The Window of Opportunity May be Closing on Valuation Discounts

Proposed IRS regulations intending to curtail the use of valuation discounts in estate planning are anticipated in September.  Although it has been threatened repeatedly in prior years, it appears that these proposed regulations will actually be issued and their scope will be broadened to include most family owned partnerships.

For decades, the use of valuation discounts to transfer interests family owned partnerships (such as family limited partnerships and family limited liability companies) to family members has been a popular estate planning technique.  This method of generational wealth transfer has proven highly successful for many families in allowing them to transfer considerable wealth from older to younger generations at a reduced value.  Under current tax laws, it is not unusual for the transfer of a minority interest in a private family entity to receive a combined discount of 20% to 35%.  In some cases these discounts can exceed 50%.  In utilizing this technique, older generations are able to both reduce their taxable estates and to gift amounts that would otherwise be in excess of their federal tax exemptions.  In addition, all appreciation of the interest gifted is outside of the donor’s estate for estate and generation skipping tax purposes.  

As an example for the purposes of illustration, the chart below shows the total pre-discount fair market value of assets which can be transferred transfer tax-free by a married couple with a combined federal estate and gift tax exemption of $10,860,000 when transferring minority interests in a family LLC.

Combined ExemptionCombined DiscountsTotal Pre-Discount Assets Which Can Be Transferred Tax-Free
$10,860,00020%$13,575,000
$10,860,00025%$14,480,000
$10,860,00030%$15,514,285
$10,860,00035%$16,707,692

The discounts that are typically applied when valuing a closely held entity for US gift, estate, and generation skipping tax purposes are: (i) lack of marketability; and (ii) lack of control.  The theory behind a discount for lack of marketability is to account for any restrictions on the sale or transfer of the interests, and to account for the difficulty a prospective owner would likely face in finding a willing buyer (as opposed to public company stock).  The theory behind a discount for lack of control is simply to account for the fact that a minority interest is worth less than a controlling interest.

Not surprisingly, as the use and popularity of valuation discounts has grown, so have the IRS’ attempted challenges to these techniques.  In 1990, these challenges manifest themselves into what is now Section 2704 of the Internal Revenue Code.  Section 2704 was enacted with the specific intent of limiting the availability of valuation discounts as applied to a limited type of family entities and provides that certain restrictions set forth in partnership or operating agreements are to be disregarded for valuation purposes if Section 2704 is not complied with.  Notwithstanding the enactment of Section 2704, the IRS has struggled to contest the use of valuation discounts outside of Section 2704 with any meaningful success to date.

Now, it is widely speculated that the IRS intends to issue further regulations which would create additional categories of restrictions that should be disregarded in determining the value of transferred interests in family owned entities. If the rumors are true, the proposed regulations will be issued this year by the middle of September, and will disallow such discounts for family entities holding passive investments and publically traded securities rather than actual operating companies.  While proposed regulations do serve to provide guidance to the public that the IRS is considering modifying the regulations or issuing rules on matters not currently addressed, such proposals do not have full force and legal effect until they are adopted as final and may be withdrawn or modified at any time.  If adopted as final, however, the IRS can elect to treat such regulations as effective from the date of the initial draft proposal and as applicable to all transfers after such date.  The actual effective date is not yet known. 

For anyone considering these gifting techniques, time is of the essence as the ability to take advantage of valuation discounts may soon be severely limited compared with current law.

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