Changes to Valuation Discounts for Family Businesses

 August 30 2016     Anna Pfaehler
At the beginning of the month the Internal Revenue Service (IRS) issued proposed regulations for Section 2704, which pertains to valuation discounts. The new changes are broad reaching and will affect those intending to transfer ownership of a family business to the next generation. 

Valuation discounts have long been a staple in planning for the transfer of closely held businesses either during life or at death. Section 2704 defines how certain rights and restrictions affect the calculation of an asset’s value. By imposing restrictions on ownership interests or splitting an interest, the value can be discounted for lack of marketability and lack of control. This in turn reduces the transfer tax liability associated with the gift or bequest of an ownership interest. 

Valuation discounts also have a history of being challenged by the IRS and additional regulations have been expected for some time. The IRS has included valuation discounts on their list of priorities for over a decade. 

The proposed changes will affect those who were counting on valuation discounts as part of their estate planning and, if the proposed regulations are enacted, will increase the transfer taxes on the planned gift or bequest of a family owned business. 

What is Changing?

  • Three-Year lookback eliminates deathbed transfers: Under current law, a person could transfer minority interests on his deathbed to lose control (50% ownership) of an entity and produce a minority discount of his remaining interest. The new regulations would require a three year look-back on these transfers and would value the remaining ownership interest as if he retained control (i.e. no minority discount). Transfers to assignees will also be subject to a three-year lookback. 
  • Changes to “applicable restrictions:” Under current law, certain “applicable restrictions” that are more restrictive than state law are ignored when valuating an ownership interest. Over time, state laws increased restrictions to achieve larger discounts for business owners, rendering the “applicable restrictions” moot. The proposed regulations would turn this upside down and ignore such restrictions if they are required under state law. Furthermore, states will not be able to create special restrictive entities to circumvent the regulations. 
  • Expanded disregarded liquidation restrictions: The proposed regulations include new “disregarded restrictions” that will also be ignored if the family maintains control before and after the transfer. The result is that interests are valued as if the owner has a six-month put option to sell the interest at its “minimum value” (basically his or her pro-rata slice of the entity’s fair market value less obligations). This severely reduces or eliminates lack of control and marketability discounts. 
  • Third Party Ownership: Under current law, transferring token ownership interests to non-family members could create minority discounts. However, under the proposed regulations, an interest held by a non-family member is ignored unless certain tests are met. In general, the transfer can no longer be a token. 

Who is Affected?

Valuation discounts are only a concern to those subject to gift and estate tax. In 2016, you can give up to $5.45 million either during your life or at death before being subject to tax ($10.9 million for a married couple). 

In fact, those who are not subject to estate tax may benefit from the proposed regulations because the value of an inherited ownership interest, and likewise their basis in said interest, will be higher. In the case of a non-taxable estate, you’d want to maximize the value of the interest so as to create the highest possible basis for heirs. 

What is the Time Frame?

The comment period for the new regulations ends on November 2, 2016. There will be a public hearing on December 1, 2016. The earliest the regulations could be enacted is January 1, 2017. 

Therefore, anyone who was planning on making transfers in the near future should act before year-end in order to take advantage of the current valuation discount rules. However, I would only do this if you were seriously considering doing so before the proposed regulations were announced. Such transfers are irrevocable and ought to be appropriate, given the operations of the business and family dynamic, regardless of the transfer tax rules. 

If valuation discounts play a role in your estate planning, you should discuss with your financial team how the changes will affect you and what steps you will need to take to adjust your future planning.