Family Business Inheritance Tax: Rates, Discounts & Deferral

A family business passed to heirs after the owner’s death is subject to federal estate tax only when the total estate crosses $15 million in 2026, and inheritance tax on a family business is a concern for a small share of estates in practice. Above that threshold, the excess is taxed at rates up to 40%, which is often enough to force a sale of the business unless the estate is structured to absorb the hit. Below it, heirs generally owe no federal estate tax and receive an additional benefit that reduces future capital gains: the tax basis of everything they inherit resets to its value on the date of death.¹ State taxes, however, can apply at much lower thresholds, and heirs need to check both.

When Federal Estate Tax Applies

The federal estate tax is imposed on the transfer of a deceased person’s property at death, including any business interests.² It only applies when the gross estate exceeds the basic exclusion amount, which the One Big Beautiful Bill Act set at $15 million per person for 2026 and made permanent, with inflation adjustments beginning in 2027.³

The gross estate takes in everything the deceased owned or had an interest in at death: the business itself, whatever its legal form; real estate; investment accounts; bank balances; and life insurance proceeds payable to the estate. If the total exceeds $15 million, only the amount above the exclusion is taxed, at graduated rates topping out at 40%.²

Portability Between Spouses

Married owners can effectively shield up to $30 million by combining exemptions. When the first spouse dies, any unused portion of that spouse’s $15 million exemption can transfer to the survivor as the Deceased Spousal Unused Exclusion (DSUE), stacking on top of the survivor’s own exemption. The transfer is not automatic. The executor of the first spouse’s estate must file Form 706 to elect portability, even when the estate is small enough that no return would otherwise be required.⁴

The election is due nine months after death, with a six-month extension available. If the estate was below the filing threshold, executors who miss that window can still file the election up to five years after the first death under a special IRS procedure.⁴ Skipping this return is one of the more expensive oversights in family business planning, because the unused exemption is otherwise lost for good.

The Step-Up in Basis Heirs Often Miss

The step-up in basis is a separate benefit from the estate tax exemption, and it matters even when no estate tax is owed. When heirs inherit a business, the tax basis of the inherited property resets to its fair market value on the date of death.¹ If a founder started a company worth $200,000 that grew to $5 million by the time they died, the heirs’ basis is $5 million. Sell it later for $5.5 million and capital gains apply only to the $500,000 of appreciation after inheritance, not to the $4.8 million of growth during the founder’s lifetime.

The step-up applies to property passed by inheritance or through a revocable trust. It does not apply to assets already moved into an irrevocable trust during the owner’s lifetime, because those assets left the estate before death. It also does not apply to retirement accounts or deferred compensation, which are taxed as ordinary income to heirs when distributed.

Reducing the Taxable Value of the Business

For estates that do cross the $15 million line, two tools cut the reported value of the business itself before any tax is calculated.

Valuation Discounts for Closely Held Interests

Owning 30% of a family LLC is not equivalent to owning 30% of a public company. There is no exchange where the interest can be sold on short notice, and a partial owner may have no meaningful say in how the business is run. The IRS recognizes these realities through valuation discounts.

A minority interest discount reflects the lack of control over decisions like asset sales, compensation, and distributions. A lack-of-marketability discount accounts for the difficulty of finding a buyer for a private business stake. Combined, these can reduce the reported value of a business interest by 30% or more, depending on the size of the interest, the transfer restrictions in the operating agreement, profitability, and the pool of potential buyers. The discounts require a formal appraisal by a qualified valuation professional, and the IRS scrutinizes aggressive discounts closely: the reduction has to reflect real economic limitations, not arrangements built solely to shrink the tax.

Special Use Valuation for Farms and Business Real Estate

Ordinarily, real estate in an estate is reported at fair market value. For a family farm or business sitting on land that could be sold for development, that figure can dwarf what the property actually earns in use. Section 2032A lets qualifying estates value real property based on its current business use rather than its highest-and-best sale price.⁵ The reduction is capped at a base of $750,000, adjusted annually for inflation.

The rules are strict. The business, counting real and personal property, must make up at least 50% of the adjusted gross estate, and the real property alone must be at least 25%.⁵ The deceased or a family member must have materially participated in operating the business for at least five of the eight years before death.⁶ The property must pass to a qualifying family member, such as a spouse, child, grandchild, or parent, who intends to keep operating the business.

The catch is the ten-year lookback. If a qualified heir stops using the property for the business or sells it outside the family within ten years of death, the IRS imposes a recapture tax that claws back the savings.⁵ The recapture applies even when the business is no longer viable, and the IRS places a lien on the property to secure it.

Paying the Tax Without Selling the Business

A six- or seven-figure tax bill due within nine months of the owner’s death is exactly the pressure that forces heirs to liquidate. Two tools address that.

Section 6166 Installment Payments

If the value of the closely held business exceeds 35% of the adjusted gross estate, the executor can elect under Section 6166 to pay the estate tax attributable to the business in installments rather than in one lump sum.⁷ The estate defers the first tax payment for up to five years, paying only interest during that period, then spreads the remaining balance over up to ten annual installments. The nine-month deadline becomes a payment window of roughly 15 years. A reduced 2% interest rate applies to a portion of the deferred tax; the remainder accrues at 45% of the standard underpayment rate.

