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to include those under the governing documents and even under state law (regardless of whether that restriction may be superseded by the governing documents).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.

A child under 18 working for a parent-owned unincorporated business is exempt from FICA and FUTA. Children under 21 are exempt from FUTA. Another advantage is that a child employed by a parent shifts income from the parent’s higher tax bracket to the child’s lower tax bracket. A recent court case illustrates the factors used by the courts when determining the deductibility of wages paid to minor children.

The taxpayer was a sole proprietor who worked as an attorney. She had three children, all of whom were under nine years old as of the close of the tax years in question. During summer school recesses, the taxpayer often brought her children into her office, usually for two hours a day, two or three days a week. While at the taxpayer’s office, the children provided various services to her in connection with her law practice. For example, the children shredded waste, mailed things, answered telephones, photocopied documents, greeted clients, and escorted clients to the office library or other waiting areas in the office complex. The children also helped the taxpayer move files from a flooded basement, they helped remove files damaged in a bathroom flood, and they helped to move the taxpayer’s office to a different location. The taxpayer did not issue a Form W-2 to any of her children for the years at issue. No payroll records regarding their employment were kept, and no federal tax withholding payments were made from any amounts that might have been paid to any of the children.

Separately from her law practice, taxpayer came up with the idea that parents traveling with children might be interested in travel books created for children, and she decided to write a series of children’s travel books each directed to a different destination in the United States or elsewhere. During the years at issue, the taxpayer traveled with her three children to Disney World in Orlando, Florida, and several cities in Europe. The purpose of each trip was to conduct research for a yet-to-be written children’s travel book. Before traveling to a particular destination, the taxpayer typically would complete a rough draft of a children’s travel book. She and the children used the rough draft to tour the area, and the taxpayer would record any helpful hints or other information she thought should be included in the final version of the children’s travel book that she planned to complete at some future date. The taxpayer also consulted with a book distributor, a graphic designer, and a book publishing company. She eventually completed at least four prototype travel books and sold some copies word-of-mouth to family and friends. She planned to hire an agent to promote her book but had not done so as of the close of the tax year for the year at issue.

The taxpayer deducted wages paid to her minor children against her gross income from her law practice. The taxpayer also reported net losses from her book writing activity. The IRS disallowed all of the deductions claimed for wages to her minor children, and disallowed all of the deductions claimed relating to her book writing activity.

The court noted that payments made to minor children by a related party for services rendered in connection with a trade or business might very well qualify for deduction. It all depends on the facts and circumstances surrounding the payments. The taxpayer did not present any evidence to show how much was paid to each child, how
many hours each worked, or what the hourly rate of pay was. Without payroll records detailing this information, the court cannot tell whether the amounts deducted were reasonable, especially when the ages of the children are taken into account. The taxpayer did not present any documentary evidence, such as bank account statements, canceled checks, records, or the filing of W-2s, to support the deductions.

The court said all things considered, the taxpayer has failed to establish entitlement to the deductions for wages to minor children claimed on Schedule C relating to the taxpayer’s law practice. However, the court said it was satisfied that each of the children
performed services in connection with the taxpayer’s law practice during each year at issue and each was compensated for doing so. Taking into account their ages, generalized descriptions of their duties, generalized statements as to the time each spent in the office, and the lack of records, the court ruled the taxpayer was entitled to a $250 deduction for wages paid to each child for each year. The court also looked at whether expenses related to the book writing activity were deductible. The court refused to consider the IRS argument that the book writing activity was a hobby. The court said at best (for the taxpayer), the expenses were for planning and
research in connection with the business she had in mind, but that the business had not yet started as of the close of the tax years at issue. Therefore, none of the expenses for the book writing activity were deductible.

The lesson learned is to keep meticulous records and documentation. Always consult your tax advisor if you are considering paying your children wages for working in your business.