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Estate Tax Considerations

Freezing the value of an estate’s assets is a common estate tax planning technique. The goal is to transfer future asset appreciation out of the estate — to a child, grandchild, or other beneficiary — so it escapes both estate and gift taxation. There are many ways to freeze a business asset’s value, from outright lifetime gifts and installment sales to more sophisticated retained interest techniques.

Closely held businesses face certain disadvantages compared to larger, publicly traded companies. Estate planners can argue these disadvantages reduce a business interest’s taxable value below what a simple formula might suggest. The Internal Revenue Code also recognizes the difficulties small business owners face and provides three special tax provisions that can meaningfully reduce the estate tax burden on family businesses.

Estate Freezing Techniques

Estate freezing transfers the current value of a business interest out of the owner’s estate, locking in today’s (presumably lower) value for gift or estate tax purposes. All future appreciation in the business accrues to the recipients — outside the taxable estate. Several techniques accomplish this goal:

Lifetime Gifts
The simplest freeze. Annual gifts within the $18,000 exclusion transfer value out of the estate without gift tax and without add-back at death. Gifts sheltered by the lifetime applicable exclusion are added back at original gift value only — all subsequent appreciation escapes both taxes.
Buy-Sell Agreement
A properly structured buy-sell agreement fixes the business’s value for estate tax purposes. If the value was locked in years ago at a lower price, future appreciation is effectively frozen in the estate — it will not be taxed above the agreement price.
Installment Sale / Private Annuity
The owner transfers the business at today’s value; any appreciation after the transfer belongs entirely to the buyer. In a private annuity, nothing remains in the estate at the owner’s death (the annuity ceases). In an installment sale, the remaining note value is in the estate but the business itself is not.
Remainder Interest / Split Purchase
The owner retains the life interest (current use and income); the buyer acquires the remainder at its actuarially computed value. The life interest is worthless at the owner’s death, so the full business value — including all appreciation — passes outside the taxable estate.
GRATs and GRUTs
Grantor Retained Annuity Trusts (GRATs) and Grantor Retained Unitrusts (GRUTs) allow the owner to transfer a business interest into an irrevocable trust while retaining an annuity or unitrust interest for a fixed term. Any appreciation above the IRS hurdle rate passes to the remainder beneficiaries (typically children) free of gift and estate tax. If the owner dies during the trust term, the assets revert to the estate — requiring careful timing.
Family Limited Partnerships (FLPs)
The owner contributes business assets to a family limited partnership and retains the general partnership interest (control). Limited partnership interests are transferred to children or trusts, often at a discount for lack of marketability and minority interest (discussed below). Any future appreciation in the LP interests accrues outside the owner’s estate. FLPs require careful structure and documentation to withstand IRS scrutiny.

Discounting Techniques

Closely held businesses face certain drawbacks that larger, publicly traded companies do not. Estate planners can argue that these disadvantages make closely held interests less valuable than their larger counterparts — and that the IRS’s appraisal should reflect these reductions. Most discounts are subjective and can result in disputes with the IRS. Objective valuations — such as bona fide buy-sell agreements — should be used whenever possible. However, when an objective valuation is not available, the IRS may allow the following subjective discounts:

Lack of Marketability
Closely held interests are not publicly traded — there is no ready market for these shares. The cost of finding a buyer, plus the costs to make the shares marketable (registration and prospectus costs, underwriting fees, legal expenses), reduces the net value a seller would actually realize. The IRS has accepted this argument when properly supported.
Key Personnel (Loss of Owner)
The business’s value is closely tied to the owner’s unique skills and participation. The death of the owner reduces the value of the enterprise. Estate planners can argue that shares should be discounted to reflect this loss. Note: the IRS’s counter-argument is that the tax code requires valuation as of the date of death — not what the company is worth after the death has taken its toll.
Minority Interest
Owners of less than 50% have far less say in how the company operates. In a closely held corporation, shares held by the majority owner carry far more control value than minority shares. The IRS has accepted minority interest discounts in the past. Minority interests are worth less on a per-share basis than majority interests.

Combining Discounts — Strategic Splitting Example

A mother owns 100% of a closely held business. She gives each of her three children a one-third interest.

Standard argument: Each child’s one-third interest = one-third of the total business value.

Planner’s argument: Each child holds only a minority interest — worth less than one-third of the whole. Furthermore, each minority interest is less marketable than the mother’s 100% controlling interest. Two discounts apply: minority interest and lack of marketability. By splitting the ownership into minority interests, the mother may have significantly reduced the business’s value for gift and estate tax purposes.

How aggressively the planner pursues these arguments depends on the taxpayer’s willingness to contest the IRS. Tax court history shows that aggressive tactics sometimes succeed — but always at a cost. The Crummey and Totten trust cases are well-known examples of taxpayers challenging the IRS and prevailing.
IRS scrutiny: Subjective discount strategies invite IRS challenge. Family limited partnerships used primarily to generate discounts — without legitimate non-tax business purposes — have been successfully attacked by the IRS. Adequate economic substance and careful documentation are essential. When an objective valuation method (such as a buy-sell agreement) is available, it should always be used in preference to subjective discounting.

