Lindabury, McCormick, Estabrook & Cooper, P.C. Firm News & Events
For decades, the standard advice to business owners with significant assets was to “get it out of your estate.” Give shares of the company, the equipment yard, or the rental property to your children during your lifetime, and you shrink the estate the IRS can tax at your death. When the federal estate tax exemption was $1 million or $2 million, that advice made a great deal of sense.
That world has changed. The “One Big Beautiful Bill Act” or OBBBA, permanently increased the federal estate and gift tax exemption to $15 million per person, indexed for inflation, or roughly $30 million for a married couple when both spouses’ exemptions are preserved. New Jersey no longer has an estate tax, and its inheritance tax does not apply to transfers to a spouse, children, stepchildren, grandchildren, or parents. The result is that most contracting families will never owe estate tax at all.
When estate tax is off the table, the question changes. It is no longer, “How do I get assets out of my estate?” but rather, “What will my children pay in income tax when they eventually sell what I leave them?” For owners of land improvement businesses, whose balance sheets are often loaded with depreciated equipment and land bought decades ago, the answer could be hundreds of thousands, or even millions, of dollars.
How Basis Works: Gifts vs. Inheritance
“Basis” is, in simple terms, what you paid for an asset. Basis can be “adjusted” for depreciation, capital improvements, or other similar changes to the asset. When you sell, you pay tax on the difference between the sale price and your adjusted basis. For purposes of this article, there are two important basis concepts:
- Lifetime Gifts get a “carry over” basis. If you give an asset to your child during your lifetime, your child generally takes over your basis. Whatever tax you would have paid on a future sale if you had not gifted the asset, your child will pay instead.
- Inheritances get a “step-up” basis. If your child inherits the asset at your death, its basis is generally reset to its fair market value on the date of death. The built-in gain, including years of depreciation deductions you already took, is wiped away.
Contractors are in a particularly strong position to benefit from the step-up. Equipment is often depreciated to zero within a few years, especially with bonus depreciation and Section 179 expensing, both of which OBBBA expanded. A yard or shop purchased in the 1990s may be worth many times what was paid for it. These are exactly the kinds of assets where the gap between basis and value is widest.
A Simple Example
Consider an owner who personally owns the yard from which his company operates, which he bought in 1995 for $300,000. It is now worth $2.5 million. He also personally owns a fleet, leased to the company, that cost $1.8 million, has been fully depreciated, and today could be sold for $900,000.
If the owner gives the yard and equipment to his son, the son takes a $300,000 basis in the land and a zero basis in the equipment. If he later sells them, he would recognize roughly $3.1 million of gain, with the equipment portion taxed as ordinary income under the depreciation “recapture” rules. Between federal and New Jersey income taxes, the bill could exceed $1 million.
If the owner instead holds the same assets until death, the son’s basis steps up to $2.5 million for the yard and $900,000 for the equipment. A sale shortly after death would produce little or no taxable gain. And because the family is well below the federal estate tax exemption ($15 million) and the son is a Class A beneficiary for New Jersey inheritance tax purposes, holding the assets costs nothing in transfer tax. In short, the lifetime gift would have cost the family more than $1 million and saved nothing.
The step-up helps a child who keeps the business going, too. Equipment still in service can be depreciated again from its stepped-up basis under the regular depreciation schedules, generating new deductions for the next generation. (Bonus depreciation and Section 179 expensing, however, are not available for inherited property.)
A Word of Caution: How the Asset Is Owned Matters
The step-up applies to the assets the owner holds at death. If equipment or real estate sits inside the company, the heirs receive a stepped-up basis in their shares or membership interests, but not automatically in the equipment or land owned by the company. Whether the benefit reaches those underlying assets depends on how the business is taxed. An LLC taxed as a partnership can often pass the asset through if it makes a timely election under Section 754 of the Internal Revenue Code; an S corporation generally cannot. For some families, this is one more reason to hold real estate and equipment in entities separate from the operating company, and it is a question to review with both your estate planning attorney and your accountant.
When Lifetime Gifting Still Makes Sense
None of this means gifting is obsolete. Lifetime transfers can still be the right choice in several situations:
- Larger estates. If your combined estate is approaching the exemption or may grow beyond it because the business is expanding or a sale is on the horizon, removing future appreciation from your estate may still outweigh the lost step-up.
- Assets expected to appreciate significantly. Transferring an interest in the business before a major contract, expansion, or sale shifts that future growth to the next generation at today’s value.
- Transferring the business itself. Succession often requires that the next generation hold equity while you are alive, to establish their standing with employees, sureties, and lenders. Non-voting interests can shift value to them while you retain control.
- High-basis assets and cash. Where an asset has little built-in gain, such as recently purchased equipment, cash, or investments that have not appreciated much, giving it away costs little in lost step-up.
- Beneficiaries other than children. Transfers at death to siblings, sons- and daughters-in-law, nieces, nephews, or key employees can trigger New Jersey inheritance tax of 11% to 16%. Gifts made within three years of death are presumed to be made “in contemplation of death” and taxed as if made at death, but gifts made earlier are not, which may make lifetime gifting the better option.
Having It Both Ways
Careful planning can sometimes capture both benefits. One technique is to give assets to an irrevocable “grantor trust” that allows the owner to swap assets of equal value in and out of the trust. Years later, the owner can exchange cash or high-basis assets for the trust’s low-basis equipment or real estate, bringing those assets back into the owner’s estate in time to receive a step-up at death. This matters because the IRS has confirmed that assets left in such a trust at death do not receive a step-up at death. These strategies require careful drafting and attention to valuation, but they offer flexibility for families who want to make gifts today without giving up tomorrow’s step-up.
Review Your Plan
Many estate plans written when exemptions were lower still assume that giving assets away is always the right answer. Before you transfer the yard, the fleet, or shares in the company, ask a simple question: what will this cost my children in income tax when they sell? Your estate planning attorney and accountant should work together to review your plan, the tax basis of your key assets, and how those assets are owned, so that your family keeps as much as possible of what you built.