If you have been considering transferring assets to family members to take advantage of partial-ownership valuation discounts, you may need to move quickly: the IRS has issued proposed regulations under Internal Revenue Code Section 2704 that could significantly reduce or eliminate discounts. The new rules would apply when valuing interests in family-owned businesses for gift, estate and generation-skipping transfer tax purposes. This will affect not only family-owned operating businesses but also limited partnerships, limited liability companies (LLCs) and corporations co-owned by family members that hold real property, passive business ventures or even publicly traded securities. These new rules could be finalized and effective as early as January 1, 2017, although a more likely scenario for an earliest effective date is towards the end of the first quarter 2017.
Background
Historically, taxpayers could reduce the value of their taxable estates or the value of taxable gifts by claiming lack of marketability and/or lack of control discounts for assets in family-owned partnerships, LLCs or closely held corporations. These discounts were powerful, typically allowing discounts of 20% to 45%. For example:
- Gift taxes: Under current law, if you transfer $8,000,000 worth of assets to an LLC and then transfer 25% of the LLC membership interests to a family member, here is a comparison of the value of the gift of the membership interests for gift tax purposes, with and without a discount:
| How Gift is Calculated | Value of Gift | |
| Without discounting | $8,000,000 x 25% | $2,000,000 |
| With discounting (asumes 30% discount | $8,000,000 x 25% LESS 30$ discount |
$1,400,000 |
Note the effect of discounting: you have gifted less value and therefore used less of your current $5,450,000 gift tax exemption, leaving more to pass tax-free at your death. (We do not normally recommend gifts that exceed the exemption amount and would cause out-of-pocket payment of gift taxes so there is no comparison of potential tax savings).
- Estate taxes: Under current law, if you own 50% of an LLC with assets worth $8,000,000 at your death, applying a lack of marketability and/or lack of control discount, here is a comparison of the value of the membership interests for estate tax purposes, and the estate tax associated with and without a discount:
| How Value is Calculated for Estate Tax Purposes |
Value for Estate Tax Purposes | Tax Due at 40% | |
| Without discounting | $8,000,000 x 50% | $4,000,000 | $1,600,000
($4,000,000 x 40%) |
| With discounting (assumes a 30% discount | $8,000,000 x 50% LESS 30% discount | $2,800,000 | $1,120,000
($2,800,000 x 40%) |
Note the effect of discounting: at a 40% tax rate, there is an estate tax savings of $480,000.
What Could Change
Under the new proposed regulations, and after the effective date, such large valuation discounts for interests in family-owned entities would no longer be recognized for gift or estate tax purposes when transfers are made between family members via sale, gift or at death except in very limited circumstances.
Note that a new “three-year rule” applies to specified transfers made before the effective date if the transferor dies after the effective date but within three years of making the initial transfer. Under these circumstances, the discount would not apply.
Next Steps
There is a window of opportunity to take advantage of the current rules allowing discounts for gifts. This is because the proposed regulations will not be finalized until thirty days after a December 1 hearing at the earliest (and many tax pundits believe this earliest date is unrealistic and that early 2017 is a more likely “earliest” timeframe; there are even experts who do not believe these changes will go into effect until 2018 or later). If you would like to discuss the impact of the change to the Section 2704 regulations and to determine how best to move forward for your particular situation, please contact us.
