Treasury Issues Proposed Regulations to Limit Valuation Discounts

On August 2, 2016, the Treasury Department issued proposed regulations under IRC Section 2704 that would significantly reduce the use of valuation discounts which, for decades, have been used by estate planners in valuing minority interests in family businesses for gift and estate tax purposes. These discounts often range from 15 percent to 40 percent, or even higher. By using discounts, significant wealth can be transferred to the next generation at greatly reduced values. Some of these techniques include transfers of fractional interests in real property or business entities such as limited partnerships, limited liability companies, or closely held corporations.

The size of the discount depends upon a number of factors, including the entity’s organizational structure, provisions of the partnership or operating agreement and if state law places restrictions on control of the entity and on marketability.  If a parent gifted a minority interest in a family business partnership to a child with provisions that restrict voting rights and the ability to sell the interest to a third party or withdraw from the partnership, under the proposed regulations, the parent’s gift to the child is valued as if those restrictions do not exist.  As a result, the value of the interest for gift tax purposes would likely be greater than what the parent would receive if he or she sold the same interest to a third party.

While details of the proposed regulations are important, it is clear that the Treasury is trying to eliminate most if not substantially all valuation discounts for family-controlled entity interests, even including active businesses owned by a family. The regulations accomplish this, in part, by expanding the class of restrictions disregarded under Section 2704 to include those under the governing documents and even under state law (regardless of whether that restriction may be superseded by the governing documents).

Over the years, the IRS has argued that many restrictions (including those currently resulting in discounts for lack of control and lack of marketability) should be ignored for transfers between family members. In most properly structured transactions, the courts have rejected the arguments by the IRS and permitted the taxpayer to take appropriate discounts on the transfer to family members.

These new regulations are particularly important in the context of intra-family gifts and sales to effectively reduce the estate tax payable at a decedent’s death. The proposed regulations will be subject to public comment and a hearing on December 1, 2016.  They are likely to be challenged and will not become effective until 30 days after the date on which Treasury issues them in final form. If you are interested in making such gifts and/or sales and believe that you would benefit from such valuation discounts, you may want to consider completing transactions that could be affected by the new regulations before year-end.