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New Treasury Regulations Target Valuation Discounts

Jan 6, 2017 - Estate Planning by

“The biggest loophole in the gift and estate tax system is the uncertainty in value of the family controlled business entity”

A large percentage of high net worth estates consist of closely-held business entities. Many of these business entities are operating businesses, while some are holding companies for investment assets. When parents transfer partial interests in these entities to their children, the market value for gift tax purposes is often subject to valuation discounts for lack of control and lack of marketability. These discounts (often ranging from 25-40% of the full value of a controlling interest), reflect the inability of a minority owner to sell or otherwise liquidate the business interest. The Internal Revenue Service has fought such discounts fiercely for decades. However, the Courts have unanimously defeated the Service by ruling that such discounts reflect real market values. In 1992, the IRS surrendered to future attacks on the application of valuation discounts with a revenue ruling that opened the door for today’s valuation “loophole.”

However, the IRS has recently issued proposed regulations to close this loophole and are designed to greatly limit the valuation discounts of family businesses where the family maintains control. One of the main targets of the new regulations is the perceived abuse of manufacturing valuation discounts with deathbed transfers. Currently, it is possible for a parent with a controlling interest in a business entity to gift a small portion of such interest to a child (at a discount) to leave the parent with a minority interest in his or her estate at death.

The proposed regulations create a three-year look-back period which will include any transfers made within three years of death in the estate for estate tax purposes, thus eliminating any minority interest discount. Worse, such transferred interests will not qualify for a marital deduction or a charitable deduction, subjecting a “phantom” interest to the estate tax.

The new rules also create a new class of “disregarded restrictions” that will apply to all family controlled entities. Specifically, any restriction on the ability of a business owner to liquidate his business interest will be disregarded for estate and gift tax purposes. The new rules impose a deemed liquidation right, or put right, on a family member for valuation purposes but not for real world purposes. The right to liquidate any business interest in six months’ time for cash payment will be assumed for valuation purposes. The rules also disregard any value below a “minimum value”, stated as a proportional share of the net asset value of the business entity as a whole.

The proposed regulations are not expected to take effect until the second quarter of 2017, at the earliest. When or if they become final, or what they will contain, is uncertain. However, there is a window of time before these regulations become operative to take advantage of the oldest loophole in the transfer tax system. The conservative approach is to act now. Valuation discounts have always been the “icing on the cake” for business owners. The primary benefit of transferring family business interests is transferring any future appreciation on the business interest out of the estate to minimize estate taxes and protect assets from potential creditor risk.

If you have questions about these proposed changes and how they may affect you, contact Dan Peare or Hugh Gill.

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