What is a Step-Up in Basis and Why Does Value Matter?
With the drastic increase to the estate tax exemption in 2018, far fewer estates have been required to file Form 706, the Internal Revenue Service’s estate tax return. As such, one would think there is no need for an appraisal of the decedent’s business. However, a business valuation can still benefit the transferee. Let me tell you why!
Under IRC 1014(a), the general rule is that the beneficiary’s basis in an assets equals its fair market value at the date the benefactor dies. What does this mean? Let’s say your grandfather bequeathed to you his interest of 10,000 shares in a closely-held business. IRC 1014(a) allows you to “step-up” the basis in such interest. If Grandpa bought the interest for $100 per share decades ago but as of the date of his death is worth $500 per share, you get the new basis of the value of the shares at the time of his death. Let’s assume you decide to retain ownership of such shares of stock for ten years before liquidating. Why does a step-up value matter? Let’s look at the math to understand why that matters to you:
At Time of Grandpa’s Purchase | At Time of Grandpa’s Death | At Time of Liquidation | |
Value per Share | $100 | $500 | $750 |
Multiplied by: Shares Owned | 10,000 | 10,000 | 10,000 |
Value of Investment | $1,000,000 | $5,000,000 | $7,500,000 |
With no step-up in basis, you would pay the tax on the gain between the time of Grandpa’s purchase and the time of liquidation. Here’s the math:
Value at Time of Liquidation | $7,500,000 |
Less: Value at Time of Grandpa’s Purchase | $1,000,000 |
Gain on Investment | $6,500,000 |
Multiplied by: Tax Rate (illustrative only) | 25% |
Tax on the Gain | $1,625,000 |
Thank goodness we have IRC 1014(a) to allow you to use your step-up in basis at the date of death! I think you will like the tax on the gain number much better in the illustration below:
Value at Time of Liquidation | $7,500,000 |
Less: Step-Up Value / Value at Time of Grandpa’s Death | $5,000,000 |
Gain on Investment | $2,500,000 |
Multiplied by: Tax Rate (illustrative only) | 25% |
Tax on the Gain | $625,000 |
Stepping up the basis in this investment saved you $1 million in tax at the time of liquidation given this simple example. Even more important, for example, had you inherited a building, or a pass through entity, the basis of the underlying assets is also stepped-up, and this allows you to re-depreciate those assets saving you potentially hundreds of thousands of dollars in income tax. But beware, that while this Code Section has been in the law for nearly a century, many on Capitol Hill recently want to eliminate this tax benefit.
So how does Business Valuation play a role in this? We know the value of the investment at the time of Grandpa’s purchase because we have the document that shows what he paid for it. That’s an easy number to obtain. And, we know what the value is at the time of liquidation because you have a purchase agreement for the sale of such interest. But, what about the value of the stock at the time of Grandpa’s death? There is no transaction, no buying or selling of such interest. And, without documentation of value, it is your word against the IRS’s word. Engage your certified valuation analyst to calculate the value at the time of Grandpa’s death.