Act Now if You Have a Family Business

The Treasury Department recently issued proposed regulations that could have a dramatic impact on estate planning by limiting, or in some cases eliminating, valuation discounts. For owners of family businesses interested in minimizing their future estate tax, this is critical.

Valuation discounts have been allowed since the 1990s and have been granted for what is considered a lack of marketability for minority interests in family businesses (partnerships, LLCs, corporations). For example, dad has a $20M estate which includes a $10M family business. He gifts 40% of the business to a trust to grow the asset out of his estate or to protect it from future creditors. The fair market value of the 40% business interest is $4M.

However, since a trust/shareholder with a minority 40% interest cannot force a sale or redemption of its interest, the non-controlling interest in the business transferred to the trust is not worth $4M; it is worth less than the pro-rata value of the underlying business. Therefore, the value is reduced or discounted to reflect the difficulty of marketing the non-controlling interest. As a result, the value of the 40% business interest transferred to the trust might be appraised, net of discounts, at $2.4M. The discount has reduced the estate by $1.6M from this one simple transaction and saves hundreds of thousands of dollars in estate taxes.

The proposed regulations would effectively limit or eliminate this valuable planning tool by ignoring certain transfers between family members when determining a controlling interest. Once the proposed regulations are effective (as early as December 31st of this year) the ability to claim discounts might be substantially reduced or eliminated, thus curtailing tax and asset protection planning flexibility.

Not Deja-vu:

We would be wise not to confuse this development with the mad rush to plan in late 2012. You may recall that back then, there was a real fear that the gift, estate and generation skipping transfer tax exemption might be reduced from $5M to $1M in 2013. This wound up not happening and many people in retrospect viewed it as a “boy who cried wolf” type situation.

For those who might be affected by discounts, the situation in 2016 is vastly different from 2012. While nothing is set in stone, and it’s possible that the proposed regulations could be changed and theoretically even derailed before they become effective, most advisors think the more likely scenario is that they will be finalized after public hearings (scheduled for December 1st) and could go into effect in early 2017. That would severely limit the ability to claim valuation discounts.

If you do undertake planning, be cognizant of an important lesson from much of the poor planning that was done in 2012. After many incurred significant costs and hassles in implementing planning quickly, the main regrets in 2012 planning were for those who transferred assets out of their own reach. That is not necessary. If you are married, for example, consider using planning techniques that assure you access to funds transferred in the discount planning.

Taking Action:

If you were planning to utilize the strategy of transferring interests in a closely held business or other family entity, expediting that process based on these potential changes makes strong sense. If you own a family business and have not considered pursuing this strategy, it is something to seriously start to examine.