Introduction
When it comes to transferring ownership of a closely held business, timing and structure are everything, especially if you’re aiming to reduce tax liability and preserve more of your wealth for your heirs. One often-overlooked strategy involves using valuation discounts during lifetime gifts of business interests. These discounts, particularly those related to minority interest and lack of marketability, can significantly reduce the fair market value assigned to the gifted portion of the business, which in turn lowers the gift tax due.
Unlike estate transfers that occur at death, lifetime gifts are valued independently and can reflect the real-world limitations that minority interests carry—such as reduced control or limited ability to sell the shares. By planning ahead and leveraging these discounts, business owners gain more flexibility over when and how they pass down ownership while also creating opportunities for strategic tax savings. Understanding how to apply these discounts properly and coordinating with a qualified appraiser is key to making this strategy effective.
What is a valuation discount?
Reduction in taxable value of minority interest
There is a significant difference between what a business is worth as a whole and what a percentage of the business is worth. If you own 100 percent of a business with a fair market value (FMV) of $1 million, you may be able to sell your interest for that amount. If you own a minority interest (less than 50 percent) in a business with the same total value, you may not be able to get a comparable percentage of the total value if you attempt to sell it. A potential buyer would probably demand a minority interest discount to compensate for the lack of marketability and the inability to control the operation or disposition of the business inherent in a minority position. Minority interest discounts may reduce the valuation of a minority interest by as much as 20 percent to 40 percent.
For example, a 25 percent interest in a business valued at $1 million may be worth only $150,000 because it is discounted by 40 percent from its pro rata value of $250,000.
Total tax liability smaller if business ownership divided during lifetime instead of at death
Gift of minority ownership interest may receive discount
A controlling interest in a closely held business is worth significantly less when it is divided into minority interests. Minority interests in a closely held business can be difficult to sell–there generally is no market, and the interest itself has no control over the business. When a gift is made of a minority interest, the gift tax is computed on the discounted value of the interest, resulting in a lower total gift tax liability than if the gift were of a total majority interest.
Estate taxes may not consider minority interest discount
Estate tax is calculated on the value of your assets at the time of your death. If you own a business valued at $1 million when you die, the estate tax will be assessed on the $1 million value even though your business may be immediately divided among your four children and may be worth only an aggregate value of $600,000 after the minority interest discount.
Divide the business through gifts to capture minority interest discount
Unlike estate taxes, which are based on the total value of the property held at death, gift tax is based on the fair market value (FMV) of the property transferred–the amount a stranger would pay for it–and you can obtain minority interest discounts by making each gift of an interest in the business small enough to qualify for the discount. This difference in the estate and gift tax systems makes it advantageous to transfer interests in your closely held business during life instead of at death.
For example, you own a business interest valued at $1 million. You give each of your four children 25 percent of your shares in the business. Assuming a 40 percent minority interest discount applies, the gift tax on the transfer would be assessed on a value of $600,000. If you left the business to your children through your will, the full $1 million must be included in the value of your estate and subject to estate tax.
More about valuation discounts
Gift entitled to minority interest discount even if recipient not minority owner
Gift tax is assessed on the FMV of the property when it is transferred, not the value when it was held by the original owner or will be held by the receiver. For example, you give your son 20 percent of your business interest for three consecutive years. The taxable value of each year’s gift would reflect a minority discount in the year of the gift, even though in year three your son has become the controlling shareholder.
Gift entitled to minority interest discount even if recipient’s family controls business
The identity of the receiver of the gift doesn’t affect the application of a minority interest discount. Gift tax is assessed on the FMV of the property–the value if it was being transferred to a total stranger. For example, if you give each of your four children a 25 percent interest in your business, each interest will be entitled to a minority interest discount even though the business remains in the family and the minority shareholders may not be treated as harshly as an outside minority shareholder.
Minority interest discount may be offset by swing vote premium
Though a minority interest can’t control the company on its own, it may represent enough stock to constitute a swing vote–when combined with another block of stock. As a result, the IRS may argue that the value of the interest should be increased with a swing vote premium. The increase resulting from the premium is generally smaller than the minority interest discount.
How do you know what is an appropriate valuation discount?
You will need a business appraiser
You will definitely need a qualified business appraiser to determine an appropriate discount. There are many factors that enter into a business valuation, and specific facts surrounding the transfer will weigh heavily into the discount. If you are making gifts over a period of years, you should probably undertake a valuation with each gift. It is recommended that the valuation be conducted as closely as possible to the time of transfer.
Conclusion
Valuation discounts for lifetime gifts offer a valuable opportunity to reduce the overall tax burden when transferring a closely held business. By giving away minority interests during your lifetime, you may be able to take advantage of discounts that reduce both gift and future estate tax liabilities. This approach also allows you to maintain control of your business while gradually passing ownership to family members or other successors.
However, because these discounts depend on accurate valuation and sound planning, it’s essential to work closely with a qualified business appraiser and your legal or tax advisors. Careful documentation and consistent evaluation ensure that your strategy stands up to IRS scrutiny and meets your long-term financial and succession goals. Used wisely, this planning method can help you build a smooth transition path while safeguarding your business’s legacy.
Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
