Proposed IRS regulations will impact family-owned businesses

Find out what the proposed IRS changes could mean for your family business.

On August 2nd, 2016, the IRS took action to limit planning opportunities for family owned businesses by issuing long awaited proposed regulations to Internal Revenue Code Section 2704. The proposed regulations address the factors that may be considered when valuing a closely held family business for gift and estate tax purposes. They have the effect of limiting a valuation expert’s ability to consider factors that would lead to a minority interest or lack of control discount. What does this mean? If the proposed regulations are made final, certain discounts that were traditionally factored into the value of a family-owned business can no longer be taken into account, resulting in a larger gift or estate tax value.

Planning Affected. For many years, clients and their advisors designed wealth transfer plans using a technique commonly referred to as a “freeze” that also incorporated the use of minority interest or lack of control discounts. The “freeze” allowed a taxpayer to shift the appreciation of an asset (commonly a closely-held business interest) tax free, to family members by gifting or selling the asset. The asset was valued at the time of gift or sale and relevant discounts were applied to the frozen value, making the “freeze” technique even more powerful. A discounted value was appropriate when the asset had a restriction, such as the inability to demand cash from the company in exchange for the interest (i.e., no right to redeem shares) or to sell the interest in the open marketplace. For example, if a twenty-five percent (25%) interest in a company to be transferred was valued at $2,000,000 based on the company financials, and the stock in the hands of the owner had restrictions as to future transfer or sale, a discount of ten percent (10%) might have been applied and the final value of the stock interest would have been $1,800,000 for gift or estate tax purposes. (It should be noted that the actual percentage discount applied varies for a variety of reasons which are beyond the scope of this article.) While the “freeze” technique described earlier is not being eliminated by the proposed regulations, the discount for transfers of interests in family-owned businesses is what the IRS is attempting to eliminate through the newly proposed regulations.

Impact of Proposed Regulations. In the past, the IRS has consistently challenged the use of discounts in valuing family-owned businesses for gift or estate tax purposes. Historically, when challenging the discounted value, the IRS was often left to simply negotiate the smallest percentage with a taxpayer in an audit or to engage in a battle of experts at trial. The proposed regulations seemingly carte blanche eliminate the use of minority discounts when valuing a family-owned business. As described above, the proposed regulations require valuation experts to ignore certain factors as if they do not exist. If made final, this puts the IRS in a position such that they may de facto deny any minority interest discount in value where a family-owned business is gifted, sold or transferred at death.

Silver Lining for Some Families. However, there is a silver lining for some families that own businesses. The current estate tax exemption amount for 2016 is $5,450,000 per person, and a married couple is able to pass $10,900,000 tax free. With these high thresholds, there are many taxpayers who will not be subject to estate tax. In fact, the beneficiaries of taxpayers under the estate tax thresholds will benefit at death when assets receive a step-up in cost basis to fair market value. The fair market value of the family business will not be reduced by any discounts, if the proposed regulations are made final.

Plan Now. Any taxpayer desiring to make a gift or shift the appreciation of their family business to other family members and take advantage of using a discounted value would be wise to seek counsel now before the proposed regulations are made final. It is anticipated that the proposed regulations may become final by the end of 2016 or early 2017. It is important to note that the “freeze” technique is alive and well. It is not being eliminated by these proposed regulations. Family owned businesses will still have the opportunity to shift the appreciation of their stock out of their taxable estates, albeit for a higher gift cost or sale price.