New Proposed Regulations Impact Valuation Discounts for Transfers of Family-Owned Businesses

Last week the Internal Revenue Service (IRS) released proposed regulations under Internal Revenue Code Section 2704 (Section 2704) that impact the valuation of interests in closely held businesses for estate and gift tax purposes. As mentioned in our September advisor, these proposed regulations have been in the works for some time and will be the topic of considerable professional debate until (and perhaps even after) they are issued in final form. The technical details surrounding the applicability and authority of the regulations are complex, but summarized below are some highlights of the rule changes, effective time frame, and planning considerations.

Background

The Section 2704 statute indicates that when valuing the transfer of a closely held business interest to a family member, certain restrictions limiting the ability of an entity to liquidate are to be disregarded. The law also gives the IRS authority to issue regulations identifying other restrictions which should be disregarded for valuation purposes on intra-family transfers. The new regulations represent the IRS’ interpretation of the current law and creation of new valuation guidelines.

Key Changes

Modifying of the Definition of “Control”. Generally a person has control in an entity if they hold 50% of the equity. A person could also have control if they are a general partner in a limited partnership. The proposed regulations make clear that Section 2704 applies to corporations, partnerships and limited liability companies, even if the entity is disregarded for other tax purposes.

Clarification Related to Voting and Liquidation Rights. No lapse in a voting or liquidation right is deemed to occur where the transferred interest is deemed to retain that right by virtue of viewing the collective family ownership interests together. For example, where there is a gift of a 15% interest to a related party out of an ownership block of 60%, both the 15% interest and remaining 45% interest will be deemed to continue to have control and the ability to cause liquidation of the company. Therefore, when valuing the transferred interest for gift or estate purposes, no discount applies with respect to such rights. However, the new rules indicate that if a transfer is made within three years of death, then the lapse is deemed to occur at the time of death. Given the other changes in the regulations, the impact of this new three-year rule is not likely to be significant.

Disregarded Restrictions. In exercising its authority to define other restrictions which are to be disregarded when valuing intra-family transfers of business interests, the IRS identified several new guidelines. The net effect of these changes is to create a presumption for valuation purposes that the transferred interest possesses a “put” right – the ability to force the business to purchase the interest at a value representative of a sale of the entire business. This effectively eliminates minority or marketability discounts that would otherwise apply. Achieving this interpretation, the IRS has taken a very narrow view of the statutory scope limitation imposed by Congress. We expect further discussion and debate as to whether the IRS has over-reached its authority here.

Effective Date

The currently proposed regulations are subject to a 90-day comment period followed by a public hearing on December 1st. The new rules likely will take effect early in 2017. Most of the new rules will be effective 30 days after the regulations are issued in final form; therefore, previous transactions and even transfers made prior to the issuance of the final regulations should not be impacted.

Planning Considerations

These regulations increase the importance of finalizing any pending transfers of family business interests sooner rather than later to take advantage of the current valuation rules.  While there are plenty of wealth and succession planning transfer tools available even with the new rules in place, this window of opportunity should be carefully considered. While it is possible that certain aspects of these new regulations may be modified prior to final issuance or challenged in the courts, planning in advance will likely prove more effective and efficient.

Please contact us to discuss how we can help you achieve your estate and wealth transfer planning objectives.