Last week the Treasury Department issued Proposed Regulations that will likely impact the strategies for, and valuation of, intra-family transfers of closely-held family businesses. If the regulations are adopted in their current form, future transfers of these interests, either at death or during life, will likely be valued without the benefit of discounts that are currently available. A public hearing on the Proposed Regulations is scheduled for December 1, 2016. Given that timing, the regulations will likely become effective for transfers after the end of 2016, thus leaving a current window of opportunity to make transfers using such discounts for family-held entities.
For years, state laws and certain court decisions have allowed transfers of closely-held entities among family members to be valued by applying discounts for a minority interest and/or lack of marketability, based upon certain restrictions placed upon the transferred interests as part of the planning. Treasury and IRS feel that such restrictions in a family entity do not have real economic effect and should be disregarded.
The Proposed Regulations are relatively complex. However, the concept of the interaction between minority interest and/or lack of marketability discounts and estate and gift taxes is relatively straightforward. The tax law imposes a tax on the transfer of property during life and/or at death to non-spouse and non-charitable transferees. The tax only applies if the cumulative value of all property transferred during life or at death exceeds certain amounts (currently $5.45 million per transferor). For purposes of the transfer tax system, the property is valued at its fair market value at the time of the transfer.
A discount is usually applied to the value of an interest in a closely-held business if the interest transferred is a non-controlling (minority) interest. The reason for the discount is that a third party would pay less for a minority interest in an entity because he or she would not be able to independently liquidate the company, compel distributions, or independently initiate a sale of the company or its assets. In other words, a discount is applied to minority interests because the minority interest holder is at the mercy of the controlling interest owners. For many of the same reasons, the owner of such an interest would have difficulty finding a market for that interest.
The Proposed Regulations would effectively deny minority interest discounts on transfers of family-held entities between family members, and also likely any lack of marketability discount. The potential for an increase in estate or gift tax on owners of family businesses is clear. For example, assume that the value of ABC, Inc. as a whole is $20 million. A parent under current law might be able to transfer a 10% interest to a child at a post-discount valuation cost of $1.4 million (assuming a 30% discount in this example), thus using less of the transferor's total exclusion amount of $5.45 million. The Proposed Regulations would essentially cause the transferred interest to be valued at 10% of the whole value of the business, or $2 million, thereby increasing the total potential value subject to estate or gift tax.
Family business owners likely have until the end of 2016 to transfer interests to family members under current law that allows minority interest discounts and also generally lack of marketability discounts. Even if the Proposed Regulations are modified somewhat prior to enactment, the implication is clear: owners of family businesses considering transferring interests to family members should do so during 2016 while there is more certainty to the tax law.