these appraisals have historically made it difficult to determine minority interests with any degree of certainty that your client will not incur gift tax liability. A recent Tax Court decision may have paved the way toward eliminating this problem for good, allowing your clients to give small interests in their companies without worrying about incurring gift tax liability if the IRS successfully challenges a valuation.
The Problem: Valuing the Gift of a Small Business Interest
Minority interests in a closely-held business are inherently difficult to value. Each case is unique, and there is usually no public market for the shares that would dictate their fair value. Because of this, the IRS requires that small business owners obtain a professional appraisal to determine the value of business interests for gift purposes.
Since the IRS is watchful of appraisals that may understate the value of assets to avoid gift taxes, it is difficult for a business owner to transfer portions of his or her business while taking full advantage of the gift tax exclusion. It may instead be tempting to give fewer interests and be certain not to exceed the annual limit.
For example, if your client owns a business and wants to make a gift of shares worth $13,000 (the 2012 annual exclusion), and an appraisal indicates that 100 shares can be transferred without exceeding this amount, the owner could transfer the shares without paying gift taxes. The IRS can later challenge this valuation and show that only ninety shares were worth $13,000. If the IRS is successful, the business owner would then be required to pay gift tax on the ten shares that exceeded the annual exclusion amount—a result that your clients would prefer to avoid.
The Wandry Case
In Wandry vs. Commissioner, the taxpayers owned a small business and wanted to give interests to their children and grandchildren while minimizing gift taxes. Because the value of the business had not yet been ascertained, the taxpayers specified in the documents governing the transfers of the business interests that the gifts were not to exceed the annual exclusion.
In other words, instead of giving a certain percentage of the business assets, the taxpayers in this case capped the gift at the amount of assets transferred. This was important because the IRS eventually challenged the appraisal that the taxpayers obtained and found that the value of the business was about 20% higher.
While the IRS argued that the taxpayers were required to pay gift taxes on the 20% increase, the court found that the additional value had never been given because the transfer documents limited the gifts to the exclusion amount instead of specified percentages of the business. Therefore, any interest in the business above the exclusion amount was treated as having been retained by the taxpayers. They were not required to pay gift taxes because the interests that exceeded the exclusion amount were simply never given.
Even though the IRS will likely appeal this decision, the Tax Court has, in the meantime, provided a way for small business owners to complete small transfers of their companies with the certainty that they will not incur gift tax liability should the IRS successfully challenge the valuation of the interests. Because we are not certain what the gift tax exemption and exclusion amounts will be after 2012, this is a planning technique your clients may want to make use of today.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, National Underwriter Advanced Markets, for a free trial.