Have you heard the news that wealthy business owners might soon see a bigger tax hit when they transfer ownership stakes to their children? Take a look at some headlines I’ve seen:
Treasury Department Targets Estate Tax Loophole for Family Businesses
IRS Estate-Tax Proposal Could Hit Wealthy Business Owners Where It Hurts
Recently proposed IRS regulations dealing with the special valuation rules of Internal Revenue Code sections 2701 to 2704 can severely restrict a taxpayer’s ability to achieve minority and lack-of-control valuation discounts with respect to the transfer of interests in many family-owned entities. However, the regulations will not be effective until finalized and may face serious opposition and even litigation.
One often-used estate planning technique involves transferring interests in a closely held business to children or to a trust for children and to claim valuation discounts for lack of marketability and lack of control. These discounts arise because the recipient of the transfer is, practically speaking, unable to sell the interest on the open market or to participate meaningfully in the operation of the business.
Think about it—what would you pay for a 10% interest in a company that was worth $1.0 million?
Would you pay $100,000 knowing that you could be out-voted in any major decisions (or were not able to vote at all if your ownership was a limited partner interest or non-voting corporate shares) and there was nobody to sell your interest too if you decided ‘to get out?”
Probably not, so for gift tax purposes you would argue that your gift of 10% was worth substantially less than $100,000. A typical taxpayer would claim discounts in the 30-40% range.
The IRS has fought an uphill battle against what it considers to be abusive valuation discount planning with family-owned entities, but on the legislative front there has been little or no concern shown by Congress on this issue. Consequently, the fact that the IRS might be unhappy with the results of certain valuation reduction strategies may seem like a minor matter.
Until now, that is. And, although one might concede that some taxpayers may have gone too far by creating family businesses for the sole purpose of obtaining discounts on such business that own only marketable securities, these proposed regulations take aim at even traditional ‘legitimate’ businesses.
What the proposal says
- The proposed regulations attack valuation discounts in several different aspects, not all of which can be discussed here. One provision would clarify what constitutes “control” of an LLC or other entity that is not a corporation, partnership, or limited partnership. Specifically, control of an LLC or of any 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.And, for purposes of determining control, using the attribution rules set out in other Code sections, an individual, the individual’s estate, and members of the individual’s family are treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.
- Another proposed change is to provide that an applicable restriction would include a restriction that is imposed under the terms of the governing documents, as well as a restriction that is imposed under a local law regardless of whether that restriction may be superseded by, or pursuant to, the governing documents or otherwise. This proposed rule is intended to ensure that a restriction that is not imposed or required to be imposed by federal or state law is disregarded without regard to its source.
- In perhaps the biggest change, the proposed regulations would add a new class of “disregarded restrictions.” Under the proposed regulations, any restriction on a shareholder’s, partner’s, member’s, or other owner’s right to liquidate his or her interest in the family-controlled entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members, without regard to certain interests held by non-family members, may remove or override the restriction.A “disregarded restriction” includes one that:(a) limits the ability of the holder of the interest to liquidate the interest;(b) limits the liquidation proceeds to an amount that is less than a minimum value (i.e., the interest’s share of the net value of the entity on the date of liquidation or redemption);(c) defers the payment of the liquidation proceeds for more than six months; or(d) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.
The amendments are proposed to be effective on and after the date that regulations are published as final regulations in the Federal Register. A public hearing is scheduled for December 1, 2016.
The regulations may be challenged, but taxpayers should consider completing any gifts as quickly as possible if they want to get the benefit of valuation discounts.
If you need help understanding estate taxes, gifting and tax consequences, give us a call.
(Excerpts of this article were taken from Wolters Kluwer Federal Estate and Gift Tax Report Letter)