A succession planning guide for Midwestern family businesses and estate tax

What to take away

What a Midwestern handover actually is

Most Midwest family businesses are never listed. They pass to children who already work in the building, over years, through documents rather than a closing.

That makes it a different transaction from a market sale. A sale produces cash and a clean break. A family transfer produces a continuing relationship, a payment stream, and a valuation the IRS can reopen for three years after the gift tax return is filed.

Founders want three things that fight each other: income for life, control until retirement, and a fair split between children inside the business and children outside it. That conflict, not the tax code, is why the paperwork takes years.

Start with the entity. A C corporation cannot make most of these transfers without triggering corporate-level tax. An S corporation or an LLC taxed as a partnership can. Plenty of Midwestern owners converted decades ago and never revisited the choice.

Then read the balance sheet. Real estate, equipment and inventory sit inside the business carrying embedded gain. Whoever pays tax on that gain is the same fight that drives asset sale versus share sale negotiations in outside deals.

Then look at the people. A handover to two siblings who disagree about strategy fails more often than one that fails on tax.

Why the Midwest is its own case

Midwest manufacturing, agribusiness and distribution companies hold heavy fixed assets. That makes the valuation exercise more concrete than it is for a software firm, and it makes discounts more predictable.

Many of these companies hold real estate in a separate LLC. A discounted transfer of operating company units is easy to defend. A discounted transfer of the real estate LLC is harder, because land has a visible market price.

Estate freezes: GRATs and preferred partnerships

An estate freeze fixes what the senior generation owns while future growth accrues to the next generation. The founder's estate stops growing. The children's estates start.

The simplest freeze is a gift of non-voting stock today, but it burns lifetime exemption equal to the full current value. A freeze that pays the founder back usually beats it.

Grantor retained annuity trusts

A grantor retained annuity trust pays the founder a fixed annuity for a set term, often two to five years. Whatever remains at the end passes to the children with little or no gift tax.

The math is unforgiving. The hurdle rate is the §7520 rate, the IRS rate used to value the annuity. Assets that grow faster than it pass the excess to the children free. Assets that grow slower come back to the founder, and the exercise still costs legal fees.

That makes GRATs good for assets expected to jump, such as a stake in a company about to land a large contract. They work poorly for stable cash-flow businesses in flat markets.

A GRAT does not remove the founder's income tax exposure. It is a grantor trust, so the founder keeps paying tax on trust income. That shrinks the estate further.

Preferred partnership freezes

A preferred partnership freeze splits the company into a preferred interest and a common interest. The founder keeps the preferred interest and its fixed distribution. The children take the common interest and all future growth.

The preferred interest is usually a limited partnership unit with a liquidation preference. The founder's estate holds a stable asset. The children hold the upside.

This draws more IRS attention than a GRAT because the preferred return must be commercially reasonable. Set the rate too low and the IRS argues the founder gave away more than intended.

Both structures need a defensible valuation at inception. That report is the first document the IRS examines, and it is where a weak file falls apart.

What a freeze does not fix

The founder still needs cash flow after retirement. A freeze that strips out all income is a freeze the founder will unwind, so build in enough preferred distributions or annuity payments to live on.

A freeze also does not settle control. Voting units can stay with the founder while economic units move to the children. That split usually works, until the children want a distribution the founder does not.

Minority and marketability discounts in family transfers

A minority discount reflects that a holder below control cannot force a sale, set distributions or fire management. A marketability discount reflects that a private interest cannot be sold on an exchange in a week.

Together they often cut a taxable transfer by 25 to 40 percent. On a $10 million company, that is real money.

How an appraiser builds them

Start with a pro rata share of enterprise value, then apply the discounts. The minority discount is justified by comparing the interest to controlling stakes in similar companies. The marketability discount is justified by restricted stock studies and by how long a private interest takes to sell.

The IRS does not accept a discount just because an interest is small. It wants evidence: transfer restrictions in the agreement, the distribution history, the absence of a market, and the specific rights the holder lacks.

A discount holds when the operating agreement genuinely restricts transfer, genuinely gives control to a managing member, and genuinely limits distributions. Paper restrictions added the week before the gift are worthless.

Where the IRS pushes back

The IRS argues for a smaller discount when the family acts as one economic unit. If the children vote with the founder on every decision, the IRS calls the minority discount fictional.

It also argues the marketability discount should shrink when a buy-sell guarantees a buyer. A mandatory purchase at a formula price creates a market, and a market undercuts the discount.

That tension is why the buy-sell and the valuation report should be drafted together, not a year apart. A buy-sell with a low formula price helps the estate and weakens the discount argument on lifetime gifts.

