The Internal Revenue Service (IRS) recently proposed new regulations that would, if enacted in their present form, limit or possibly eliminate discounts in valuation of family business interests for gift, estate and generation skipping transfer tax purposes. These proposed regulations would make transferring closely-held business interests more difficult and could dramatically impact your estate plan if you own those types of business interests. But the regulations were met with wide-ranging criticism and confusion, and given the uncertainty surrounding the recent election, it is difficult to predict whether or not the regulations will be enacted, and if enacted, if they will be enacted in their present form.
The IRS has long been concerned that taxpayers are undervaluing closely-held business interests in intra-family transfers. The proposed regulations are the IRS’s response to those concerns.
Valuation discounts are used to reflect the reality that a minority interest that is subject to restrictions (most often restrictions on control and transferability) is inherently less valuable than its proportional share of a closely-held business entity. For example, a thirty percent interest in a ten million dollar closely-held business is typically valued as less than three million dollars. The value is often discounted because the minority interest holder does not have control of the business, does not control when distributions are be made, cannot readily transfer the interest and cannot easily liquidate the interest.
If enacted, the proposed regulations to Internal Revenue Code Section 2704 could reduce or eliminate, for gift and estate tax purposes, certain discounts on closely-held business valuations. The discounts, which reduce gift and estate taxes, have traditionally have been recognized. The proposed regulations would affect corporations, partnerships (including family limited partnerships) and limited liability companies.
Specifically, some of the provisions of the proposed regulations would:
- Create Disregarded Restrictions. The regulations create a new category of disregarded restrictions. Valuation discounts would no longer be available for provisions found in the entity’s governing instrument that would:
- limit the holder of the interest’s ability to liquidate the interest;
- limit the redemption of the interest for an amount that is less than the holder’s share of the entity’s value;
- permit the payment of the liquidation proceeds in any manner other than cash or other property; or
- defer the proceeds payment for more than 6 months.
- Limit Valuation Rules for Transfers Made Within Three Years of Death. The proposed regulations attempt to discourage so-called "deathbed transfers" of business entities. Under the three-year rule, if the transferor dies within three years of the date of a transfer of an interest in a family-controlled entity and the transfer results in a loss of the transferor’s ability to force a liquidation of the entity, the transfer will be deemed to have occurred at the date of death, so that the value of the transferred entity will be valued for estate tax purposes as if the transfer had not occurred.
- Eliminate a Strategy. The proposed regulations would eliminate a taxpayer strategy to avoid the application of Code Section 2704 through the transfer of a nominal partnership interest to a nonfamily member, such as a charity, to ensure that the family alone does not have the power to remove a restriction. The proposed regulations would generally disregard the non-family member interest unless the interest transferred to the non-family member are substantial and longstanding.
- Possibly Create a Six-Month Put Right. Some commentators have interpreted the proposed regulations to require the valuation of a transferred interest as though it were subject to a six-month put right—that is, the transferred interest would be entitled to be liquidated upon six-months notice for a liquidation price of the interest’s minimum value, that is, for a pro rata portion of the value of the whole entity, without discounts. Not all commentators agree that the wording of the regulations has the effect of creating this liquidation right, and some regulators have publicly declared that this was not intended.
At this time, the regulations are merely proposed and are not in effect. While a public hearing is scheduled for December 1, 2016 for the solicitation of comments, given the uncertainty surrounding the regulations and the recent election, it is not clear when the regulations will become final, or if the regulations will become final in their present form. Based on public comments by a Department of Treasury official, many commentators have concluded that the final regulations will likely be revised to clarify that conventional lack of control and lack of marketability valuation discounts for gifts of interests in family-owned businesses would still be available, while other planning techniques would no longer be effective.
If, however, you own closely-held business interests we advise that you review and revise your estate plan and business documents in response to these proposed regulations. If the regulations eliminate or even limit the application of valuation discounts, it is important to act as soon as possible to complete business succession planning.