Estate Valuation Discounts

Texas Firm Logo - Star

Last month, the Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations under Section 2704 of the Internal Revenue Code which, if adopted, would significantly limit valuation discounts when valuing interests in family-owned entities for transfer tax purposes (i.e., gift, estate, and generation-skipping transfer taxes). For example, these new regulations would make it very difficult, if not impossible, for taxpayers to claim valuation discounts for gifts of family limited partnership interests to family members. A public hearing on these proposed regulations is scheduled for December 1st and the proposed regulations could become final and effective as early as the end of December 2016, although a later effective date is more likely.

Background

Taxpayers have traditionally relied upon valuation discounts (for lack of control and lack of marketability) when making gifts of closely-held business interests to family members (or to trusts for the benefit of family members). A buyer of an interest in a business will often demand a price reduction (i.e., a "discount") because the buyer would not have control over the business' operations, no ability to liquidate the interest, and no ready market to re-sell the interest. The application of these discounts - typically between 20% and 40% - reduces the value of these interests for transfer tax purposes, thereby permitting taxpayers to transfer more value for the benefit of their families at a lower transfer tax cost.

In 1990, Congress enacted Section 2704 with the purpose of reducing the availability of valuation discounts in valuing interests in family-controlled entities for transfer tax purposes. Section 2704 provides special rules for valuing transfers of interests in corporations and partnerships subject to lapsing voting or liquidation rights and restrictions on liquidation. Such rights and restrictions are to be ignored for valuation purposes when the interests are transferred to a family member. Since the enactment of Section 2704, however, several U.S. Tax Court decisions, state statutes, and estate planning techniques have limited its application.

Now, the Treasury Department and the IRS seek to correct what they believe are flaws in the current rules and to further curtail the availability of valuation discounts by amending and expanding aspects of Section 2704. The general effect of the proposed regulations would be to prevent the undervaluation of transferred interests in family-controlled entities for transfer tax purposes.

The scope of the proposed regulations is broad. The proposed regulations would apply (1) to all entities including corporations, partnerships, limited liability companies, and other businesses or arrangements, with no distinction made between operating businesses and passive entities (in contrast, currently the restrictions under Section 2704 apply only to partnerships and corporations); (2) when the family of the transferor "controls" the entity (by owning 50% or more of the company or if the family members, in the aggregate, would have the power to cause the company to liquidate); (3) when an interest in the entity is transferred to or for the benefit of family members; and (4) for the purposes of valuing the interest transferred for tax purposes. Further, while the proposed regulations will not be effective until they are finalized, a new "three-year rule" might apply to transfers made before the effective date if the transferor dies after the effective date but within three years of making the initial transfer.

If enacted in their current form, the regulations would prohibit any meaningful discount for lack of marketability or lack of control in connection with the transfer of an interest in family-controlled entities. As a result, taxpayers who are contemplating transferring an interest in a family-controlled entity to family members during their lifetime or at death will face greater possibility for gift and estate tax liability.

Immediate Planning

In light of the above, we encourage you to contact our office to determine if the proposed regulations might impact your business succession and/or estate plan. We especially recommend you contact us if you are considering transferring interests in family-controlled entities to family members or freezing the value of such interests, if you are holding interests in family-controlled entities or considering the formation of family-held entities, if you have a need for business succession planning, and/or if your estate is subject to the imposition of the estate tax. We would be happy to discuss options for the tax-efficient transfers of interests in your family-controlled entities utilizing current valuation rules before the proposed regulations become final.