A worked example

Take a 40 percent limited partnership interest in a Midwest distribution company. Pro rata enterprise value of that interest is $4 million.

A 20 percent minority discount brings it to $3.2 million. A 25 percent marketability discount brings it to $2.4 million.

The taxable gift is $2.4 million instead of $4 million. At a 40 percent estate tax rate, the discount saves roughly $640,000, assuming the exemption is already used elsewhere.

That only holds if the appraiser can defend both numbers. A discount pulled from a textbook without entity-specific support is the file the IRS wins.

Section 2704: the 2016 proposal, the 2017 withdrawal, today

Section 2704 sits in the estate and gift tax provisions of the U.S. Code. It lets the IRS disregard certain restrictions and rights when valuing interests transferred to family members.

In 2016 the Treasury proposed regulations under Section 2704 that would have sharply limited minority and marketability discounts in family transfers. Family business groups across the Midwest filed comments against it.

The regulations were withdrawn in 2017 before taking effect. No final rule was issued. Section 2704 itself was not repealed, and its original text still applies.

What that leaves

Discounts remain available. The withdrawal created no safe harbor and told appraisers nothing about what a defensible discount looks like.

The IRS still challenges aggressive discounts under existing law, often through the general valuation rules and penalties for substantial valuation misstatement. A 40 percent discount with a two-page memo invites that challenge.

Assume the issue returns. A future administration can propose new regulations under the same statute, and the drafting burden lands on the same family businesses.

Defenses that hold up

Get a qualified appraisal from a credential holder, such as an ASA or NACVA member, before the transfer rather than after. File Form 709, the federal gift tax return, on time and with adequate disclosure under §6501(c)(9), which starts the three-year limitations period. The annual exclusion under §2503(b) is small next to a business interest, so assume the transfer is reportable.

Keep the operating history clean. Distributions that track ownership percentages undercut a minority discount argument, and so do side agreements guaranteeing the children a return.

Document the non-tax purpose. A freeze that moves a business to the next generation is legitimate. One that exists only to cut a tax bill is not.

State estate tax: Illinois, Ohio and the neighbors

Federal estate tax is half the picture. The federal exemption is the basic exclusion amount under §2010(c); it changes with legislation and is adjusted each year, so confirm the figure for the year of the transfer. For 2026 the IRS estate and gift tax update gives it: the Working Families Tax Cuts Bill, Public Law 119-21, amends §2010(c)(3) by increasing the basic exclusion amount to $15,000,000 for calendar year 2026. The same page lists the annual exclusion per donee by year; it is small next to a business interest, which is why a gift of one is almost always reportable on Form 709.

The federal estate tax return is Form 706, an accounting of everything the founder owns or has certain interests in at the date of death, valued at fair market value. Several Midwestern states levy their own tax, at thresholds far below the federal exemption.

Illinois is the state most Midwest owners should study. The Illinois Attorney General's estate tax fact sheet states that the exclusion amount for Illinois estate tax purposes is $4,000,000. That threshold is $4 million, and it is not portable between spouses the way the federal exemption is. An Illinois estate over $4 million owes Illinois tax even when it owes no federal tax.

Ohio is the opposite case. Its estate tax was repealed for deaths on or after January 1, 2013, so Ohio residents face no state estate tax, though the state still taxes income and property.

Indiana, Michigan, Wisconsin and Missouri have no state estate tax. Minnesota and Iowa do, and Iowa is phasing its tax out. Minnesota's exclusion amount is set in Minnesota Statutes section 291.016: $3,000,000 for decedents dying in 2020 and thereafter, so a Minnesota founder meets the state tax well before the federal one. Property in more than one state can pull an estate into each state's system.

Why the Illinois threshold catches working businesses

A $4 million threshold reaches family businesses that would never face federal tax. A Midwest manufacturer worth $6 million, owned outright by one founder, is an Illinois estate tax case even though the federal exemption shelters it.

Illinois calculates the tax on a graduated scale that produces a cliff at the threshold. An estate just over $4 million can owe more in tax than the amount by which it exceeds $4 million.

Illinois has no gift tax, so lifetime gifts generally escape the Illinois estate tax. That asymmetry is the single most useful planning point for Illinois owners. The Illinois estate tax return is Form 700, filed with the Illinois Attorney General's office. Confirm current thresholds and the cliff calculation with that office or a qualified tax adviser before relying on them.

Property in more than one state

Land and equipment in another state can pull an estate into that state's system. A Wisconsin company owned by an Illinois resident with an Illinois home has two potential filings.

