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Matthew Litz, CPA

New Proposed Rules Limit Valuation Discounts for Family-Controlled Entities

2016-09-06

The IRS recently issued new proposed regulations that may significantly limit the ability to use valuation discounts when transferring interests in family-controlled entities. While the proposed changes appear limited in scope, they could have far-reaching impacts on both family-controlled entities and estate planning.

Valuation discounts have become common practice when transferring interests in a family-controlled entity as an important part of estate and gift tax planning. Using valuation discounts enables significant wealth to be moved within a family at a discounted value when a fractional interest in the family-controlled entity is transferred. This allows any potential gift or estate tax liability to be reduced.

  • There is a strong consensus amongst tax practitioners that the proposed regulations, as drafted, will significantly limit the availability of valuation discounts when transferring interests in family-controlled entities.
  • Before these rules become final, the IRS will consider comments and has scheduled a public hearing on December 1, 2016. Thus, final regulations will likely not be effective until after 2016.

How do valuation discounts work?

For gift and estate tax purposes, the Internal Revenue Code generally requires an interest in a family-controlled entity to be valued at its fair market value at the date of transfer (or date of death in the estate tax context). When a fractional interest in a family-controlled entity is transferred, valuation discounts may be available for lack-of-control and/or lack-of-marketability of the transferred interest.

The rationale for the lack-of-control discount is the inability of the minority interest holder to exercise rights generally afforded to the holder of the controlling interest in the entity. With respect to the lack-of-marketability discount, an interest in an entity has more value if the interest is readily marketable, and an interest in a closely held entity may not have the same marketability as other investments.

In addition to control of the entity and current market factors, a valuation will look to restrictions in the entity’s governing documents and state laws regarding the control and transfer of interests in a closely held entity to effectuate these valuation discounts. When a fractional interest in a family-controlled entity is transferred to family members, these factors are relied upon, in part, to come up with a discount used to reflect the fair market value of the interest in the entity at the date of transfer. Valuation practice, and the marketplace for transactions, have demonstrated time and again that a minority interest in an entity is worth less than its pro-rata portion of the entire enterprise.

Because gift and estate taxes are computed based on the fair market value of the gifted assets or assets included in an estate, the transferor of an interest in a family-controlled entity may use these valuation discounts as part of an estate plan to minimize the amount of gift or estate tax that may ultimately be due by the transferor or the transferor’s estate.

What are the proposed changes?

The proposed regulations appear to significantly limit the availability of lack-of-control and lack-of-marketability discounts when transferring interests in family-controlled entities. The proposed rules target transfers to family members and liquidations of family-controlled entities. Some of the pertinent provisions in the proposed regulations include the following:

  1. Lapse of Certain Rights
    Under the current regulations, when there is a transfer of an interest in a family controlled entity any lapse of a voting or liquidation right is not taken into consideration when valuing the interest. Thus, the full value of the interest (before the voting or liquidation lapse) is taken into consideration for gift and estate tax purposes. There is, however, an exception within the current regulations providing that a transfer resulting in a loss of a voting or liquidation right will not be deemed a lapse if the rights with respect to the transferred interest are not restricted or eliminated.

    Under the proposed rules, if there is a transfer of an interest in a family-controlled entity that occurs more than three years before the transferor’s death then the exception included in the current rules, as noted above, will not apply. Thus, any transfer within three years of the transferor’s death that results in the transferor losing a voting or liquidation right will be considered a lapse of such right under the proposed regulations, regardless of whether the voting or liquidation rights of the transferred interest were restricted or eliminated.
    This rule appears to aim at curbing deathbed transfers. The IRS, it seems, expects that a transfer of an interest in a family-controlled entity should have a subsequent meaningful economic impact on the transferor.
  2. Liquidation Restrictions
    The current rules indicate that certain restrictions on liquidation included in a family-controlled entity’s governing documents are ignored for purposes of a valuation. The rules provide that a restriction on liquidation included in the governing documents of a family-controlled entity is ignored if the restriction is more restrictive than the restrictions on liquidation as provided under relevant state law.

    Under the proposed regulations, restrictions on liquidation included in the governing documents of a family-controlled entity appear to be ignored regardless of the relevant state law. Thus, the proposed regulations significantly limit the ability of a transferor to use these restrictions when determining a valuation discount.
  3. Disregarded Restrictions
    The proposed regulations create a new class of restriction that will be disregarded (or ignored) for valuation purposes, described as a “disregarded restriction.” A disregarded restriction includes a restriction that: (1) limits the ability of the holder of the interest to liquidate the interest; (2) limits the liquidation proceeds to an amount that is less than the interest’s share of the net value of the entity on the date of liquidation or redemption; (3) defers the payment of the liquidation proceeds for more than 6 months; or (4) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.

    As a result of these proposed rules, for valuation purposes the owner of an interest in a family-controlled entity is treated as having the right to redeem or liquidate his or her interest for a respective share of the net value of the entity regardless of any contrary restrictions or provisions included within the governing documents of the entity. Furthermore, the interest holder is treated as having the right to payment of the net value within six months in cash or other property regardless of any contrary restrictions or provisions included within the governing documents of the entity.
  4. Straw Man Transfers
    The proposed regulations provide rules for determining when the transfer of an interest in a family-controlled entity to a non-family member will be ignored for purposes of computing control of the entity by the family.

    These rules are intended to eliminate planning techniques using a “straw man” (i.e., a non-family member transferee who has no ability to control his or her interest in a family-controlled entity) when computing family control of the entity.
  5. Family Attribution Rules
    The proposed regulations expand on the current family attribution of ownership rules used to determine family control of an entity.

Next Steps

Because of the departure from the economics of a minority interest, which fair market value is meant to approximate and the dramatic change to the family attribution rules contemplated, we expect that the final rules will be modified to clarify the scope of these changes. Then again, we never expected federal estate tax exemptions to climb in excess of $5 million per person. Rule changes are unpredictable.

Many commentators believe the proposed regulations are an overreach by the IRS and will be challenged if finalized in their current form. However, for anyone considering a gift or other transfer of an interest in a family-controlled entity, it may be prudent to consider completing the transaction before final regulations become effective.