Denha & Associates, PLLC Blog

Make Your Gifts Now Because Proposed 2704 Regulations May Cause A Damper On Your Estate Plan

By: Randall A. Denha, J.D., LL.M.

Individuals who are considering gifting their interest in a closely-held business entity may want to consider making such gift sooner rather than later in light of the proposed regulations issued by the IRS on August 2 regarding valuation for estate and gift tax purposes of certain transferred assets. This subject was written about by me in November of 2015 with the warning that the IRS wanted to limit certain opportunities for transfer.  That day is here.

On August 2, 2016, the United States Department of the Treasury (the “Treasury Department”) issued broad and sweeping Proposed Regulations under Internal Revenue Code § 2704 which, if enacted, would significantly limit the ability of families to utilize valuation discounts for transfers of closely-held corporations, partnerships, and limited liability companies. In effect, these new rules prohibit the use of certain discounts customarily applied when valuing interests in family-controlled entities, such as corporations, partnerships and limited liability companies. Clients frequently employ estate planning techniques designed to take advantage of these valuation discounts to shift wealth to younger generations in a tax-efficient manner.

Under current law, individuals can increase the amount of wealth they shift to their family members by utilizing valuation discounts on transfers of closely-held enterprises. This is accomplished, in part, by transferring (during life or at death) minority and non-voting interests to other members of the family. Because each family member receiving the ownership interest lacks control of the entity, the value of each such interest is reduced to reflect that lack of control. In addition, the value of each minority interest is further reduced because it is not freely marketable – there is a limited market for selling a minority or non-voting interest in a closely-held entity. When combined, these discounts for lack of control and lack of marketability significantly reduce the value of the asset for estate and gift tax purposes. However, because all (or almost all) of the ownership interest remains within the family, the family retains control over the entity and could theoretically enjoy a value greater than the discounted value.

The current strategy of transferring discounted interests in a family-controlled entity typically enables more overall wealth to be transferred to heirs, free of estate taxation. As an example, instead of passing only $10.9 million worth of actual value with the $10.9 million exemption (for 2016), it is far better to pass $15.5 million of interest (reduced by a 30% valuation discount), thereby “squeezing” more value through the $10.9 million exemption portal. In effect, less of the taxpayer’s gift and estate tax exemption is utilized when transferring a discounted value of interest, leaving more exemption remaining to apply to subsequent transfers. As such, these valuation discounts serve to potentially reduce the taxable value of the estate.

An additional example is worth noting.  It has long been accepted that a gift of a minority interest in assets, such as real estate or a business, is not worth a proportionate share of the full market value of the asset, due to the lack of control of the whole asset and lack of a viable market for a sale of that fractional interest to a third party. This has resulted in appraisals at 20, 30 and even higher percent discounts from the value that would be attributable to the value of the whole asset. Lower appraisals reduce the estate and gift taxes paid on the transfer. If the proposed changes become permanent as written, taxes on these assets will increase.

The Treasury Department has long targeted valuation discounts for lack of control and lack of marketability, particularly when they occur in the context of intra-family transfers. The Treasury Department, however, has been largely unsuccessful in the court in its attempts to challenge the discounts.  Now, with the proposed regulations, the Department of Treasury has limited, if not entirely eliminated, the availability of the discounts for lack of control and lack of marketability where there is an intra-family transfer. Should the proposed regulations be enacted, an individual could no longer discount for transfer tax purposes the value of an ownership interest as part of an intra-family transfer of a closely-held entity. Thus, individuals who wish to transfer ownership of a family business to other family members will face greater exposure for estate and gift tax liability.

Despite the potentially significant impact of these proposed changes, it should be emphasized that nothing has yet been enacted. There is a 90-day period during which the public may submit written comments on the proposed regulations, followed by a public hearing on December 1, 2016. The final regulations will then be published sometime thereafter, but it is unclear how long that may take. The final regulations could also be different from the proposed regulations. Moreover, many commentators view the proposed regulations as exceeding the authority of the Treasury Department and, thus, subject to court challenge.

This potentially leaves a very limited window of opportunity to structure tax efficient transfers under current law. The time to act is NOW.