Business Owners May Have Little Time to Act Before Rules Are Finalized

The valuation of a family member's interest in a family business has a major impact on the success or failure of a transfer of such interest to other family members, whether the transfer occurs during the transferor's life by sale or gift, or upon the transferor's death. This valuation may be substantially affected by the valuation discounts an appraiser would apply to the family business interest to lower its value. Two principal valuation discounts are for the lack of the family member's ability to sell the interest to non-family members (lack of marketability) or the lack of control a family member has over the entity.

For decades, members of family businesses have engaged in various techniques to maximize valuation discounts for their business interests as a means of minimizing estate and gift taxes. Congress viewed many of these techniques as abusive and, in 1990, Section 2704 was added to the Internal Revenue Code. In general, this section provides special valuation rules for valuing intra-family transfers of interests in family controlled entities for estate and gift tax purposes. This section limits valuation discounts that arise from a family member's holding of certain voting or liquidation rights that are restricted or eliminated when business interests are transferred to other family members.

In response to Section 2704, state legislators introduced modifications with respect to corporate, partnership and LLC law which to date limit the effectiveness of IRS challenges to valuation discounts under Section 2704 and the regulations issued in 1992. After hints as early as 2003 that revised regulations under Section 2704 might be forthcoming, the IRS published proposed amendments to the regulations under Section 2704 Aug. 2, 2016.

As expected, the proposed regulations would further limit or altogether eliminate valuation discounts for certain interests in family controlled entities (including corporations, partnerships, LLCs and other business entities).

The tax effect of the proposed regulations is to limit or even eliminate valuation discounts on transfers of family business interests either by gift or at death.
The proposed regulations will become effective upon their publication as final regulations, which may occur as early as the first quarter of 2017. Thus, business owners may have only a short window of opportunity to complete business succession planning involving valuation discounts before the regulations take effect and eliminate many of these discounts.

The following are highlights of the effect these proposed regulations would have on the valuation of certain family business interests:

  1. Restrictions on Liquidation. The IRS would create a new category of restrictions on liquidation (such as limitations on the ability of a business owner to require the entity or other owners to redeem the owner's interest at fair value) which are to be disregarded in determining the value of a transferred interest.
  2. Nominal Interests Disregarded. The proposed regulations also address attempts to avoid the application of Section 2704 by giving a nominal interest to a charity or another non-family member, thereby causing the entity not to be subject to Section 2704. The proposed regulations would generally disregard such interests unless the interests are economically substantial and longstanding.
  3. Lapsed Voting or Liquidation Rights. The proposed regulations address the issue of "deathbed transfers" of an interest in an entity to create a valuation discount. The proposed regulations would provide that if a transfer is made within three years of the transferor's death and has the effect of diluting the ability to liquidate the interest in the entity by dividing up the interest among multiple family members, the transfer is deemed to have occurred at the date of death and will be valued for transfer tax purposes as if the liquidation right was not diluted.

The tax effect of the proposed regulations is to limit or even eliminate valuation discounts on transfers of family business interests either by gift or at death.

The proposed regulations will become effective upon their publication as final regulations, which may occur as early as the first quarter of 2017. Thus, business owners may have only a short window of opportunity to complete business succession planning involving valuation discounts before the regulations take effect and eliminate many of these discounts.