Valuation Discounts for Family Businesses Under Attack

This past summer, the Treasury Department issued a controversial set of proposed regulations designed to prevent the long-standing practice of discounting the value of interests in family businesses given to other family members. The regulations have received significant criticism from family business owners and their professional advisors, who claim that the regulations are too broad and constitute an impermissible exercise of Treasury’s regulatory authority. Public comment on the proposed regulations is due in November and Treasury will hold a public hearing on December 1st. The regulations will not take effect until they are issued in final form, which is not expected until early to mid-2017 or later. Until then, taxpayers may continue to claim discounts in accordance with current practice.

Since most practitioners believe that the final version of the regulations will retain the anti-discount bias of the proposed regulations, family business owners contemplating large gifts to family members over the next 6-12 months should consider accelerating their timetable for making these gifts to take advantage of the discount benefits allowed by current law before the final regulations take effect.

The proposed regulations attempt to eliminate the ability to claim discounts for lack of marketability and minority interest in connection with gifts of interests in family businesses to other family members. Here is an example of a common situation where discounts apply: A family business owner creates a limited partnership or limited liability company and transfers $5,000,000 of marketable securities to the entity. The taxpayer then gives away 20% interests in the LLC to his two children. Even though each child’s 20% share of the underlying assets of the LLC is worth $1,000,000, under current law the taxpayer can claim two types of discounts to reduce the value for gift tax purposes of the 20% LLC interests given to his children by 30-50% in most cases. This allows the donor to reduce the amount of the gift and preserve more of the donor’s estate and gift tax exemption for future gifts (or reduce the amount of the donor’s gift tax owed if the donor has already used up all of his or her exemption).

A part of the discount is for lack of marketability. This discount is available when the LLC interest given away is not traded on the public market. The fact that the underlying assets of the LLC consist of marketable securities traded on a stock exchange does not change this result because the focus is on the asset given away — the LLC interests — and not the assets owned by the LLC. A second part of the discount can be claimed for minority interest since the 20% interests given away to each child represent a minority interest in the LLC and do not provide the recipient with the right to control the entity.

Taken together, the discounts for lack of marketability and minority interest often allow a taxpayer to discount the value of each gifted 20% LLC interest by 30-50%, with the result that the 20% LLC interests would not be valued for gift tax purposes at 20% of the LLC’s underlying $5,000,000 of assets—a gift of $1,000,000 per child—but instead at 30-50% less, or $500,000-$700,000 per child.

For years the IRS has objected to this result in the context of gifts of interests in family entities to other family members. The IRS takes the view that families operate as cohesive and unified units, and consequently the owner of the 20% interest can effectively influence a decision to sell the underlying assets of the LLC at full market value and thereby realize the full value of his or her share of the LLC’s assets. As a result, the IRS argues, no discounts should be allowed in this situation.

The proposed regulations adopt this philosophy and go even further. The regulations are complicated and quite broad in reach, in addition to being controversial. It is difficult to predict how much of the proposed rules will survive the upcoming public comment and hearing process, or when the regulations will get finalized. Assuming the final regulations incorporate most of the rules proposed this summer, individuals have a short window of opportunity remaining to make gifts to family members that take advantage of the current discount valuation rules.

About Andy O'Donnell

Andy is a partner of the firm, practicing in the areas of tax law and estate and business planning. He is the former chair of the Trusts and Estates Group, and he currently serves as a member of the Management Committee.
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