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On August 4, 2016, the Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations addressing the valuation of certain business interests for federal estate, gift and generation-skipping tax purposes.
Set to drastically change how the value of an interest in a closely held corporation or family partnership (including LPs and LLCs) would be determined, the proposed regulations are intended to either significantly reduce or eliminate the use of valuation discounts on intra-family transfers.
If you’re a family business owner planning to transfer wealth to family members, now is the time to do so to take advantage of any applicable valuation discounts currently allowed.
Under the current laws and regulations, when a family business owner transfers an interest in a closely held business to another family member, the value of the transfer is recorded at fair market value. As described by the IRS, fair market value is defined as:
“the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”
When transferring a fractional interest in a family held business, the value of the business is often reduced for certain allowable discounts. Commonly used discounts include a discount for lack of marketability, lack of control and lack of voting rights.
Taking advantage of these allowable discounts may reduce the value of the transfer for gift, estate, and/or generation-skipping taxes thus resulting in a lower amount of taxes owed. The proposed regulations would reduce or eliminate the use of these discounts.
The proposed regulations modify the existing regulation dealing with lapsing (i.e., disappearing) of voting and liquidation rights.
If a family member makes an intra family transfer and triggers the lapse of either a voting or liquidation right, the value of the lapsed right increases the value of the transferred interest. Ultimately, value is determined by comparing the value of the interest with the right over the value of the interest without it.
A liquidation right refers to the holder’s right or ability (including voting power) to cause the entity to acquire all or a portion of the holder’s equity interest, regardless if this would cause the termination of the entity. A liquidation right will lapse once it becomes restricted or is eliminated unless the right remains in force. For example, where a minority interest is transferred inter-vivos (during life) and the transferor still retains the voting power to liquidate the entity.
The proposed regulations retain this result with one modification. Any transfer made in conjunction with the death of the transferor will cause the right to lapse unless the transfer is made three years prior to the death of the transferor. The lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor’s death is treated as a lapse occurring on the transferor’s date of death and includible in the gross estate.
As proposed, the regulations will modify how to deal with restrictions on the ability to force a liquidation of an entity, as well as add a set of rules to establish a new type of restriction that will be ignored for valuation purposes, referred to as “disregarded restrictions.”
Restrictions on liquidation are defined as “applicable restrictions” which restrict an entities ability to liquidate. These restrictions are disregarded when they lapse upon the transfer of an interest or where they can be removed post transfer by the transferor or the transferor’s family. However, any restriction imposed by federal or state law generally does not fall within this definition.
Historically operating agreements and articles of incorporation have been relied upon to take advantage of this exception, so these rules were not triggered and discounts could be applied to the value of the transferred interest.
In order to change this result, the proposed regulations re-define the meaning of an “applicable restriction” to include restrictions imposed under the terms of the governing instrument, as well as local law, regardless of whether or not the agreement or law can supersede the other.
It also includes a new class of “disregarded restrictions”. These restrictions are deemed to have lapsed and are disregarded if the transferor, either alone or acting with other family members, has the ability to override or remove the restriction post transfer. As these restrictions will have been deemed to have lapsed upon the transfer of the interest they would not be considered in determining its value.
Clarifying the types of entities that would be covered, the proposed regulations states lapsing rights and regulations apply to corporations, partnerships, LLC’s, and other entities and arrangements that are business entities. This is true regardless of whether it is domestic or foreign, its classification for other federal tax purpose and if it is disregarded as an entity separate from its owner for other federal tax purposes.
Now open for public comment until Nov. 2, the proposed regulations are scheduled to be discussed in a public hearing on Dec. 1, 2016. Given the short time frame between the comment period and hearing, it is likely the IRS is pressing to finalize these rules prior to any new administration taking effect. These provisions will become effective upon the publishing of the final regulations with the exception of the newly defined “disregarded restrictions” provisions, which will go into effect 30 days after that date.
With the potential for such a profound impact on your estate it is important for family business owners to be aware the clock is ticking on valuation discounts as we know them. Start moving forward with business succession, estate planning and general wealth transfers before these proposed regulations take effect to minimize the impact the legacy you wish to leave behind.
By: Jason LeRoy, ASA, CVA, CFE – Shareholder, Litigation and Valuation Support Group
George Grzywacz, CPA, JD – Shareholder, Tax Group
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