Estate Planning Options Might Get More Expensive for Family-Owned Businesses

If transferring shares of a family-owned entity plays any role in your estate planning, you may want to think about making those transfers sooner rather than later.

That’s because the Internal Revenue Service (“IRS”) released new proposed regulations under Internal Revenue Code (“IRC”) § 2704. These regulations will limit certain valuation discounts when interests in limited liability corporations (“LLCs”), partnerships, and corporations are transferred among family members. This restriction will apply to interests in both active business entities and passive investment vehicles. And that could mean a bigger tax bill for you and ultimately less wealth passed to certain family members.

Background

Depending on your individual situation, one way to reduce estate or gift tax liability (and thus preserve more of your hard-earned assets) is to transfer partial interests in a family-owned entity to family members. What makes this particular way to transfer wealth special is that current rules let you discount the value of those transferred interests. The most common of these valuation discounts relate to minority ownership and lack of marketability.

A discount for minority ownership may apply when you own less than 50% of an entity. A minority ownership means you won’t have a controlling interest for voting purposes, you don’t manage the entity, and you can’t initiate a sale or liquidation of its assets. As a result, the interest is generally worth less than your proportionate share of the entity’s assets.

A discount for lack of marketability applies when there are legal or practical factors that reduce either the amount that a buyer would be willing to pay for the interests or the pool of prospective purchasers. These factors could include things such as contractual restrictions on ownership, a history of profits being retained in the business rather than distributed to owners, the holding of significant liquid assets by the entity, and certain restrictions on liquidation.

Combined minority and marketability discounts could range from 15% to 50%, depending on individual circumstances. Because of the discounts at stake, some owners of family-owned entities work with their tax advisors to purposely structure restrictions into their agreements to help support these discounts.

For example, let’s say Jane has a 40% minority interest in My Family Business, LLC (“MFB”). The operating agreement includes provisions that only allow sales to individuals who are “qualified investors” (based on SEC rules) and that limit distributions to 20 percent of profits. A qualified appraiser determines that all the facts justify combined valuation discounts of 40%. If the value of all of MFB’s assets is $1,000,000, Jane could transfer her 40% interest while being treated as transferring only $240,000 for gift tax purposes. This $160,000 discount could save $64,000 in transfer taxes.

What’s Changing under the Proposed Regulations

The proposed regulations the IRS released on August 2, 2016, would reduce or eliminate many valuation discounts for interests in family-controlled corporations, partnerships, S-corporations, and LLCs. These restrictions would apply regardless of whether the entity in question operates an active business or manages an investment portfolio.

That’s because the government’s point of view is that taxpayers are using these discounts as a way to “understate the fair market value of their assets for estate and gift purposes”, according to Mark Mazur, assistant secretary for tax policy at the Treasury Department. The government doesn’t want people to use this “tax loophole”, as Mazur puts it, to avoid intergenerational wealth estate, gift and generation-skipping transfer taxes.

The proposed regulations aren’t final yet. A public hearing is scheduled for December 1, 2016. This will offer an opportunity for the public to convince the IRS that valuation discounts serve a valid purpose and that the regulations should change to reflect that. However, since the IRS has been talking about these regulations for many years, many experts expect them to be finalized with or without some changes. Any regulations that are finalized will be effective on the date when they are published in final form.

What to Do Now

Because the outcome of these proposed regulations is very much up in the air – and the changes could be costly – individuals looking to transfer interests of family-owned corporate entities to family members are encouraged to look into doing so sooner rather than later. That way, they can still take advantage of the current rules governing valuation discounts.

Do these new proposed regulations have you wondering about your estate plans, what options are best for you and your business, and when you should make the move to transfer interests? What discounts might apply to the assets you currently own? If you reach out to Gustavo Perez on Cherry Bekaert’s Valuation team, you’ll be able to ask him and team members questions about your specific situation. You can also contact Michael Kirkman, CPA, National Leader of Estate, Gift and Trust Services.