Valulation Discounts Disappear for Family Owned Business
The IRS has issued proposed regulations that will almost entirely eliminate discounted values for any family owned business interests sold, gifted or bequeathed next year. A window of opportunity exists to complete these transfers by years end.
History of 2704 RegsFor many years now, courts have upheld discounted valuations of closely held business interests, and tax planners have relied on those court cases for business and estate planning. These valuation discounts included discounts for lack of marketability, lack of control, lack of liquidity, etc. When a qualified appraisal of the business assets and qualified business valuation was done, the discounts often reduced the value of transferred interests by 30% or more. This created large savings for sales to family members, or for gift and estate taxes.
Effect of Proposed RegulationsThese new proposed regulations sweep away many of the prior court holdings, eliminating most if not all discounted valuations for any business enterprise interest. If you are doing, have done or contemplate doing any business interest transfer, including gifts, sales and bequests to family members, or to trusts for family members, or to entities owned by family members, these regulations could impact your valuations for the transfers.
Essentially, all business and investment endeavors, either registered in the state of formation or "for profit", are covered by these proposed regulations. Active businesses are included along with "passive" investment entities. Tenants in common ownership and joint ventures can be included. Any such business interest is included unless non-family members own at least 20% of the total value of the business, one non-family member owns at least 10%, the member can "put" their interest for a pro-rata asset value and the transfer was completed at least three years before the transferor's death.
Once the proposed regulations apply, discounted values are not permitted for any contractual or state statutory restrictions, loss of rights on transfer, and more. The rights lost on transfer might include voting or liquidation rights, so all 'assignee' interests which don't have full ownership rights, restrictions imposed on a transferee, and minority interests receive no discounts. Colorado state law, and many other state statutes, provide transfer, voting and other restrictions that have been used as the basis for discounted values under the prior law. These will now become ineffective under the proposed regulations. Your operating agreement, buy-sell or shareholders agreement will also be ineffective to support discounted values. Family members' ownership is aggregated for control purposes, so a father making a gift or sale to a son and a daughter, or trusts for these children, yields the same ownership before and after the transfer, removing all minority discounts for gifts of a controlling interest to multiple parties.
IRS AuthorityThere is some discussion by high level estate and tax advisors that the proposed regulations are unconstitutional, or exceed the IRS's regulatory authority. Even if that is shown to be the case, it will take years for a case to make its way to the Supreme Court and overturn these proposed regulations. In the meantime, anyone valuing a business interest in conflict with these proposed regulations for any transfer occurring after 2016 can expect an audit and assessment of unpaid taxes, with penalties and interest.
ConclusionTherefore, if you have any interest in a family owned or controlled entity for which you have considered making a gift or sale of some or all of those interests for business succession or estate planning purposes, you should proceed immediately so the transfer can be completed before these proposed regulations become final and effective. If you planned to bequeath a business interest to your heirs, you might want to consider making a partial gift or sale now to your spouse or heirs, or to a trust for them, to utilize both the current valuation discount rules and the current $5.45 Million per donor lifetime gift tax exemption (which may also be in jeopardy after the election).
DisclaimerThis Article is published for general information, not to provide specific legal advice. . Nothing in this article is or is intended to create an attorney-client relationship or be legal advice. The application of any ideas discussed in this article to any reader's particular situation requires knowledge and analysis of the specific facts involved, so a qualified tax professional should be consulted for any such application.