Proposed Rules Threaten Valuation Discounts for Family Businesses

But there is still time to act before they’re gone

The U.S. Treasury Department and the Internal Revenue Service recently issued proposed tax regulations prohibiting valuation discounts for transfers of interests in family-controlled entities.  For many business owners, the elimination of discounts would significantly increase their estate and gift tax exposure.

There likely is only a brief window  to gift or sell business interests at a discount before the regulations are finalized and become effective. Don’t miss out on this opportunity, which could save you and your family thousands or even millions of dollars in estate and gift taxes.

What are valuation discounts?

When an individual, during life or at death, transfers an interest in a business entity (corporation, partnership or LLC) to family members or to trusts for their benefit, that interest must be valued for gift or estate tax purposes. If the value of the gift or the individual’s estate is high enough, gift or estate taxes are assessed at a 40% rate.

When calculating the value of a non-controlling interest in an entity, business appraisers have been permitted to take into account restrictions on the owner’s ability to sell or liquidate his or her interest. Such restrictions typically result in the appraiser applying “discounts,” thus reducing the estate or gift tax value of the interest.

For example, using a hypothetical valuation discount of 25%, a 40% interest in a business valued at $25 million might be valued at $7.5 million after discounts, rather than $10 million. The difference of $2.5 million would reduce the tax base, which could save the transferor or his estate up to $1 million of estate or gift taxes.

What do the regulations say?

The proposed regulations are very broad. They would eliminate virtually all valuation discounts for all family-controlled entities – investment holding companies, such as family limited partnerships, and active businesses. However, the regulations will not be effective until after they are finalized.

For the next few months, the Treasury Department will accept written comments from the public, culminating with a public hearing on December 1, 2016. Thereafter, Treasury could release final regulations at any time, with the regulations to become effective 30 days later.  Thus, there is a window through at least the end of 2016 during which discounts may still apply to gifts and sales of entity interests.

Will the elimination of discounts render gifts and sales of family business interests obsolete?

No, even after the regulations become effective, there will still be benefits to gifting or selling family business interests. Valuation discounts are rarely the primary reason or benefit.

Other reasons may include incentivizing family members to learn and grow the business and having them participate in the economic benefits of the business. Furthermore, transfers of business interests can yield significant estate tax savings, even without discounts, by removing future appreciation and income from the transferor’s estate. Moreover, if the transfer is to a “grantor trust,” the transferor can remove additional assets from his or her estate by paying income taxes on the trust’s behalf.

However, there is a clear benefit to acting now. For gifts and sales of business interests occurring before the regulations become effective, you may be able to obtain the foregoing benefits as well as the tax savings achieved by valuation discounts.

What should you do?

If you own an interest in a family-controlled entity, contact your estate planning or tax advisor immediately to discuss how you might benefit from transferring your interest before the regulations become effective.