The ability to take valuation discounts on the transfer of an interest in a family business for estate, gift and generation-skipping transfer tax purposes would be drastically limited under long-awaited proposed regulations from the Treasury Department.
The most impactful element of the proposal bars any significant discount for lack of control or lack of marketability associated with the transfer of an interest in a family-controlled entity.
If the regulations are finalized as written, the tax cost for transferring interests in such businesses will be substantially higher.
The rules would apply to family-controlled corporations, partnerships, limited liability companies (LLCs) and other similar entities.
Under current rules, transfers of interests in family businesses may be discounted due to lack of marketability and lack of control. The idea is that if you give a percentage of interest in your business to your child, it should be discounted because your child wouldn’t be able to immediately sell his or her interest to someone else for the same amount. Discounts of this nature can yield significant tax savings.
For example, assume three siblings inherited an equal third of their parents’ business and now one of them wishes to transfer her third to her children. Assume if the business was liquidated or sold, the value of her one-third interest would be worth $5 million.
If a combined 30 percent discount for lack of control and lack of marketability were applied to the business interest, then the value of the gift would be $3.5 million. If the regulations become final and eliminate discounts, then the value of the same gift would be $5 million. At a 40 percent gift and estate tax rate, the impact of the elimination of discounting on this family would be $600,000 in additional tax.
As a result of the proposed changes, if you’ve been thinking of doing such a transfer involving a family business for estate planning purposes, it’s critical to consider doing it now, before the regulations become final.
What’s the timing?
The proposed regulations were issued in early August and a public hearing about them was scheduled for December 1. Generally, the rules go into effect on the day they are published in final form, although certain portions will be effective for transfers occurring 30 or more days after the date of publication.
While it’s unclear exactly when that will be, the rules aren’t expected to be finalized until sometime in 2017. Still, you should act soon and contact an estate planning lawyer if you want to take advantage of the discounts under current law before then.
Could the rules be retroactive?
Even if you make transfers now, though, there is one new rule in the proposal that might have a retroactive effect. The so-called “three-year rule” in the proposed regulations may prohibit certain discounts taken for transfers made within the three years before the transferor’s date of death.
That rule would apply to transfers that result in the transferor losing a liquidation right. That means that if a transfer is made soon to take advantage of the current rules on discounts — or if the transfer has already been made — the discount might be lost if the final rules go into effect and the person who transfers the interest dies within three years.
The same rule would also apply to measure any gift component of a transfer that has been structured as a sale. Therefore, discounts on gift tax elements of such transfers could also be caught by the three-year rule.
Are there other significant changes?
The proposed regulations are lengthy and some of the applications are still unclear.
But it’s important to be aware of one new section of the rules that could have a big impact. That is the creation of a new set of “disregarded restrictions.”
These restrictions would be “disregarded” when valuing the transferred interest for estate or gift tax purposes in any family-controlled entity.
They include any provision that limits the ability of a holder of an interest in a family-controlled entity to compel liquidation or redemption.
For valuation purposes, that means the new rule would assume that someone who holds an interest in a family-controlled entity has the right to liquidate or redeem the interest for its pro rata share of the net asset value in cash or other property payable within six months of exercise.
Under the rules, “disregarded restrictions” will be disregarded if they lapse after the transfer, or if the transferor or the transferor’s family may remove or override them.
With respect to restrictions that will be ignored for valuation purposes, the new rules no longer focus on those that are more restrictive than the relevant state law rules, but instead will affect virtually any restriction that limits the ability to liquidate.
Through public comments and a hearing, the rules will continue to be debated and discussed before they become final. To understand the possible application to your family business, contact an estate planning lawyer.