The short answer: yes. In general, state- and federal-agencies want to tax any transfer of ownership, assets, or property—especially if it involves something of high-value, such as a small business. So it may be no surprise that the IRS can in-fact tax gifts that are given from one individual to another, even if the recipient is family member.
Importantly, when a tax is levied on a gift, it’s the giver that is taxed, not the recipient. Either way, there are strategies that can be taken to minimize—or even avoid—these taxes all together. But what exactly constitutes a “gift”? Could a Christmas present to your spouse be considered a taxable gift? What about a short-term loan to a child or relative? It turns out that the IRS isn’t very particular about what is (and what isn’t) a gift. According to their website:
“[It is] any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return…the general rule is that any gift is a taxable gift”
There are some important stipulations to this definition: first and foremost, congress sets an annual exclusion for gifts, meaning that gifts under a certain amount will not be taxed. There’s also a lifetime exclusion limit. Also worth noting, gifts to a spouse are non-taxable, as are medical expenses and tuition payments. Finally, donations to eligible political originations or charitable groups are also exempt.
One major point of contention in the above definition is the phrase within the parentheses: “measured in money or money’s worth”. Obviously if you gift your child $75,000, the value of the transfer is $75,000. But what if you gift them your business? Placing an accurate value on a business is much more of a challenge that often requires a business valuation. In these instances, the IRS’s determines the worth of a business based on its Fair Market Value or FMV.
Business Valuation via Fair Market Values
The IRS relies heavily on valuation via FMV. That being said, it’s a far-from-perfect method to determine the true value of a business (being fair, there’s not one ideal way to valuate a business and the best valuation method often depends on your role in the transaction).
A business FMV is essentially an estimate based on what a potential buyer might pay for a given business considering its location, profitability, and other various economic factors. For a more formal description, the U.S. Supreme Court defines fair market value as:
“the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
Actually calculating this estimate often requires a team of business valuation experts. If your business’s FML is determined to be $2 million and you gift it to your child, it will be taxed as if you gifted them $2 million. But what exactly does this tax look like? That depends on a number of factors, including the current annual exclusion for gifts, the current lifetime exclusion, and your future plans for your estate.
Annual and Lifetime Exclusions for Gifts
Earlier we discussed how gifts—even if they’re given to children or family members—can be taxed by state- and federal-authorities. Although this is true, they are taxed differently than a regular transaction would be. Namely, individuals are allowed to gift a certain amount to their recipients before the IRS takes a cut. These exemption limits are defined in the ever-changing gift exclusion regulations. These laws work on two levels: annual and lifetime.
As of 2019, the annual gift exclusion is $15,000 per person, per year. In other words, an individual is allowed to gift $15,000 worth of assets to any other individual before the IRS will levy a tax. An important point to understand however, is that this is per person, per year. For instance, you could gift $45,000 worth of assets to three people without incurring a tax.
When the $15,000 limit is surpassed, the excess value is then added to the individual’s lifetime exemption. For example, should somebody gift their child $115,000 in a single year, $15,000 will be untaxed and the remaining $100,000 will be taxed. The individual that gave the gift can either pay the tax that year, or they can charge it to their lifetime exclusion. The current lifetime exclusion limit is $11.4 million, meaning that the individual would be able to gift another $11.3 million over their lifetime before the government taxes the gifts.
There’s another key point to understand about the lifetime exemption: in the U.S., an individual’s lifetime gift exemption and their estate tax are part of the same pool. In other words, large amounts of lifetime gifts reduce the amount of exemption that can be used to protect your estate from future taxation. For example, if an individual gives away $8 million in gifts over their lifetime, their estate exemption would be reduced to $3.4 million. Thus, the amount of lifetime gifts directly influences estate exemptions.
The Bottom Line for Business Owners
In the U.S., essentially any gift is subject to tax. It’s crucial to either review the tax code or to consult a professional that can clarify the regulations for you. For owners looking to gift, the goal should be to reduce the tax-burden as much as possible.
Also, it’s always the giver that incurs the tax, not the recipient. This is important, as individuals that exceed their yearly exclusion must charge their lifetime exclusion, which influences how their estate is taxed down-the-road. Instead of charging their lifetime exclusion, the individual can opt to pay the annual tax once it’s incurred, however these rates can sometimes be upwards 40%. This is true for individuals that exceed the lifetime exemption as well.