The quest to reduce the value of a transferred interest in a closelyheld (family) company has long been an important goal in the context of estate and gift tax planning. In 1990, the IRS enacted a series of statutory provisions aimed at reducing or eliminating the ability of a family business owner to accomplish an “estate freeze.” In other words, the IRS clamped down on the means by which a family business owner could shift the value, voting control, and future appreciation in his or her business enterprises to future generations of owners.
Although specific Regulation projects have been in the discussion stages at the IRS for years, recent developments, including an announcement by a Treasury Department estate and gift tax official, have led the estate planning community to believe that the IRS may attempt to further curtail tax efficient business transition planning through the issue of new Treasury Regulations focused on limiting the availability of business valuation discounts.
Section 2704 of Chapter 14 of the tax code initially placed limits on the availability of valuation discounts by stating that certain restrictions that reduced the value of the subject business would be disregarded. Those disregarded restrictions were defined by statute and related to limits on the ability of the entity to liquidate which lapsed after a transfer between family members. The statute further provided, however, that any restrictions imposed or required by Federal or State law would not be disregarded. As a result, many states responded by imposing their own restrictions that would allow their resident businesses the ability to achieve discounts even in light of the limits of Chapter 14.
Additionally, business owners and their planners continued focusing significant attention on obtaining valuation discounts to add leverage to the downstream transfers of non-controlling interests in the equity of their companies. Such valuation discounts were often achieved because certain provisions in the governing documents of business entities such as family limited partnerships, family LLCs and family corporations imposed restrictions on minority owners. These restrictions further punctuated the inherent limitations on marketability and lack of control associated with minority ownership, and in many instances led to substantial discounts in the fair market value of those business interests upon appraisal.
The commentators believe that the IRS will mount an attack against business valuation discounts by issuing Regulations under express authority of the tax code stating that “the Secretary may by Regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”
At this point, we cannot be certain as to when such Regulations might be published, the scope of such Regulations, or their effective date. We did, however, consider it important to bring this matter to your attention. If you have been considering a business transition strategy, the perceived success of which could be measured by the magnitude of the business valuation discount, it may be time to consider action.