Last Updated: December 2025

Cost basis and fair market value (FMV) are two of the most consequential numbers in business ownership , and confusing them costs owners millions in unnecessary taxes. Cost basis is what you paid for an asset, adjusted for improvements and depreciation. Fair market value is what an arm’s-length buyer would pay today. The gap between these two figures determines your taxable gain, your estate tax exposure, and the tax burden your heirs will ultimately inherit.

For estate planning attorneys, CPAs, and the business owners they serve, understanding when each number governs a transaction is not optional , it is the foundation of every meaningful tax strategy. Sofer Advisors is a certified business appraisal firm based in Atlanta, Georgia, providing defensible FMV determinations for estate planning, gift tax filings, installment sales, and litigation support. When the IRS scrutinizes a basis position, a credentialed appraisal is the first line of defense.

Key Takeaways

  • When a business owner dies, heirs inherit assets at FMV on the date of death under IRC Section 1014, eliminating all embedded capital gains accumulated during the owner’s lifetime.
  • Gifts of appreciated business interests carry over the donor’s original cost basis to the recipient under IRC Section 1015, transferring the capital gains liability along with the asset.
  • The gift-versus-bequest decision hinges on comparing estate tax exposure against the beneficiary’s expected holding period and marginal capital gains rate , there is no universal answer.
  • ISO shares, NQO shares, and RSUs each carry distinct basis rules; failure to track these correctly across multiple grant cycles creates material audit exposure for business owners.
  • When original purchase records no longer exist, the IRS can assert a $0 cost basis, making 100% of sale proceeds taxable , reconstruction requires contemporaneous documentation and expert support.

What Is the Step-Up in Basis at Death?

Under IRC Section 1014, assets included in a decedent’s gross estate receive a new cost basis equal to their fair market value on the date of death , or, if elected, the alternate valuation date six months later. For business owners who built significant equity over decades, this provision can eliminate tens of millions of dollars in embedded capital gains in a single step.

Consider a concrete example: a founder acquired her manufacturing company in 1995 for $500,000. By the time of her death in 2025, the business has grown to a fair market value of $3,000,000. Her original cost basis was $500,000, meaning a lifetime sale would have triggered $2,500,000 in long-term capital gain , roughly $625,000 in federal tax at a 25% effective rate, plus applicable state taxes. Under Section 1014, her heirs inherit the business with a new basis of $3,000,000. If they sell immediately for $3,000,000, their capital gain is zero.

While enterprise-focused firms like Stout and Kroll (formerly Duff & Phelps) serve Fortune 500 clients, Sofer Advisors specializes in middle-market and closely held businesses where personalized service, transparent pricing, and next-business-day responsiveness make a measurable difference.

The step-up applies to the business interest itself, not just its underlying assets. This distinction matters in asset sales versus stock sales. In an asset sale following inheritance, the step-up in basis on the stock effectively translates to a stepped-up basis in the underlying assets if a Section 338(h)(10) election is made. Estate planning counsel should evaluate whether structuring the entity as a pass-through versus C-corp affects the utilization of the step-up.

The step-up is not unlimited. Congress has periodically proposed eliminating or modifying it, most recently in 2021. Business owners with significant unrealized appreciation should treat the step-up as a planning asset to be preserved , not a permanent feature of the code that requires no attention.

How Does Carryover Basis Work for Lifetime Gifts?

When a business owner gives away appreciated property during life, IRC Section 1015 governs the recipient’s basis. The donee takes the donor’s adjusted cost basis , not the fair market value at the time of the gift. The capital gains problem that existed in the donor’s hands transfers intact to the donee’s hands.

Using the same example: the founder gifts her $3,000,000 business to her adult child while she is alive. The child’s cost basis is $500,000 , identical to the mother’s original basis. When the child eventually sells the business for $3,000,000 (or more), she recognizes a $2,500,000 gain and owes federal capital gains tax on it. The gift accomplished a reduction of the founder’s taxable estate , potentially reducing estate taxes , but it transferred a substantial tax liability to the next generation in the process.

One nuance: if the fair market value of the gifted property is less than the donor’s basis at the time of the gift, the recipient’s basis for purposes of calculating a loss is limited to the FMV on the gift date. This loss-limitation rule prevents donors from transferring built-in losses to recipients in a lower tax bracket.

Partial gifts , such as minority interest transfers to family limited partnerships , are commonly used to shift value out of an estate while retaining control. These structures require defensible FMV appraisals that account for applicable minority interest and lack of marketability discounts. An unsupported valuation invites IRS scrutiny under Section 2512.

