New IRS Regulation Targets Valuation Discounts on Family-Owned Businesses

On August 4, 2016, the IRS published proposed rules that will have a significant effect on the valuation of family-owned businesses for estate and gift tax purposes. This proposed regulation targets valuation discounts applicable to minority ownership interests in family-owned corporations, partnerships, LLCs and other entities. These family-owned entities have historically benefited from valuation discounts resulting from voting or liquidation rights that lapse at the time of the decedent’s death and restrictions on the sale or transfer of the ownership interests.

The loss of these estate planning options will increase the tax cost of transferring interests in family-owned businesses.

Background

The IRS cited the result of the case of the Estate of Harrison v. Commission as the need for the new regulations. This case involved a decedent and two of his children who each held a general partnership interest in a partnership before the decedent’s death. Each general partner had the right to liquidate the partnership, but this right lapsed on the death of that partner. This provision benefited the estate by reducing the value of the decedent’s partnership interest at the time of his death. When estimating the value of a business interest, the inability to quickly convert or liquidate that interest into cash resulted in a discount to the fair market value of that ownership interest. As a result, the Court determined the value for transfer tax purposes of the decedent’s partnership interest to be worth less than it was just prior to his death due to the lapsed liquidation right.

In addition, the proposed regulations also aim for restrictions that limit the owner of a family-controlled entity to require the entity or other owners to buy out that owner. Currently, a majority family-owned entity can adopt provisions that, as described by the IRS, “effectively limits the ability to liquidate, but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or the transferor’s family, either alone or collectively.” The liquidation restrictions resulting from such provisions have historically resulted in valuation discounts as well.

Effects of Proposed New Regulations

The new regulations seek to limit or completely disregard the above commonly used estate planning techniques. The lapse of a voting or liquidation right in a family-owned entity would now be treated as a transfer by the person holding that right immediately before his or her death. The regulation also amends a provision that exempts such a transfer if the rights with respect to the transferred interest are not restricted or eliminated. The proposed regulation denies this exemption for transactions occurring within three years of the decedent’s death for circumstances in which the entity remains in the control of the family (i.e. the gifting of a controlling interest to a child). If this exemption is denied, the value of control over liquidity is deemed to have occurred at the time of the individual’s death and be included in the transferor’s estate.

The IRS will also disregard all restrictions on liquidity except those mandated by federal or state law in determining fair market value. The ability of non-family owners to block the ability of family members to remove provisions will also be disregarded unless the non-family owners own a substantial interest and have the right to be bought out within six months for cash or property. Finally, any discounts based on a transferee’s status as an assignee will be eliminated.

Final Rules Pending

A public hearing is scheduled for December 1, 2016 and it is possible that certain changes could occur. The new rules will take effect 30 days after the final rules are published.

However, since the regulations include a three year test, it may be possible for transfers occurring before the effective date to be caught by the new rules.

We recommend clients begin planning for these changes immediately. Please contact Tax and Consulting Partner Catherine Marchelletta to discuss individual planning options.