On August 2, 2016 the Treasury released proposed regulations under Internal Revenue Code Section 2704. If adopted in their current form, these regulations will dramatically change valuation laws to impact both active businesses and passive investment holding companies of all sizes that are controlled by one family. A hearing on the proposed regulations is scheduled for December 1, 2016. They could become final early in 2017, which means that the time to determine the effect on you--and plan accordingly--is now.
Value for tax purposes: The proposed regulations would effectively eliminate almost all lack of marketability or lack of control discounts that have for decades been used in valuing family business interests in order to reduce the impact of estate, gift and generation-skipping transfer taxes. Discounts reflect the value a third-party at arm’s length would be willing to pay for an interest in a business: for example, since a non-controlling owner cannot force a sale (or redemption) of his or her interest, the non-controlling interest is worth less to a third-party than its pro-rata share of the underlying business. Such discounts, which can exceed 30% depending upon the circumstances, have regularly been upheld by the courts and can be illustrated as follows: under current law, if the value of a business is determined to be $1,000,000, a one-third owner’s 30% discounted interest could be valued for estate and gift tax purposes at $233,333 [$333,333-($1,000,000/3 x 30%)], not $333,333. Thus tax (or use of exemption) is calculated on the lower discounted value.
How would the proposed changes work?: Practically speaking, the proposed regulations (which operate in a fairly complex manner) would eliminate the 30% discount in the above example. Many actual restrictions on an owner’s interest would be disregarded for transfer tax valuation purposes and an interest being valued would effectively be deemed to carry a “put” right at a “minimum value” (equal to the net value of the entity, multiplied by the percentage interest in the entity the owner holds). The interest in the above example will be worth $333,333, not $233,333. Transfers that occur within three (3) years of death would also be included in the transferor’s estate, apparently at the date of death value. This “retroactive” effect can have devastating results if not anticipated.
What can be done?: Talk to your advisors. The impact of the proposed regulations (which are expected by many to be adopted with only minor changes) will vary depending upon your state estate tax regime and the outcome of the November presidential and congressional elections. One candidate proposes an elimination of such taxes, the other proposes a reduction of exemption amounts to the 2009 levels ($1,000,000 lifetime gift tax exemption, and a $3,500,000 unified estate and gift tax exemption amount), plus an increase from a 40% estate tax rate to 45%. Few claim the ability to predict the outcome in connection with estate and gift tax payments. Even if the federal estate and gift tax exemption amounts (with the $5,450,000 per person exemption amount (indexed for inflation) and a 40% rate) remain unchanged, state estate taxes for New Jersey business owners may increase. Analyzing possible outcomes now could enable you to take steps to minimize the negative impact on your family’s financial well-being.