The IRS has published proposed regulations concerning the valuation of family-owned businesses for estate and gift tax purposes that are potentially game changing. The sweep of these regulations is broad and encompasses both active family businesses and passive, investment-driven family enterprises that have primarily been created for wealth transfer planning purposes. Anyone with an interest in a family-controlled business of any kind needs to pay attention to these changes.
For many years, families whose fortunes exceeded the applicable estate tax exemption amount (currently $5.45 million) have tried to reduce the value of their estates for estate and gift tax purposes by utilizing planning techniques that take advantage of discounts available in the valuation of assets held by entities such as LLCs, partnerships or corporations. For instance, clients have been advised to create family limited partnerships or family limited liability companies and to transfer a portion of their assets to these entities. Then, clients are encouraged to make gifts of sufficient interests in the business such that they are left with a minority interest in the company and their children each also own minority interests. The gifts of the minority interests to the children are subject to valuation discounts such as minority discounts and lack of marketability discounts that reduce the “cost” of the gift for gift tax purposes. And then, when the client passes away, similar discounts are available to lower the estate tax value of the interest retained by the client. In this way, it is possible to reduce the value of the property passing subject to estate and gift taxes by 30-40% or more. For clients with active businesses, the same discounting techniques are available and often advisable.
The new proposed regulations may change the ability of family business owners, even of active businesses, to take discounts once the regulations become effective. Although there is some disagreement among commentators about the scope of the Section 2704 Proposed Regulations, there is some consensus that there is a significant risk that the discounts will simply disappear for family-controlled entities or, at the very least, become far less attractive as a planning tool.
The proposed regulations add a new three-year rule which would treat certain transfers which occur within three years of the death of the original transferor, like the plan described above, as a deemed transfer of the lapsed voting or liquidation power at the transferor’s death. This results in the value being included in the gross estate of the transferor. As a result, it seems that the discounts that otherwise would have been available on the transfer of minority interests are recaptured, and no discount is available for the minority interest that is retained. Additionally, the proposed regulations would deny the ability for discounts based on the status of a transferee as a mere “assignee” instead of being a full member of the business.
In addition to these roadblocks, the Service has proposed that certain restrictions be “disregarded” for valuation purposes. These would include the ability of a non-family member, such as a charity, to prevent the removal of the restrictions that would otherwise allow for discounts unless the non-family member meets certain criteria, including significant ownership interests for significant periods of time and the right to be bought out of the business for cash or property. The criteria are such that it is unlikely to be workable in practice. In addition, the proposed regulations state that restrictions that are not mandated by federal or state law are to be disregarded. This is particularly problematic, because most state statutes are not mandatory by nature. Rather, they provide default rules in many cases but allow the business entity to make choices for itself about liquidation rights, voting rights and many of the other important rights that affect the valuation of an ownership interest in a business entity.
The details of the proposed regulations are too extensive and complicated to cover completely in this newsletter. The proposed regulations will not be effective until 30 days after the regulations are finalized. There is a hearing scheduled in Washington, D.C. on December 1, 2016 to discuss the proposed regulations, and we expect that the regulations will not be finalized until sometime in 2017. We, therefore, have some time to take advantage of planning opportunities for discounts that may not be available next year. Of course, we do not know the scope of the three-year rule and exactly how it will be changed when the regulations are finalized. There is some risk that transfers made before the regulations are finalized may become subject to the regulations that will include the discounts taken into the estate of the transferor if the transferor dies within three years of the transfer.
The attorneys at the Hook Law Center are ready to meet with you to discuss your options, to review your operating agreements and to assist you in planning to meet the challenges posed by the proposed regulations. Furthermore, if transfers have already taken place, it may be important to discuss a plan for the payment of estate taxes on any amount added back to the gross estate. For all our clients engaged in active family businesses, business succession planning is always challenging; however, the proposed regulations do provide some safe harbor relief that must be investigated on an individual basis to determine what may work for your situation.
Ask Kit Kat – Reindeer Struck by Lightning
Hook Law Center: Kit Kat, what can you tell us about the reindeer in Norway that were killed on August 26, 2016 by a terrible lightning strike?
Kit Kat: Well, this is a very sad tale, indeed! 323 reindeer were struck by lightning in a hunting area of the Hardangervidda mountain plateau of central southern Norway on Friday, August 26. At those altitudes, the mountains are treeless, and the reindeer took the brunt of the lightning strikes. From a picture in the article which appeared in The Washington Post, it looked like something out of a science-fiction or horror movie. Deer were stopped in their tracks, and fell dead right where they stood. In some cases, this meant falling right on top of one another. Reindeer when grazing, cluster in herds, and this was quite a large herd. This is especially true during bad weather. A gamekeeper discovered them. He notified NTB, a Norwegian news outlet. In turn, experts were called in to take samples of the carcasses which were later sent to a state veterinary institute to officially determine the cause of death.
Unfortunately, animals being struck by lightning is not unheard of. Before this latest incident, the largest group of animals known to be killed by lightning was a group of 68 Jersey cows in Australia in 2005. And just this past March (2016), 21 cows in South Dakota were killed when they became electrocuted from their metal feeder, which was struck by lightning. Yet, some animals get lucky! A male bison in Iowa, who lives at Neal Smith Wildlife Refuge, was struck by lightning in the shoulder in 2013. He lives to this day, though he has a large, hairless patch where he was hit. His caretakers have fittingly named him “Sparky!” (Karin Brulliard, “A lighning strike killed 323 reindeer, and this is the ghastly aftermath,” The Washington Post, Animalia section, August 29, 2016)
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