New rules have been proposed by the Internal Revenue Service (IRS) which would regulate the valuation of transfers of business interests between family members. Based upon recent interpretation, it appears that the IRS is planning to eliminate, if possible, or otherwise reduce valuation discounts that have been used in valuing ownership interests and transfers of interests in family-controlled entities. If individuals are contemplating any intra-family transfers in such scenarios, they should consider taking action prior to this calendar year-end.
The proposed regulations, if adopted, are likely to reduce or possibly eliminate gift and estate tax valuation discounts for intra-family transfers of interests in family-controlled entities, including corporations, partnerships and limited liability companies (LLCs). Restrictions on liquidation and withdrawal that affect the value of an interest in a family-controlled entity would largely be disregarded for estate and gift tax valuation purposes.
The regulations would apply to corporations, partnerships, LLCs and other entities and arrangements that are business entities within the meaning of the Internal Revenue Code, regardless of whether the entity or arrangement is domestic or foreign and regardless of how the entity or arrangement is classified for other federal tax purposes. The proposed regulations clarify that control of an LLC or other entity or arrangement that is not a corporation, partnership or limited partnership would constitute the holding of at least 50 percent of either the capital or profits interests of the entity or arrangement, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement.
Under current law, if a transfer results in the transferor's loss of a controlling interest in an entity, such a transfer may avoid estate tax. The proposed regulations, however, would provide that a transfer that results in the restriction or elimination of the right of the transferor to liquidate an entity within three years of death would be treated as a lapse of those rights at death within the meaning of the Internal Revenue Code. The result is that the decrease in value attributable to reducing the transferor's interest will be subject to estate tax.
Certain restrictions currently are disregarded for valuation purposes if they are more restrictive than state law. The proposed regulations would accomplish their purpose in part by providing that only mandatory state law restrictions on liquidation and withdrawal would be considered for purposes of valuation.
The changes to the regulations also disregard restrictions that limit the ability of the holder of an interest to liquidate the interest, limit the liquidation proceeds to an amount that is less than a minimum value, defer the payment of the liquidation proceeds for more than six months or permit the payment of the liquidation proceeds in a manner other than in cash, other property or certain notes. Minimum value is the interest's pro rata share of the net value of the entity on the date of liquidation or redemption. The net value of the entity is the fair market value as determined under the Internal Revenue Code and applicable regulations, reduced by any outstanding obligations of the entity.
The IRS is accepting comments on the proposed regulations, and a public hearing on the proposed regulations has been scheduled for December 1, 2016. The proposed regulations would apply to transfers on or after the publication of a Department of Treasury decision adopting the rules as final regulations in the Federal Register. Although the regulations may be effective immediately upon publication as final regulations, it is anticipated that at least part of the regulations would be effective 30 days after they are published as final regulations.
Based upon reactions in the legal, accounting and expanded community, it is expected that the regulations will be challenged, likely on the basis that the contents of the regulations exceed the legislative grant of regulatory authority and that they are inconsistent with the statutes and legislative history of Chapter 14. The likely effective date of the regulations and the outcome of any legal challenge to the regulations are uncertain, although it is believed that the Obama administration would like to finalize the regulations before a new president takes office. A bill was introduced in Congress on September 15 that would revoke the proposed regulations. Although practitioners do not expect the bill to pass, it could have the effect of delaying the effective date of the final regulations.
Nevertheless, it is clear that the IRS intends to eliminate, if possible, or otherwise reduce valuation discounts that have been used in valuing ownership interests and transfers of interests in family-controlled entities. Thus, individuals who plan to make intra-family transfers are well advised to consider doing so prior to the end of December 2016.