When Should You Gift vs. Bequest Business Interests?

The central tension in estate planning for appreciated business interests is this: gifting removes value from the estate (reducing estate tax exposure) but preserves the capital gains liability in the donee’s hands. Bequeathing keeps the asset in the estate until death but delivers a full step-up in basis, eliminating the capital gain entirely.

The math that governs this decision involves three variables: (1) the size of the estate relative to the federal estate tax exemption, currently $13.61 million per individual in 2025 but scheduled to sunset to approximately $7 million in 2026; (2) the donee’s expected holding period and marginal capital gains rate; and (3) the current and projected FMV of the business interest.

For estates well below the exemption threshold, gifting appreciated business interests during life is almost never optimal from a pure tax standpoint. The estate incurs no estate tax, but the gift locks in a carryover basis that will generate capital gains tax on sale. Retaining the asset until death and allowing the step-up to eliminate the gain is the dominant strategy in these cases.

For estates above the exemption , particularly those facing the 40% federal estate tax rate , the calculus changes. If the business interest is gifted today and removed from the estate, the estate tax savings may exceed the future capital gains tax cost, depending on the beneficiary’s holding period and rate. Advisors should model both outcomes with explicit assumptions before recommending a strategy.

Transaction Type Basis Rule Capital Gain Trigger Planning Opportunity
Sale during lifetime Adjusted cost basis Proceeds minus adjusted basis Installment sale, charitable remainder trust, opportunity zone deferral
Bequest at death FMV at date of death (IRC §1014) None , full step-up eliminates embedded gain Retain appreciated assets in estate; use annual exclusion gifts for cash
Lifetime gift Donor’s carryover basis (IRC §1015) Donee pays capital gains on donor’s original gain when sold Gift low-basis assets to 0% capital gains rate taxpayers; use GRATs
ESOP transaction Cost basis of shares sold to ESOP IRC §1042 rollover defers gain if reinvested in QRP securities Sell to ESOP, reinvest proceeds, defer gain indefinitely
Charitable gift FMV (deduction); donor avoids gain No gain recognized; full FMV deduction up to AGI limits Donate appreciated interests to DAF or CRT before sale

How Is Cost Basis Calculated for Stock Options?

Business owners who participated in their own company’s equity compensation plans , or who hold equity in other companies , face some of the most complex basis tracking requirements in the tax code. The rules differ materially depending on the type of equity award.

Incentive Stock Options (ISOs): ISOs have two separate basis figures that coexist simultaneously. For regular income tax purposes, the basis of ISO shares is the exercise price , the amount actually paid to acquire the shares. No income is recognized at exercise for regular tax purposes. However, for alternative minimum tax (AMT) purposes, the spread at exercise (FMV minus exercise price) is an AMT preference item, and the AMT basis of ISO shares equals their FMV at exercise. If a taxpayer exercises ISOs in a year when AMT applies, the AMT basis exceeds the regular tax basis. Selling the shares in a later year can produce a regular tax gain and an AMT loss simultaneously , a confusing outcome that many taxpayers and some preparers mishandle.

Non-Qualified Stock Options (NQOs): When an NQO is exercised, the spread between FMV at exercise and the exercise price is ordinary income, reported on the W-2 (for employees) or 1099 (for consultants). The taxpayer’s cost basis in the shares equals FMV at exercise , the price they effectively “paid” including the income component. Future appreciation above that exercise-date FMV is capital gain. NQO basis tracking is simpler than ISO tracking but requires retaining records of the FMV at each exercise date, which may have occurred across multiple years.

Restricted Stock Units (RSUs): RSUs are taxed as ordinary income at vesting , the FMV at vesting is the basis. There is no exercise; the shares simply vest and the FMV becomes both the income recognized and the cost basis going forward. Subsequent appreciation is capital gain. RSU basis tracking is complicated when vesting occurs across multiple years at different share prices, particularly for founders who received large RSU grants early in a company’s growth.

How Does Basis Allocation Work in Installment Sales?

When a business owner sells a company on an installment basis , receiving payments over two or more years , IRC Section 453 governs the timing of gain recognition. The key principle is that basis must be allocated proportionally across all payments, not front-loaded or back-loaded to suit the seller’s preference.

The gross profit ratio is computed as the gross profit (selling price minus adjusted basis) divided by the total contract price. This ratio is applied to each payment received in the year it is received to determine the taxable gain component of that payment. The remainder of each payment is treated as a return of capital (basis) and is not taxable.

