Introduction

Every business owner will need to exit their company at some point in time, whether it be an
opportunistic sale, retirement, disability, or other reasons. A well-thought-out exit strategy is
paramount to a smooth transition that leaves the owner(s) with the maximum reward for their
years of hard work. Advisors and business owners should be aware of current policies that
could impact their exit strategies, including upcoming changes to policies involving annual gift
tax exclusions and lifetime gift and estate tax exemptions.


What it is?

The annual federal gift tax exclusion allows an individual to gift up a specified amount each year
that will not be counted toward the so-called “ lifetime exemption”. As of 2023, the current
annual gift tax exclusion is set at $17,000 per recipient, marking the highest annual exclusion
amount ever. For business owners, this allows them to transfer more of their business over
time while maximizing tax efficiency. If an individual makes taxable gifts in excess of the annual
exclusion in a given year, a gift tax return (Form 709) may need to be filed.
The lifetime federal gift and estate exemption is the amount that you can give during your
lifetime (or death) that will be exempt from federal estate and gift taxes. The current lifetime
limit is set at $12.92 million per individual or $25.84 million (doubled) for married couples.

How will these limits change?

In 2017, the Tax Cuts and Jobs Act (TCJA) was enacted which included a doubling of the lifetime
gift and estate tax exclusion for individuals from $5 million to $10 million (with additional
annual adjustments for inflation, pushing the exclusion to $12.92 million today). This change
allowed individuals with large estates to pass along more of their assets while reducing
potential estate taxes.


The annual lifetime gift exclusion is set to sunset after 2025 and return to its inflation-adjusted
pre-TCJA level. It is expected that for 2026, the lifetime gift limit will be roughly cut in half from
its current level (bringing it to ~$6.8 million per person). It is still possible that Congress could
make changes to maintain or even expand the current elevated exclusions levels; however, it
may be wise to plan for the current expected trajectory.

How does this impact advisors and owners?

The estates of most U.S. citizens are not large enough for this policy change to have any
significant impact. However, these changes will be notable for business owners and other high-net-worth individuals that have large and growing estates.

As it stands now, if an individual passes away their assets will become part of their estate and
will be subject to estate taxes. For business owners, their estates will normally include any and
all ownership interests. Typically, an estate is not subjected to federal estate tax if the estate’s
value is less than the exemption amount. Estates valued beyond the federal lifetime exclusion
will generally be subject to a steep 40% estate tax rate against any excess value above the
exclusion level. It is noteworthy that many states also levy some variant of an estate tax,
including seemingly punitive tax schemes which apply the estate tax rate against the ENTIRE
estate once it exceeds the relevant threshold, e.g. Illinois.


Gifting the business before it goes to an estate and before policies change could provide one
avenue for maximizing tax efficiency in a business transfer. Estate planning is one of the most
valuable services offered by many wealth advisors, insurance agents, and exit planners.
Consider a business worth $10 million today that is growing at 5% per year. In 10 years that
same business would be worth more than $16.2 million. If an owner were to gift that business
today, they would be giving a gift of $10 million which would fall under the federal lifetime
exclusion (assuming no other gifts had already been made) and any business value growth
thereafter would accrue to the recipient of said $10 million gift.


Alternatively, if the owner held onto the business and passed away in 10 years, the business
would now be worth $16.2 million which would go into their estate. Assuming the current
federal lifetime exclusion threshold, approximately $3.3 million of the value ($16.2 current
worth less than $12.92 current exclusion) could be subject to an estate tax (around $1.32 million or
40%). However, the lifetime exclusion in 10 years may be much less than it is today (based on
the aforementioned changes coming in 2026), meaning the majority of the value of the
business would likely be subject to the estate tax.


Under the first scenario, the owner gifts the business at $10 million with no gift/estate taxes
which then (all other things equal) grows to $16 million in ten years.
In the second scenario, the owner does not transfer the business over the ten-year period
while it has still grown to $16m, subjecting the owner to the then-existing estate tax at the
time of transfer.

What happens to the portion of the exclusion you have already used?

With the significant changes to the federal lifetime gift and estate exclusions, those who have
used portions of their exclusion may be curious about how the new cuts impact them.


Scenario #1 – An individual has used less than $6.8 million of their exclusion


For most individuals, they will not have used a significant portion of their exclusion before the
policies change. In those cases, the new threshold (expected to be $6.8m) will be in effect. For
instance, if an individual has used $5 million of their lifetime exclusion by the time the policies
change in 2026, then they will have $1.8m remaining on their exclusion.

Scenario #2 – An individual has used more than $6.8 million of their exclusion


Suppose an individual has used $10 million of their lifetime exclusion before the thresholds
revert to $ 6.8 million in 2026. In this case, they will have effectively used up their total lifetime
exclusion and can make no more tax-free gifts above the annual exclusion unless policies
change again in the future.


Importance of Business Valuation for Advisors and Their Business-Owning Clientele


The optimal management of wealth stemming from the ownership of business interests
requires careful planning and attention to detail. One important detail concerns the ever-
changing value of these business interests and proper planning should incorporate periodic
business value assessments. Thousands of wealth advisors, insurance agents, and commercial
bankers have rightfully decided that the patented 7-Step online business valuation
tool/algorithm is an essential component of their service offerings to their highly prized
business-owning clients.


With the well-documented surge in baby boomer retirements with corresponding business
value estimated to be as much as $70 trillion and the recent surge in new business formations
during and after the pandemic, every business advisor can benefit from the years of
development invested into the creation and management of the BizEquity platform.

Summary

The current federal lifetime gift and estate exclusion is expected to drop from its current level
of $12.92 in 2023 to $6.8 million by 2026. These lifetime exclusions provide a powerful tool for
individuals to pass on more of their wealth without exorbitant tax obligations. Business owners
with large estates should consider the impact of these gift/estate changes and how they impact
their ongoing tax planning. These changes may cause some to consider revisiting their
transition plans to assess any possible impact on their respective timelines. It might be
beneficial for some individuals to take advantage of the higher exclusion limits today (or prior
to 2026) so that they can pass on more of their business without additional estate taxes.