On August 2, 2016, the Treasury Department issued proposed regulations under Section 2704 of the Internal Revenue Code. The proposed regulations, if adopted in their current form, essentially will eliminate all minority discounts or lack of control discounts and lack of marketability discounts for transfers between family members of interests in family-controlled businesses.
The proposed regulations accomplish this result in complex ways. But here are some points to consider as you decide whether to act quickly.
- The regulations are “proposed.” This means that they are not currently in effect. The Internal Revenue Service has scheduled a public hearing on the regulations in Washington, DC on December 1, 2016. They take effect when the IRS announces that they are “final.” Thus, these regulations could take effect shortly after the hearing, sometime in 2017, years from now, or never (in theory). The IRS may change the regulations in meaningful ways before adopting them as final.
- These proposed regulations have stirred up more conversation and interest than any regulations in recent memory. One Representative has even introduced a bill in Congress to block their adoption. One would assume that the IRS would take its time to consider what likely is to be a flood of written and oral comments submitted at the hearing. But there really is no way to tell.
- If adopted “as is,” the regulations will eliminate virtually all discounts for family-controlled entities, whether active businesses or not, for gift, estate and generation-skipping transfer tax purposes. Transfers of even small interests in family businesses would be valued for all of these purposes at the “going concern” value of the entire business, multiplied by the percentage interest gifted by the donor or owned by the decedent. In the case of more “passive” family partnerships or limited liability companies owning real estate or securities, the value of the entity would essentially be its net asset value (i.e., the value of the underlying assets of the entity less liabilities).
- The rules apply to gifts made and to estates of decedents dying after the regulations become final. But shareholders agreements, partnership agreements and LLC operating agreements created before the final regulations are still subject to them. Therefore, such agreements structured to produce discounts on gifts or transfers at death of interests in the businesses still are affected by these rules.
- In certain circumstances, even gifts made before the effective date of the regulations are subject to them if the donor dies less than three years after the date of the gift (in essence causing them to be included in the donor’s estate at an undiscounted value).
- The proposed regulations do not expressly apply to transfers of undivided interests in real estate, but they imply that if under state law, a tenancy in common interest in real estate would be treated as a partnership, these rules would apply to such transfers.
- The proposed regulations make it significantly harder to avoid these rules by having non-family members own a portion of the entity.
- If interests in the business are already spread among extended family members in the second or third generation, these rules may not apply.
As a basic example of how the regulations could affect you: assume that X previously formed an LLC with $10 million of assets. X gifts a 20% LLC membership interest to a separate trust for the benefit of each of X’s three children. An independent appraiser applied a 30% discount to each of the gifted interests in the LLC.
Under current law, each gift would be valued at $1,400,000 ($2,000,000 less 30%). Similarly, the remaining 40% of the LLC held by X at X’s death would be a minority, non-marketable interest, included in X’s estate at $2,800,000 ($4,000,000, assuming for simplicity that the LLC didn’t change in value between the gifts and X’s death, less a 30% discount). The entire entity was transferred by gifts and bequests at a total value of $7,000,000. This saves gift and estate tax of $1,200,000 (40% tax on the $3,000,000 entity value never taxed because of the discounts).
However, under the proposed regulations, both the gifts and the 40% remaining in X’s estate would be valued at the net fair market value of the assets of the LLC multiplied by the percentage gifted or the percentage remaining in the estate. The full $10,000,000 of asset value would be taxed; there is no $1,200,000 savings.
Similarly, if X wanted to sell, rather than gift, LLC interests to X’s children, the sale price would be undiscounted as well. The additional cash flow needed to service a loan could adversely affect the viability of the transaction.
If you have any questions about the impact of these regulations or want to implement a transaction before the regulations become final, please contact us.