Estate and Gift Tax Update: Proposed Regulations for 2017 will Significantly Impact Valuation of Family-Controlled Businesses

The Treasury Department has proposed new Regulations that will severely curtail the use of valuation discounts for transfers of interests in family-controlled entities. If the Proposed Regulations go into effect as written, they will have a significant impact on estate planning for owners of family-controlled corporations, partnerships, limited liability companies, and other business entities.

For many years, valuation discounts have been used to reduce the gift and estate tax consequences of transfers of family-controlled businesses. The value of interests in a family-controlled business is often subject to lack of control discounts (also referred to as minority interest discounts) and lack of marketability discounts because of restrictions imposed on, or that occur as a result of, transferred interests. For example, the holder’s inability to force a distribution or liquidation and/or to sell or transfer the interests is often a basis for significantly discounting the value of such interests. As proposed, the new Section 2704 Regulations would limit the use of these valuation discounts.

The Proposed Regulations have three key components, which are aimed at curtailing valuation discounts:

  1. The proposed rules would impose a new 3-year lookback to determine whether a minority interest discount should apply;
  2. The proposed rules would create a new class of restrictions, called “disregarded restrictions,” which are to be ignored when valuing interests in a family-controlled entity; and
  3. With respect to the current “applicable restrictions” which are to be ignored for valuation purposes, the proposed rules would no longer focus only on restrictions that are more restrictive than relevant state law default rules.

NEW 3-YEAR LOOKBACK RULE TO DETERMINE LACK OF CONTROL DISCOUNTS

The current rules exclude from transfer tax the lapse of voting or liquidation rights if the lapse occurs as a result of a transfer of interests and, following the transfer, those interests retain the voting or liquidation rights. Thus, under current rules a transferor who transfers an interest in a family-controlled business entity, and thereby loses his or her controlling interest in the entity, can claim a minority interest discount on the loss of this right. The Proposed Regulations would allow this transfer tax exception only for transfers occurring more than 3 years before the death of the transferor. Any lapse of voting or liquidation rights for transfers made within 3 years of the transferor’s death is treated as a lapse at death, making the interest includible in the transferor’s estate for estate tax purposes. This new rule is aimed at eliminating “death bed transfers” intended to convert a majority interest to a minority interest at or near death in order to obtain a lack of control discount on the remaining shares held at death.

NEW CATEGORY OF “DISREGARDED RESTRICTIONS”

The Proposed Regulations also create a new category of restrictions, called “disregarded restrictions,” which will not be taken into account when valuing a family business if the family still has control in the aggregate to eliminate the restriction after the transfer. The proposed disregarded restrictions include the following:

  • Restrictions on the ability to liquidate the transferred interest;
  • Restrictions that limit the liquidation proceeds to an amount that is less than a minimum value (defined as the fair market value of the entity, reduced by any outstanding debt);
  • Restrictions that defer the payment of the liquidation proceeds for more than six months; and
  • Restrictions that permit the payment of the liquidation proceeds in any manner other than in cash or other property. An exception to the disregarded restrictions is allowed if each owner of an interest in the entity has an enforceable “put” right to receive, upon liquidation or redemption of the holder’s interest, cash or other property with a value that is at least equal to the minimum value of the business entity within six months after the holder gives notice of his or her intent to liquidate.

In determining whether the family has the “control” to remove the restriction after the transfer, the interests of non-family members may be considered. That said, the Proposed Regulations disregard an interest held by a non-family member that (1) has been held less than 3 years before the date of the transfer; (2) constitutes less than 10 percent of the value of all of the equity interests; (3) when combined with the interests of all other non-family members, constitutes less than 20 percent of the value of all the equity interests; or (4) lacks a right to put the interest to the entity and receive a minimum value.

NARROWING OF THE RULE THAT ALLOWS APPLICABLE RESTRICTIONS TO BE IGNORED

Under the current rules, the definition of “applicable restrictions” is limited to restrictions that are more restrictive than relevant state default laws. Since the enactment of Section 2704, state default laws regarding partnerships have become more restrictive, thereby allowing partnerships to choose less restrictive rules, and rendering the applicable restrictions largely ineffective. Under the Proposed Regulations, an applicable restriction will only be ignored if the restriction is required to be imposed by law. Such a mandatory provision under law will only be considered if it applies to all entities covered by the law (thereby preventing states from creating a special class of restrictive entities to undermine the new rules).

Comments have been requested on the Proposed Regulations and a hearing is scheduled for December 1, 2016. It is anticipated that some form of these rules will be finalized and take effect by early 2017. If you own any interest in a family-controlled business, these proposed Regulations will significantly impact you. If you have made transfers of interests to family members for estate planning purposes in the past, you should carefully review your gifting strategy. Any new transfers must be completed before the Proposed Regulations become final in order to claim current valuation discounts.

Please contact one of our estate planning attorneys immediately to determine how these proposed Regulations will affect you. Do not miss this opportunity to take advantage of current valuation discounts before year end. If you have questions or comments about this article, attorneys Heather Walser and Jackie Luthringshausen can be reached at Lavelle Law, Ltd. at (847) 705-7555. You can also contact them directly at hgwalser@lavellelaw.com or jluthringshausen@lavellelaw.com