Proposed Rules May Impact Interests in Family Business Entities

The IRS has issued long awaited proposed regulations under Section 2704 of the Internal Revenue Code that would make sweeping changes to the valuation of interests in family business entities for estate, gift, and generation-skipping transfer tax purposes. If they are adopted, the proposed regulations will reduce the availability of certain valuation discounts used in valuing transfers of business interests between family members. Thus, clients considering transfers of interests in family businesses may want to consider implementing those transfers before the regulations are finalized to facilitate more favorable valuations.Under current law, when transfers of interests in family business entities are reported on a gift or estate tax return, the appraised value often reflects minority-interest and lack of marketability discounts, supporting values for estate and gift tax purposes that may be lower than the actual percentage of the interest in the total value of the enterprise. For example, if a family member owned a 20% interest in a family LLC that operated a business, the appraised value would likely be discounted by another 20% to 40% to reflect the minority position transferred and the lack of any market for such business interests, thus reflecting a value less than 20%. In addition, some legal arrangements seek to add restrictions that would limit further the rights of owners in an effort to reduce the value more. The new proposed regulations focus primarily on disregarding these restrictions on liquidation in determining the fair market value of a transferred interest, and by treating the lapse of voting or liquidation rights as an additional transfer.The proposed regulations are in a 90-day comment period, to be followed by a public hearing scheduled for December 1, 2016. It is expected, because these regulations are controversial, that the IRS will receive many comments, and that the final regulations will not be issued until sometime in 2017 at the earliest. We understand that IRS personnel have already commented that the proposed regulations were not intended to eliminate minority and marketability discounts. We will be keeping a close eye on further developments in this area.In general, the regulations would apply to transfers made after the regulations are made final, although they might apply to transfers made before that date if the transferor were to die after the effective date but within three years of the date of the transfer.We believe that for families who have contemplated transfers but have not yet done so, there is still time to act. Clients who are considering transferring interests in family-controlled entities that are not controlling interests and do not have liquidation rights should consider making the transfers soon.