Last month on August 2, 2016, the Treasury Department issued Proposed Regulations under Section 2704 of the Internal Revenue Code. This development has been reported as one of the most significant developments in the federal estate and gift tax law in the last 25 years.
These Regulations relate to valuing stock, partnership interests and limited liability company interests in family-owned businesses. If you own stock in a family Subchapter S or Subchapter C corporation, a partnership interest in a family general or limited partnership, or a membership interest in a limited liability company, these regulations may affect you.
Under current law, if a family owns all or at least has control of a privately held company, the value of the equity interests in the company can often be discounted substantially due to two different factors. First, since the stock or other equity interest is not publicly traded, it can be discounted for a lack of marketability. Second, if the stock or other interest represents less than a 50 percent ownership interest, it can often be discounted because it reflects a minority interest and lack of control. For these reasons, the value of a less than 50 percent ownership interest in a family company often may be discounted by 25 to 40 percent for federal gift or estate tax purposes, depending on the circumstances.
For example, assume that a family company is owned 51 percent by grandfather and 49 percent by grandmother and that grandfather and grandmother together have an estate greater than the current $10.9 million aggregate exemption amount that applies to their marital unit – $5.45 million per person. Assume that grandfather and grandmother want to reduce their federal estate tax and transition ownership of their business by making gifts of stock to children working in the business and by making gifts of other stock to a trust for their children and/or grandchildren. In this case, each of grandfather and grandmother would be entitled to discount the value of the stock for federal gift tax purposes, perhaps by 25 percent or more. This is the case even though together grandfather and grandmother own 100 percent of the stock. Similarly, if grandmother died owning 49 percent of the stock, the value of the stock for federal estate tax purposes would not be 49 percent of the value of the net assets of the company but would be reduced by a discount of perhaps at least 25 percent. If the stock was worth $10 million, grandmother’s stock would not be worth 49 percent of $10 million or $4.9 million for federal estate tax purposes; it would be worth $4.9 million less for example a 25 percent discount for a federal estate tax value of $3.675 million.
With some exceptions, the Proposed Regulations generally eliminate the discount that under current law is permitted. Once the Proposed Regulations are finalized, grandfather and grandmother generally will no longer be entitled to valuation discounts on transferring their stock or other interest either as gifts during life or upon death. This may lead to greater federal gift and especially estate tax liability.
A hearing on the Proposed Regulations is to be held on December 1, 2016. The Regulations will be finalized thereafter, perhaps very early in January 2017. The law will change on the date the regulations become final.
If you own stock, a partnership or LLC membership interest in a family-owned company, you may want to consider the impact of this upcoming change in the law on the projected federal estate tax liability of the older generation members of your family. Some clients are contemplating making gifts of stock or LLC interests to children now before the law changes and the amounts of those gifts can no longer be reduced by discounts.