Tax Considerations When Gifting Business Interests

Overview

Gifting business interests — shares in an S‑corporation, membership units in an LLC, or partnership interests — is a common tool for succession planning, estate-tax management, and bringing family into ownership. However, a transfer that looks like a generous gift often carries tax, valuation, and legal consequences that can materially change the tax cost and business control over time.

In my practice working with business owners and family offices, the most common surprises are: (1) underestimating valuation scrutiny, (2) not filing Form 709 when required, and (3) overlooking the income‑tax basis carryover rules that can affect future capital gains when the recipient sells the interest.

Authoritative guidance on gift taxes is provided by the IRS; see its gift guidance for the latest annual exclusion rules and filing requirements (IRS: Gifts). For practical filing helps, our FinHelp guides explain how to report gifts and the differences between annual exclusion use and lifetime gifting strategies (see Gift Tax Basics and How to File a Gift Tax Return).

(IRS: https://www.irs.gov/businesses/small-businesses-self-employed/giving-gifts)

Key tax areas to understand

1. Gift tax reporting and the annual exclusion

• Gifts of business interests may be partially or fully covered by the IRS annual exclusion per recipient; anything over that exclusion requires filing Form 709 (United States Gift (and Generation‑Skipping Transfer) Tax Return). The annual exclusion amount is adjusted annually for inflation — always confirm the current amount on the IRS website before executing a gift.
• Even when no gift tax is ultimately owed, Form 709 is required to report gifts that exceed the annual exclusion or to elect gift‑splitting by a married couple.
• See our guide on how to file a gift tax return for step‑by‑step instructions and common pitfalls (FinHelp: How to File a Gift Tax Return).

1. Lifetime exemption and estate-tax interaction

• Federal law treats gift and estate taxes under a unified credit, meaning large lifetime gifts typically reduce the estate‑tax exemption remaining at death. Many owners use lifetime gifting to move expected future appreciation out of their estate, but that decision should account for current exemption levels and anticipated tax-law changes.

1. Valuation: fair market value (FMV) and discounts

• The donor must generally value the gifted interest at its fair market value on the date of transfer. For privately held businesses, FMV valuation requires a reputable business appraisal that documents methodology, comparable transactions, and any discounts for minority interest or lack of marketability.
• Valuation discounts can reduce reported gift value (and therefore gift tax exposure). However, the IRS commonly scrutinizes aggressive discounts; a well‑documented third‑party appraisal and consistent corporate formalities improve defensibility.

1. Income‑tax basis rules for recipients

• Gifts are not taxable income to recipients. For income‑tax purposes, the recipient generally takes a carryover basis equal to the donor’s adjusted basis in the gifted interest (subject to the dual‑basis rule for potential losses). That means appreciated assets given as gifts may create larger capital gains if the recipient later sells, compared with waiting until the donor’s death when a step‑up in basis often eliminates pre‑death capital gains.
• This carryover basis consequence is a leading reason some owners delay gifting until after death, depending on their goals and the family’s holding horizon.

1. Generation‑skipping transfer (GST) tax

• Gifts to grandchildren or unrelated younger generations can trigger GST tax rules and use part of the recipient’s or donor’s GST exemption. Proper planning is necessary if you intend to skip generations.

1. State rules and other taxes

• Some states have separate estate or inheritance taxes that interact with gifting strategies. Confirm state law and reporting obligations before transferring interests.

Practical steps before gifting a business interest

1. Start with a written business valuation

• Obtain a qualified, contemporaneous business valuation. Courts and the IRS evaluate discounts and assumptions; a professional appraisal reduces audit risk.

1. Analyze control, cash flow, and governance

• Decide whether you are gifting voting or nonvoting interests, or creating buy‑sell obligations. Keeping minority blockers or voting control can achieve succession goals while limiting gift value.

1. Use tax‑efficient vehicles when helpful

• Consider transferring interests into trusts (for example, intentionally defective grantor trusts or partial interest transfers) or using tools such as Grantor Retained Annuity Trusts (GRATs) to shift future appreciation out of your estate while retaining income during the trust term. Each structure has trade‑offs in complexity and ongoing administration.

1. Coordinate gift tax filings and estate plans

• File Form 709 when required; gift tax returns are due on the same date as your individual tax return (including extensions). Coordinate lifetime gifts with your estate plan and beneficiary designations so documents remain consistent.

1. Plan for capital‑gains exposure

• If beneficiaries plan to sell interests soon after receiving them, consider how the carryover basis will affect taxes. In some cases, a partial sale or a buy‑sell arrangement executed before or after the gift may be useful.

Common valuation and tax traps I see in practice

• Relying on informal or outdated valuations. A valuation memo prepared years earlier is not acceptable at transfer. Always refresh the valuation to reflect current market and business conditions.
• Treating family loans or capital contributions as gifts without documentation. Transactions between owners and family members should be documented to avoid recharacterization.
• Failing to account for minority or marketability discounts properly, or applying large discounts without supporting evidence. The IRS may revalue transactions in audit, leading to additional tax, penalties, and interest.

Sample planning scenarios (illustrative)

1. Small gift strategy using annual exclusions

• You want to transfer ownership gradually. By gifting small percentages each year using the annual exclusion to multiple family members, you can move appreciation out of your estate while minimizing gift‑tax reporting. This requires careful tracking and a valuation method that supports partial transfers.

1. Large transfer using lifetime exemption

• For a sizable transfer, you may elect to use part of your lifetime exemption and file Form 709 to report the gift. This reduces the future estate exemption but removes future appreciation on that transferred share from your taxable estate.

1. Retaining control while gifting economic interest

• You structure a transfer of nonvoting membership units to family while retaining voting units. This lowers gift value (and thus gift tax exposure) relative to transferring voting control, but governance changes and buy‑sell agreements should be documented.

How professionals can help

Engaging a team—tax attorney, CPA, and valuation expert—early is essential. In my client work, coordinating the valuation with tax elections and trust drafting significantly reduces friction at transition and strengthens audit defenses.

For step‑by‑step filing guidance, see our FinHelp resources:

• Gift Tax Basics: Annual Exclusion, Lifetime Exemption, and Reporting (FinHelp) — useful for understanding exclusions and exemptions.
• How to File a Gift Tax Return (FinHelp) — practical filing tips and deadlines.

(Internal links: https://finhelp.io/glossary/gift-tax-basics-annual-exclusion-lifetime-exemption-and-reporting/, https://finhelp.io/glossary/how-to-file-a-gift-tax-return/)

Checklist before you execute a gift

• Obtain a current third‑party valuation and documented methodology.
• Decide whether to gift voting or nonvoting interests and prepare updated operating agreements or shareholder agreements.
• Confirm the current IRS annual exclusion and whether Form 709 will be required.
• Discuss capital‑gain consequences with recipients and consider alternative structures if they intend to sell.
• Coordinate the gift with estate‑planning documents and consider state tax rules.

Closing guidance and disclaimer

Gifting business interests is a powerful tool but requires careful coordination of valuation, tax reporting, and governance changes. In my experience, owners who plan early and document each step avoid most costly audits and family disputes. This article is educational and does not replace personalized legal or tax advice; consult a qualified CPA or tax attorney before making transfers.

Authoritative sources and further reading:

• IRS — Gifts: https://www.irs.gov/businesses/small-businesses-self-employed/giving-gifts
• FinHelp — Gift Tax Basics: https://finhelp.io/glossary/gift-tax-basics-annual-exclusion-lifetime-exemption-and-reporting/
• FinHelp — How to File a Gift Tax Return: https://finhelp.io/glossary/how-to-file-a-gift-tax-return/