For example, if a business sells for $2,000,000 with an adjusted basis of $400,000, the gross profit is $1,600,000 and the gross profit ratio is 80%. Each payment received , whether it arrives in year one or year five , has an 80% gain component and a 20% basis recovery component. A seller who attempts to accelerate basis recovery to defer gain is taking an incorrect position that the IRS can challenge on audit.

Installment sale treatment is not always available or optimal. Interest on deferred payments is taxable as ordinary income, not capital gains, which can erode the benefit of installment deferral. Additionally, if the business has significant ordinary income recapture (Section 1245 or 1250 recapture), that recapture is taxable in full in the year of sale regardless of the installment structure.

What Happens When Basis Records Are Missing?

The burden of proof for cost basis lies with the taxpayer, not the IRS. If a business owner cannot document the original purchase price of an asset, the IRS has the authority , and the incentive , to assert a $0 adjusted basis, making 100% of sale proceeds taxable as gain. This outcome, while extreme, is not hypothetical. It occurs regularly in audits of business sales, particularly when the original acquisition occurred decades ago, the records were lost in a disaster, or the business changed hands informally without formal documentation.

Reconstruction strategies exist but require effort and contemporaneous evidence. Acceptable reconstruction methods include: locating original bank records showing the purchase payment; recovering the original asset purchase agreement or closing settlement statement from the escrow company or the seller’s attorney; obtaining a copy of the original tax return for the year of purchase, which would have reported the acquisition; and using comparable sales data from the period of acquisition to establish a reasonable FMV basis for an inherited or gifted asset where Section 1014 or 1015 applies.

Expert appraisals can be used retrospectively to reconstruct FMV as of a prior date. A qualified appraiser with access to historical financial data can opine on what the business was worth , and therefore what a reasonable basis would have been , at a specified date in the past. These retrospective appraisals, while less reliable than contemporaneous ones, are admissible in Tax Court and can be persuasive when combined with corroborating documentary evidence.

The practical lesson for business owners and their advisors: basis records should be treated as permanent files, not subject to the normal document retention schedule. The original purchase agreement, the closing statement, and any capital improvement records should be maintained in perpetuity or until the asset is sold and the tax return for the year of sale has passed the statute of limitations , which is at least three years but can extend to six years or beyond in cases involving substantial understatement of income.

Frequently Asked Questions

What is the difference between cost basis and fair market value?

Cost basis is what you originally paid for an asset, adjusted upward for capital improvements and downward for depreciation. Fair market value is the price a willing buyer would pay a willing seller in an arm’s-length transaction, with both parties having reasonable knowledge of the facts. The gap between these two numbers determines your taxable gain when you sell or transfer the asset. They are often equal at the time of acquisition but diverge as the business grows in value over time.

How does the step-up in basis work at death?

Under IRC Section 1014, heirs who inherit assets from a decedent receive a new cost basis equal to the asset’s fair market value on the date of death. All capital gains that accumulated during the decedent’s lifetime are permanently eliminated. If an heir sells the inherited asset immediately for its date-of-death value, no capital gains tax is owed. This provision is one of the most powerful tax benefits available in estate planning and is the primary reason retaining appreciated assets until death is often preferable to gifting them during life.

What happens to the capital gains when I gift business interests to my children?

Under IRC Section 1015, the recipient of a gift takes the donor’s original adjusted cost basis , not the asset’s current fair market value. This means the embedded capital gain transfers from the donor to the donee. When the recipient eventually sells the gifted interest, they will owe capital gains tax on the appreciation that occurred both before and after the gift was made. Gifting removes value from your taxable estate for estate tax purposes, but it does not eliminate the capital gains liability , it transfers it.

Should I gift my business interests now or hold them until death?

The answer depends on the size of your estate relative to the federal estate tax exemption and on the beneficiary’s expected tax rate and holding period. If your estate is below the exemption threshold, holding appreciated assets until death and receiving the step-up in basis is almost always superior to gifting. If your estate significantly exceeds the exemption, the estate tax savings from removing the asset may outweigh the capital gains cost. This analysis requires quantitative modeling with your CPA and estate planning attorney.

What is the cost basis for inherited business interests?

Inherited business interests receive a step-up in basis equal to the business’s fair market value on the date of the decedent’s death. To establish this basis, a qualified appraisal of the business interest must typically be obtained as of the date of death. For estate tax return purposes, this appraisal is a filing requirement under IRC Section 2031. The appraised value becomes the heir’s new cost basis, and any subsequent appreciation above that value will be taxed as capital gain when the heir sells.

