On August 4, 2016, the IRS proposed new regulations that, if adopted in their current form, would make sweeping changes to the valuation of interests in family-controlled entities and businesses for estate, gift and generation-skipping transfer tax purposes. In particular, the proposed regulations would dramatically reduce or eliminate the availability of valuation discounts for “lack of control” and “lack of marketability” that typically apply to transfers of minority (non-controlling) entity interests between family members. Below is a brief summary of the proposed regulations and their potential impact. We’ll also discuss the actions you can take now to avoid the impact from these regulations.
Background: What Are Valuation Discounts?
Valuation discounts are an invaluable tool used in many common wealth transfer planning techniques, including transfers of entity interests via gifts or sales to family members. Valuation discounts allow a partial ownership in a family-controlled entity to be treated, for transfer tax purposes, as having a lower value than a proportionate share of the net fair market value of the entity’s assets. The two most common valuation discounts are the “lack of control” and “lack of marketability” discounts.
Government Concern Regarding Valuation Discounts
Both Congress and the IRS have long been concerned about the ability of taxpayers to structure transfers of interests in a family-owned entity so that the value of the interests are reduced for transfer tax purposes (typically in the range of 25% to 50%), without any actual decrease in the economic value of the interest received by the recipient. In response to these concerns, Congress passed laws to prevent perceived abuses related to the valuation of family-controlled entities.
In particular, Section 2704 of the Internal Revenue Code ignores certain restrictions that would otherwise reduce the value of interests in family-controlled entities. The IRS believes, however, that the existing laws are “substantially ineffective” in stopping the use of valuation discounts. As a result, the IRS has proposed new regulations that would largely eliminate those discounts.
Summary of IRS Proposed Regulations
The proposed regulations include, among other things, the following key provisions:
- Covered Entities. The proposed regulations apply broadly to all types of family-controlled entities, including corporations, partnerships and LLCs. They also apply to “active” businesses as well as more “passive” family investment companies.
- Disregarded Restrictions. The proposed regulations create a new category of “disregarded restrictions” that, in effect, values a transferred interest in a family-controlled entity as if the recipient has a “put” right to sell the interest for an amount equal to a proportionate share of the net fair market value of the entity’s assets.
- Transfers Within Three Years of Death. The proposed regulations establish a new “three-year rule” that will apply to certain transfers made within three years of the transferor’s death. Under this rule, if a transfer is made within three years of the transferor’s death, and such transfer results in the transferor losing certain rights (related to voting and liquidation of the entity), the value of the relinquished rights will be includible in the transferor’s estate for estate tax purposes. This three-year rule could create a “phantom asset” in the transferor’s estate; i.e., the transferor’s estate would be required to include the value of the relinquished right even though the transferor no longer owned the transferred interest at death.
- Default Restrictions. Restrictions on liquidation that are not mandated by federal or state law are disregarded and can no longer be considered in valuing transferred interests.
Taken as a whole, the new regulations described above would effectively eliminate “lack of control” and “lack of marketability” discounts in many situations.
The proposed regulations will not be effective until they are finalized (or, in some cases, 30 days after they are finalized). It is not yet clear whether the new regulations might also apply to taxpayers who have recently made transfers and who die after the regulations are finalized but within three years of the transfer.
Because the IRS has scheduled a hearing on these proposed regulations for December 1, the very earliest that the regulations can go into effect is at the end of December 2016. We anticipate that it will more likely occur sometime during early-to-mid 2017.
Planning Opportunities: You May Be Able To Avoid These Rules
Transfers made before the proposed regulations go into effect should not be subject to the new restrictions, except possibly, as noted above, for taxpayers who die within three years. So, business owners that wish to pass their businesses to their children may need to act now. This also applies to families who have considered setting up a family entity to pass wealth to their children. These people should consider making the transfer as soon as possible, before the proposed regulations are finalized.
To learn more about how the new proposed regulations may affect your tax situation or to discuss planning opportunities, please contact a member of the McGrath North Tax Group.