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August 23rd, 2016
IRS Proposes Rules to Deny Estate and Gift Tax Discounts for Family Businesses
There's important news for family business owners and their heirs. On August 4, 2016, the IRS released proposed regulations to change significantly the valuation of family businesses. If adopted, the proposal would disallow discounts of family-controlled entities, including limited liability companies. It would have a broad impact on the planning and taxation of gifts and estates involving family businesses. Here's a summary of what you need to know.
For decades, the IRS and our courts have permitted the valuation of privately owned business interests to include a discount for lack of control or lack of liquidity. The discounts often range from 20% to 40%. They reduce the estate tax burden on the transfer of business interests at death when funds may not be available to pay the tax. The discounts also create greater flexibility to make gifts, so families can plan to reduce estate taxes through lifetime transfers that shift the burden to income taxes at lower rates. As a reminder, the Federal estate tax burden is 40% and state death taxes can increase the total burden to as much as 49.6%.
The proposed rules would apply section 2704 of the Internal Revenue Code to disregard minority and illiquidity discounts when family members own interests that control an entity and its liquidation. The rules would apply not only to corporations and partnerships but also to limited liability companies. Restrictions on voting or liquidation rights created by the governing documents and controlled by family members, and the lapse of those same rights, would be disregarded when valuing transfers during life or at death. In determining control, interests held by charities or other third parties of less than 10% individually and 20% collectively would also be disregarded. Any entity subject to the rules would have a "minimum value" based upon the property it owns, reduced only by liabilities allowable as estate tax deductions. In essence, the minimum value rule would require separate balance sheet entries to be reported as if directly held, while disregarding long recognized principles for determining fair market value.
Public comments on the proposed regulations must be submitted to the Treasury Department by November 2, 2016. (Comments may be submitted electronically via the "submit a formal comment" button at the top of this page.) A public hearing is scheduled for December 1, 2016. Then, the proposed rules may be revised to reflect the comments. The regulations become effective thirty days after final publication.
The new rules would apply only to transfers by gift or death occurring after their formal adoption. Importantly, most existing entities are not "grandfathered." The new rules would apply to existing entities subject to restrictions on voting and liquidation rights created after October 8, 1990. If the new rules are adopted, valuation principles that have been relied upon in the development of many estate plans will no longer apply.
The opportunity to use valuation discounts to manage and reduce the tax burden on family owned entities will continue for at least three to four months. If the new IRS rules are adopted in their present form, families will then have to consider alternative planning strategies to mitigate the estate and gift tax burden. For example, we expect the new rules to make minority co-investments an attractive planning technique, and to increase reliance on life insurance, deferral of estate taxes and gifting techniques that are not solely dependent upon valuation discounts, such as Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs).
If you have questions about the proposed rules or about other estate and tax planning matters, please contact Barbara Shiers at (212) 826-5526 or firstname.lastname@example.org, Linda Wank at (212) 826-5546 or email@example.com, or any other member of the Frankfurt Kurnit Estate Planning and Administration Group.
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