How is basis calculated for incentive stock options?

ISO shares have two separate basis figures. For regular income tax, the basis equals the exercise price , the amount actually paid. No income is recognized at exercise for regular tax. For alternative minimum tax purposes, the basis equals the fair market value at exercise, because the spread at exercise is an AMT preference item. These two basis figures diverge whenever ISOs are exercised in a year when the stock’s FMV exceeds the exercise price, creating a situation where selling the shares can produce a regular tax gain and an AMT loss simultaneously.

What happens if I can’t prove my cost basis in an IRS audit?

The burden of proving cost basis rests with the taxpayer. If you cannot document your original purchase price, the IRS may assert a $0 basis, making 100% of your sale proceeds taxable as gain. Reconstruction is possible using bank records, original closing statements, prior tax returns, or retrospective appraisals, but the process is burdensome and the outcome uncertain. Maintaining original acquisition documents permanently , not subject to normal retention schedules , is the only reliable way to protect your basis position.

How does installment sale basis allocation work?

In an installment sale, you must allocate your cost basis proportionally across all payments using the gross profit ratio , gross profit divided by total contract price. This ratio is applied to each payment received to determine the taxable gain component of that payment. You cannot front-load basis recovery to defer gain. Each payment received carries the same percentage of taxable gain, regardless of when it arrives during the installment period. Misapplying this allocation is a common audit issue in business sale transactions.

Does a business valuation affect my cost basis?

A business valuation directly establishes fair market value , which becomes the cost basis in several scenarios: when you inherit a business interest (date-of-death appraisal sets basis under Section 1014), when you receive a gift and basis must be confirmed for loss purposes (Section 1015), or when RSUs vest (FMV at vesting is the basis). A defensible, credentialed appraisal protects you in each of these situations by providing a documented, IRS-supportable FMV figure on which your basis claim rests.

What valuation discounts apply to gifts of minority business interests?

Gifts of minority interests in closely held businesses can be valued at a discount to the pro-rata enterprise value, reflecting the recipient’s lack of control and lack of marketability. Minority interest discounts typically range from 15% to 35%; lack of marketability discounts typically range from 10% to 30%. These discounts reduce the taxable value of the gift, reducing gift tax owed and the amount removed from the estate. However, the discounts must be supported by a qualified appraisal , without one, the IRS will likely disallow them and assess additional gift tax and penalties.

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Executive Summary

Cost basis and fair market value govern the tax consequences of nearly every significant business ownership event , from lifetime sales and gifts to death transfers and equity compensation. The step-up in basis at death under IRC Section 1014 is the most powerful single tax benefit available to business owners with appreciated assets, eliminating all embedded capital gains in one event. Lifetime gifts, by contrast, transfer the capital gains liability to the recipient under IRC Section 1015. The optimal strategy for any individual owner depends on estate size, the estate tax exemption in effect at death, and the beneficiary’s projected tax position. Complex equity compensation , ISOs, NQOs, RSUs , adds additional layers of basis tracking that require careful documentation. Missing basis records expose taxpayers to IRS assertions of $0 basis, making comprehensive record retention a legal and financial imperative.

What Should You Do Next?

If you are planning a business sale, gift, or estate transfer and need a defensible fair market value determination, the team at Sofer Advisors can provide a credentialed appraisal that satisfies IRS requirements and withstands scrutiny in audit or litigation. Contact us at soferadvisors.com to discuss your valuation needs , whether for estate tax, gift tax, installment sale basis allocation, or basis reconstruction support.

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About the Author

This guide was prepared by David Hern CPA ABV ASA, founder of Sofer Advisors – a business valuation firm headquartered in Atlanta, GA serving clients across the United States. David holds dual accreditations as an Accredited Senior Appraiser (ASA) and is Accredited in Business Valuation (ABV), credentials recognized by the IRS, SEC, and FINRA. He also holds the Certified Exit Planning Advisor (CEPA) designation. With 15+ years of valuation experience, David has served as an expert witness in 11+ cases across multiple jurisdictions and built Sofer Advisors into an Inc. 5000-recognized firm with 180+ five-star Google reviews. The firm’s full W2 employee team maintains subscriptions to all major valuation databases and operates under a next business day response policy.

For professional business valuation services, visit soferadvisors.com or schedule a consultation.

This article provides general information for educational purposes only and does not constitute legal, tax, financial, or professional advice – consult qualified professionals regarding your specific circumstances.

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