Proposed Treasury Regulations Would Eliminate a Popular Estate Planning Technique

On August 2, 2016, the U.S. Department of the Treasury announced long-anticipated proposed regulations applying to valuation discounts for transfers of ownership interests among family-controlled entities. While the proposals are complex and broad in scope, if implemented they would substantially limit the discounts applicable to the value of family-controlled business interests for transfer tax purposes. People with these types of assets should move quickly to take advantage of favorable valuation discounts under current law.

Issue Background

Wealthy families commonly hold a portion of their assets in a closely-held entity, such as a limited partnership, limited liability company, or corporation. Some of them are actively operating businesses while others own passive investments such as marketable securities.

Family members often transfer all or portions of their ownership interests to younger generations as part of their estate planning in order to reduce estate, gift, and generation-skipping transfer tax exposure. This kind of transfer has two advantages: first, it removes the asset from the transferor’s taxable estate, and second, any future appreciation in value of the asset will accrue while in possession of the transferee, and therefore will not count as part of the transferor’s estate for tax purposes.

When such interests are transferred to other family members, the value of the asset is usually subject to two ‘discounts.’ The first, a ‘lack of control discount,’ reflects a minority owners’ limited ability to convert the investment to control the entity. The second, a ‘lack of marketability discount,’ reflects the owner’s limited ability to convert the investment to cash through liquidation, redemption, or sale of the interest. It is these valuation discounts, typically exceeding 30% of the net asset value, that lower the tax cost of transferring interests in closely held entities to other family members.

The IRS has long held that these valuation discounts are not an accurate reflection of value when applied to family entity interests. Both the IRS and the Department of the Treasury attempted for years to persuade Congress to enact legislation to tighten the applicable portion of the Internal Revenue Code – Section 2704 – to reduce abuses in valuation discounts for family entities. When it became evident that no legislation was forthcoming, they took matters into their own hands.

Proposed Regulations

The proposed Dept. of the Treasury regulations under Section 2704 were released on August 2, 2016. If the proposals are adopted, the loss of valuation discounts would result in a substantially greater transfer tax liability than current regulations enforce.

Before the proposed regulations become law, a 90-day public comment period followed by a public hearing must take place. There are extensive comments from valuation experts and estate planning professionals that question, among other things, whether it is within the power of Treasury to create an “alternate reality” that ignores much of state law property rights. In all likelihood, the earliest the new regulations could become final is sometime in early 2017.

The Importance of Estate Planning – Now

As of now, no one knows if or when the regulations will be finalized, whether any changes will be made to the proposals, or whether there will be litigation that challenges the legitimacy of the regulations. As currently constructed, though, the regulations would end a significant estate planning technique, causing a sizable increase in the cost of transferring interests in family-controlled entities.

Clients above the Federal estate tax redemption threshold (in 2016, $5.45 million per individual, $10.9 million for married couples) who are considering transferring interests of family-controlled entities should act quickly to ensure transfers are completed as soon as possible, while the planning window is still open.

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