The election must be attached to a timely filed Form 706. Missing the filing deadline forfeits it.

Buy-Sell Agreements Funded by Life Insurance

Even with installments, the tax still has to be paid eventually, with interest. A buy-sell agreement funded by life insurance is the most direct way to have cash on hand when the bill arrives. These agreements set a predetermined price at which the business or the remaining owners will buy out a deceased owner’s interest, giving the estate liquid funds to pay taxes and settle debts without disrupting operations.

Life insurance is the usual funding mechanism because the payout is triggered by the same event that creates the tax liability. The business can own policies on each owner’s life, with the death benefit sized to the expected obligation. Without an arrangement like this, heirs may end up borrowing against business assets, selling shares to outsiders, or liquidating entirely. A buy-sell agreement can also help establish the business’s value for estate tax purposes, though the IRS is not bound by the contract price if it does not reflect fair market value.

Lifetime Gifting Before the Next Transfer

Owners who plan ahead can move value out of their estate before death. The gift tax and estate tax share a unified exemption, so every dollar used during life reduces what remains at death. At $15 million in 2026, most business owners have real room to make lifetime gifts.⁸

On top of the lifetime exemption, each person can give up to $19,000 per recipient per year without touching that exemption at all.⁹ Married couples can jointly give $38,000 per recipient. Combined with the valuation discounts described above, gifts of minority interests can move meaningful economic value out of the estate at a modest exemption cost. Contemporaneous appraisals and documentation are essential to withstand IRS review.

Filing Deadlines and Penalties

Form 706 is due nine months after the date of death.¹⁰ A six-month extension is available if requested before the original due date, but estimated tax must still be paid on time. Late filing without reasonable cause triggers a penalty of 5% of the unpaid tax for each month the return is overdue, capped at 25%.¹¹

The IRS also imposes a 20% accuracy-related penalty on underpayments that stem from a substantial valuation understatement, and 40% for a gross valuation misstatement.¹² On a multimillion-dollar business, that penalty alone can exceed what the estate hoped to save by underreporting. A credentialed appraiser and complete documentation are the best defense.

Passing the Business to Grandchildren

Families that want to skip a generation face a separate layer of taxation. The generation-skipping transfer (GST) tax is a flat 40% imposed on transfers that skip a generation, designed to prevent families from avoiding one round of estate tax by moving wealth directly to grandchildren.¹³ The GST tax has its own exemption, matching the estate tax exemption at $15 million per person in 2026. Any transfer to a grandchild or other skip person above that amount gets taxed on top of whatever estate or gift tax applies. Mistakes in how the GST exemption is allocated can produce double taxation that better planning would have avoided.

State Estate and Inheritance Taxes

Federal rules are only half of the picture. About a dozen states impose their own estate tax, and a handful levy an inheritance tax on the recipients. An estate tax is based on the total value of the deceased’s assets; an inheritance tax is based on what each individual heir receives and often varies by the heir’s relationship to the deceased.

State exemption thresholds are far lower than the federal $15 million. Some states set them at $1 million or $2 million, so a business worth $3 million might owe nothing federally and still face a state bill. State tax rates can reach 16% at the top brackets. Not all states offer the same deferral options or special use valuation available under federal law, which means the state tax may need to be paid in full within months of death even while the federal tax is being paid in installments.

In inheritance tax states, the rate typically depends on the heir’s relationship to the deceased: spouses and children usually pay little or nothing, while more distant relatives and unrelated beneficiaries face higher rates. A separate state return generally accompanies the federal Form 706 in states that impose these taxes. Confirm your state’s rules early, because they can change which planning tools actually help.

1
Office of the Law Revision Counsel. 26 U.S.C. 1014 – Basis of Property Acquired From a Decedent
2
Office of the Law Revision Counsel. 26 U.S. Code 2001 – Imposition and Rate of Tax
3
Office of the Law Revision Counsel. 26 U.S. Code 2010 – Unified Credit Against Estate Tax
4
Internal Revenue Service. Instructions for Form 706 (09/2025)
5
Office of the Law Revision Counsel. 26 U.S.C. 2032A – Valuation of Certain Farm, Etc., Real Property
6
eCFR. 26 CFR 20.2032A-3 – Material Participation Requirements for Valuation of Certain Farm and Closely-Held Business Real Property
7
Office of the Law Revision Counsel. 26 U.S.C. 6166 – Extension of Time for Payment of Estate Tax Where Estate Consists Largely of Interest in Closely Held Business
8
Internal Revenue Service. What’s New – Estate and Gift Tax
9
Internal Revenue Service. Gifts and Inheritances
10
Internal Revenue Service. Filing Estate and Gift Tax Returns
11
Office of the Law Revision Counsel. 26 U.S.C. 6651 – Failure to File Tax Return or to Pay Tax
12
Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments
13
Congress.gov. The Generation-Skipping Transfer Tax (GSTT)