Tax Breaks for Small Businesses

The Internal Revenue Code recognizes the liquidity and valuation difficulties closely held business owners face at death. Three special provisions provide meaningful relief:

§303
Corporate Stock Redemption

Generally, when a corporation redeems its shares from a deceased shareholder’s estate, the redemption proceeds are taxed as a dividend — ordinary income to the estate. Section 303 creates an exception: under qualifying conditions, the redemption is taxed as a capital gain (typically at the lower long-term capital gains rate) rather than as ordinary income. Since the estate usually receives a stepped-up basis equal to date-of-death value, the capital gain may be small or nonexistent.

Requirements:

  • The stock must be included in the decedent’s gross estate (shares given away during lifetime do not qualify)
  • The value of the stock must represent at least 35% of the adjusted gross estate
  • The amount redeemed is limited to estate taxes + funeral and administration expenses

The 35% requirement means Section 303 works best when the business is the dominant asset. Owners may need to transfer non-business assets out of the estate during their lifetime to ensure the stock meets the 35% threshold. Note that this provision does not solve all liquidity needs — the estate still needs cash for debts, bequests, and other obligations not covered by the limited redemption.

Section 303 — Example

Sam dies with a gross estate of $5 million. His shares in a family corporation are valued at $2 million (40% of the estate — qualifies). Estate taxes and administration costs total $500,000. The corporation redeems $500,000 of Sam’s shares. Because the estate received a stepped-up basis of $2 million on the shares, there is no capital gain on the redemption. The estate receives $500,000 in cash to pay the tax bill without a forced liquidation of the business.
§6166
Installment Payment of Estate Taxes

Federal estate taxes are normally due within nine months of the decedent’s death. For estates with a significant closely held business interest, this deadline can force a sale of the business at a distressed price. Section 6166 allows the executor to defer and pay in installments the portion of estate taxes attributable to a qualifying business interest.

Requirements:

  • The closely held business interest must represent at least 35% of the adjusted gross estate
  • The business must qualify as a closely held business (generally, a business with 45 or fewer partners or shareholders, or one in which the decedent held a 20% or greater interest)

Payment schedule:

  • Interest only is paid for the first five years after the normal estate tax due date
  • Principal and interest payments are spread over the following ten years (14 years total)
  • A favorable 2% interest rate applies to the deferred taxes on the first $1 million (indexed) of closely held business value above the applicable exclusion; the remaining deferred taxes accrue interest at 45% of the regular underpayment rate

Section 6166 can be a valuable lifeline for estate-tax-burdened business heirs. However, it does not solve all cash flow problems — interest must still be paid during the deferral period, and the IRS can accelerate the entire obligation if the estate fails to make timely payments or if the business is sold or liquidated.

Section 6166 — Example

Mary dies with an estate worth $8 million. A family manufacturing business valued at $3.5 million (43.75% of the estate) drives the tax bill. The estate taxes attributable to the business interest qualify for installment treatment. Instead of a forced sale to pay a $1.4 million tax bill within nine months, the executor elects Section 6166: five years of interest-only payments, then ten annual principal-and-interest installments. The business continues operating, generating the cash flow needed to service the payments.
§2032A
Special Use Valuation

Normally, estate assets are valued at their highest and best use as of the date of death. For farmland or closely held business real estate, the highest-and-best-use value may be far higher than the land’s value as a farm or operating business (e.g., suburban farmland with development potential). Section 2032A allows qualifying real property to be valued at its current use value rather than its development potential.

Requirements:

  • The real property must be used for farming or in a closely held business
  • The adjusted value of the qualified real and personal property must represent at least 50% of the adjusted gross estate
  • The adjusted value of the qualified real property alone must represent at least 25% of the adjusted gross estate
  • The property must pass to a qualified heir (member of the decedent’s family)
  • The decedent or a family member must have owned and materially participated in the business for at least 5 of the last 8 years before death
  • A qualified heir must continue using the property for the original qualifying purpose for at least 10 years after the decedent’s death; early cessation or sale triggers a recapture tax

The maximum reduction in estate value from special use valuation is $750,000 (indexed for inflation; currently approximately $1.4 million). While the ceiling limits its value for the largest estates, Section 2032A can be a significant benefit for qualifying farm estates and small business owners whose primary asset is the business real estate.

Section 2032A — Example

Old MacDonald owns a 500-acre farm near a growing suburban area. At highest and best use (residential development), the farm is worth $3 million. At its current use as a working farm, it is worth only $1.2 million. The farm represents 60% of the adjusted gross estate (qualifies). The executor elects Section 2032A: the farm is valued at $1.2 million instead of $3 million — reducing the taxable estate by $1.8 million (subject to the indexed ceiling). MacDonald’s heirs inherit the farm and continue farming for 10+ years. No recapture tax applies.
Planning note: All three of these provisions require that a qualifying business interest represent a specific percentage of the adjusted gross estate (35% for §303 and §6166; 50%/25% for §2032A). If the owner has significant non-business assets, lifetime transfer of those assets may help ensure the business represents a sufficiently large portion of the estate to qualify. These provisions work best as part of an integrated estate plan developed during the owner’s lifetime — not as an afterthought once the owner has died.
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