Media Type: Alert
Update: The U.S. Treasury Department has recommended withdrawing the proposed regulation under I.R.C. Section 2704. Under the current law, which will remain in place, when transferring a non-controlling interest in a closely held business (such as a limited liability company or partnership), the interest being transferred may generally be discounted for transfer tax purposes.
On August 2, 2016, the Treasury Department released proposed regulations under I.R.C. Section 2704 that could severely impact wealth transfer techniques currently utilized as part of estate planning. If finalized, these regulations could eliminate many valuation discounts that currently exist when valuing transfers of an interest in a closely held (or family-owned) business for estate, gift and generation-skipping transfer tax purposes. In particular, the proposed regulations disregard certain key factors that support valuation discounts in determining the “fair market value” of interests in these closely held businesses. Although the Treasury has threatened to curb discounts in the past, the impact of these regulations appears to be much more significant and widespread than was anticipated.
Under current law, when transferring a non-controlling interest in a closely held business (such as a limited liability company or partnership), the interest being transferred may generally be discounted for transfer tax purposes. From a practical perspective, this makes sense because a buyer is unlikely to pay full value for a non-controlling interest that is also not readily marketable. To reflect the fact that such a buyer would likely pay less for the interest in the open marketplace, current law allows the interest to be valued with a “minority discount” based on the dual concepts of a lack of control and marketability (that could range from 25-35%or even higher). In the context of closely held businesses, the use of these discounted values has enabled owners to effectively shift ownership interests to other family members (whether by gift or sale) while also removing the future appreciation in the transferred business interests from the transferor’s taxable estate.
For purposes of illustration, assume that a father transfers property with a value of $500,000 to a Limited Liability Company (LLC). Further assume that the father gifts each of his two children a 20% interest in the business and retains ownership of the remaining 60%. The fair value of each gifted interest is $100,000, but, due to the fact that the transfer involves a minority interest and the interest cannot be sold to anyone outside of the family (assuming the operating agreement restricts transfers to anyone other than family members), the father would likely be able to discount the gifted interests. Using a 30% discount, he could gift interests with a “fair value” of $100,000 to each child at the discounted “fair market value” of $70,000 for gift tax purposes. As a result, again for tax purposes, he could remove assets potentially worth $200,000 from his estate but only utilize $140,000 of his lifetime gift tax exemption. In addition, he, and his spouse (if married), would each be able to apply their federal gift tax annual exclusion amount of $14,000 to the transfer, to the extent they are not already utilizing it in connection with other gifts.
Under the proposed regulations, the IRS would subject many of these intra-family transfers to a new valuation standard that would eliminate many of the discounting opportunities currently available. Many professionals initially believed that the IRS designed these regulations to target passive entities (such as investments with only marketable securities). However, it appears that the proposed regulations will apply to active businesses as well. Moreover, although Section 2704 refers only to corporations and partnerships, the proposed regulations would affect valuation discounts applied to transfers of interests in all corporations and partnerships as well as other closely held business arrangements, such as LLCs.
A public hearing is scheduled for December 1, 2016, following which the proposed regulations may be revised or finalized. In light of the breadth of the proposed regulations, legislation to void these regulations has already been proposed in both the U.S. Senate and House of Representatives. As a result, the full impact of the proposed regulations remains unknown and we anticipate that, at the earliest, the regulations will not become final until sometime in 2017.
In any event, the proposed regulations, if finalized, would substantially limit the discounts available to closely held businesses for transfer tax purposes thereby increasing the tax cost of transferring interests in closely held entities. Our hope is that the impact will become clear between now and mid-December 2016. In the meantime, we recommend that clients considering transfers of closely held business interests act promptly to determine whether to proceed with the transfers before the regulations are finalized.
Even if you are not contemplating transfers of business interests at this time, a review of your existing business related documents and overall business succession plan can address whether they require any other modifications or updates based on recent changes in your business or the law. For questions regarding your family owned business(es) or other personal estate planning questions, please contact a member of our business department or estates and trusts department at 301-340-2020.
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