Family Owned Businesses: Valuations & Proposed IRS Regulations

In August 2016, the IRS issued long-rumored proposed regulations under Internal Revenue Code Section 2704 concerning one of the provisions that governs the valuation of interests in family-owned corporations, partnerships and limited liability companies for gift, estate and generation-skipping transfer (GST) tax purposes. IRC Section 2704, enacted in 1990, provides special valuation rules for interest in family-controlled businesses subject to certain lapsing, voting or liquidation rights. The proposed regulations are complex, and expert commentators have developed different opinions on their impact.

Some commentators believe the proposed regulations, if adopted in their current form, will have the effect of eliminating virtually all minority (lack of control) valuations as well as lack-of-marketability discounts for transfer tax purposes in the context of family-controlled entities. If this is the case, then elimination of those valuation discounts reduces the effectiveness of traditional gift and estate planning regarding lifetime and death transfers of minority interests in family-controlled entities because it increases the value of the minority interests for transfer tax purposes.

Other commentators believe the proposed resolutions, because they could be interpreted to eliminate all valuation discounts, would be overly broad and invalid. Finally, it has been reported that congressional House and Senate Republicans may be introducing bills aimed to prevent the regulations from being made final.

Recommended Action

There is a 90-day comment period in effect and a public hearing is scheduled on December 1. Accordingly, final regulations will be issued no sooner than December 2016 and likely not until 2017. This gives taxpayers a limited period of time to plan under the current law, which provides for well-established rules regarding valuation discounts. Families with closely held businesses should review with their tax advisors the possible acceleration of gifting programs before the finalization of the regulations. In addition, if the regulations are made final, all gift programs and estate plans should be reviewed to consider the impact of those rules, and shareholder, partnership and LLC agreements should be reviewed to determine whether amendments are needed to accommodate future transfers.

Planning Note

With respect to lifetime gift tax planning, taking a valuation discount to reduce the value of the gift of a minority interest in the business is the first part of the planning. The second, and often (hopefully) most important part of the planning, occurs after the gift as the transferred business interests will appreciate outside of the taxpayer’s taxable estate. If a generation-skipping or dynasty trust was used to own the transferred business interests, then appreciation can pass free of transfer tax to future generations.

Deborah L. Anderson is a partner in the Private Clients group at Nixon Peabody. Read more Nixon Peabody blogs here.