Apportionment rules vary. Some states tax only in-state property; others tax a share of the whole estate, and each state has its own return and filing process. The federal estate tax allows a deduction for state death taxes paid under §2058, which softens the cost without removing it. Local counsel in each state should review the plan.

The buy-sell agreement and how it gets funded

A buy-sell controls what happens to an owner's interest on death, disability, a voluntary sale or divorce. Without one, the interest passes to heirs who may want nothing to do with the business.

The agreement needs a trigger, a price and a funding source. Most drafts get the first two right and the third wrong.

Choosing the price mechanism

A fixed-price agreement sets a number and updates it annually. It is cheap and it goes stale.

A formula agreement applies a multiple to earnings or book value. It is more durable and produces fights when earnings swing.

A valuation agreement defers to an appraiser at the trigger. It is the most accurate and the most expensive, and it works best when the agreement names the appraiser selection method in advance.

Whichever mechanism you choose, review the price after every major capital investment. A formula tied to earnings punishes a company that just spent $3 million on equipment.

Price setting is a tax question as much as a business one. Under §2703 the IRS can disregard an option or buy-sell price that is not comparable to fair market value, so a formula that is never tested against the market is a weak anchor for the estate and for the discount. A plan that leaves the seller with control, the use of the business, or an unfunded promise can also be pulled back into the estate under §2036 and §2038. Draft the buy-sell with both sections in view.

Funding the death trigger with insurance

Life insurance is the standard funding tool for death triggers. Each owner buys a policy on the others, or the entity buys policies on all owners, and the proceeds fund the purchase from the deceased owner's estate.

Policy ownership matters. A cross-purchase arrangement among three owners means nine policies. An entity redemption arrangement means three policies but can create alternative minimum tax exposure and leaves surviving owners with a basis problem.

Larger Midwest family groups often use a hybrid, with a partnership holding the policies. That needs a lawyer who has done it before.

Funding disability and retirement

Disability and retirement triggers are usually funded by installment notes. When family buyers pay over time, the seller reports gain as payments arrive, which the rules for installment reporting describe in Publication 537 (2025), Installment Sales | Internal Revenue Service.

A note from a family buyer needs real security. An unsecured promise from a child who runs the company is not funding, it is hope.

Basis is the other half of the choice, and it is the decision the family actually has to make. An interest inherited at death takes a step-up to fair market value on the date of death under §1014, so the heir can sell with little gain. An interest bought under an installment note gets no step-up, and the buyer pays with after-tax dollars while the seller reports gain as payments arrive. That difference often matters as much as the price.

A succession checklist from valuation to closing

The checklist has two standing items and seven ordered steps. Keep the two checks in view from the start and work the seven steps in order; skipping a step usually means paying for it twice.

The seven steps, in order

Where an outside sale still fits

Some family handovers fail and the business goes to market. Owners who prepare for a family transfer are also preparing for a sale, which is why the same seller preparation work applies either way.

Gain recognition on an asset sale follows the rules in Publication 544 (2025), Sales and Other Dispositions of Assets | Internal Revenue Service, and the entity type determines who pays it.

The IRS business tax hub at Businesses | Internal Revenue Service lays out filing obligations by entity.

If a buyer cannot pay the whole price at closing, the seller may need to structure an earnout or take a note. Either way, the family should not sign a deal document that conflicts with the estate plan.

For the split of tasks between owner, accountant, lawyer and intermediary, see the seller preparation checklist. The estate and gift tax provisions, including Section 2704, sit in the U.S. Code: Table Of Contents | U.S. Code | US Law | LII / Legal Information Institute.

Common questions

Does the withdrawal of the Section 2704 regulations mean discounts are safe?

No. The proposed regulations were withdrawn in 2017, but the statute remains and the IRS still challenges weak appraisals under existing law. A well-documented discount from a qualified appraiser is defensible; a number pulled from a rule of thumb is not.

How much can minority and marketability discounts reduce a family transfer?

Combined discounts commonly land between 25 and 40 percent of pro rata value, depending on the entity, the operating agreement and the market evidence. The exact figure depends on the facts, and the appraiser has to support it.

Does Ohio still have an estate tax?

No. Ohio repealed its estate tax for deaths on or after January 1, 2013. An Ohio resident with property in Illinois, Minnesota or another taxing state may still owe tax there.

What is the Illinois estate tax threshold?

$4 million, and it is not portable between spouses the way the federal exemption is. The graduated rate structure creates a cliff just above the threshold, and because Illinois has no gift tax, lifetime gifts generally reduce the taxable estate. Confirm the current figure with a qualified tax adviser.