The Internal Revenue Service (IRS) recently released proposed regulations that will dramatically change the valuation of interests in family-controlled entities, including corporations, partnerships and limited liability companies, for purposes of both the gift tax imposed on lifetime transfers and the estate tax imposed on transfers at death. The regulations are only proposed and will not become final until after a public hearing, currently scheduled for December 1, 2016.

Increased Value For Estate And Gift Tax Purposes

When an asset is transferred by gift during lifetime or upon death, the value of the asset that is reported on the gift or estate tax return is the fair market value of the asset. Generally, fair market value is the price a hypothetical “willing buyer” would pay a hypothetical “willing seller” for the asset. When a partial interest in an asset or entity is valued for gift and estate tax purposes, adjustments are made to account for the lack of control and lack of marketability inherent in the partial interest – these adjustments can result in “discounting,” typically in the range of 15% to 45%. While the percentage discount is often a point of discussion with the IRS in the event of an audit, the appropriateness of allowing a discount in valuing partial interests has been consistently upheld by the courts and has long been acquiesced to by the IRS.

Under the proposed regulations, many of the factors that support discounting must be disregarded when valuing interests in family-controlled business entities transferred to family members. As a result, if the proposed regulations are adopted in their current form, the value of the family-controlled business interests gifted during lifetime or included in the estate at death and passing to family members will be significantly higher than in the absence of the proposed regulations. Thus, the proposed regulations could significantly increase an individual’s gift or estate tax liability.

The proposed regulations do contain exceptions. The new valuation rules would not apply to transfers to unrelated individuals or to charities. In addition, not every business entity is subject to these rules. Only business entities “controlled” by the family are subject to the proposed regulations. “Control” is broadly defined and generally means a 50% or more interest in the entity. Further, if a non-family member has a significant interest in a family-controlled entity and certain other rights, including a right to receive a cash payment equal to the full value of his or her interest on withdrawal, an interest may still be valued using valuation discounts.

If you hold interests in any family-controlled entities that you intend to transfer to family members, we recommend that you contact us so that we can review with you the impact of the proposed regulations on your estate plan and whether any modifications to your estate plan or the structure of your entities should be considered.

Lifetime Transfers That Could Result In Estate Taxation

In addition to effectively increasing the value of interests in family-controlled entities for gift and estate tax purposes, as discussed above, the proposed regulations also operate to increase an individual’s estate by the value of certain transfers made within three years of death. The proposed regulations provide that an interest in a family-controlled entity transferred to a family member by gift within three years of the transferor’s death that results in the transferor losing the ability to control liquidation will be included in the transferor’s estate for estate tax purposes, even though the transferor has no rights to, or control over, the transferred interest at the time of death. This aspect of the proposed regulations is especially problematic because (1) it is not clear from the regulations how the value of the transferred interest included in the transferor’s estate is to be determined and (2) if the transferor’s estate plan is not updated to take the additional estate tax into account, disputes may arise as to how the additional estate tax is paid, and by whom.

If you have recently transferred, or intend to transfer, interests in a family-controlled entity to a family member, we recommend that you contact us so that we can review with you the application of the proposed regulations to your situation and determine how any additional estate tax will be paid if you were to die within three years of the transfer.

Planning Opportunities

The proposed regulations do not apply to any transfers that occur before the date on which the proposed regulations become final. If you wish to engage in any additional planning involving family-controlled entities under the existing valuation rules, you will need to do so before the proposed regulations become final. Although it is unclear when the proposed regulations will become final, it will not occur before the December 1, 2016 hearing scheduled to receive public comment on the proposed regulations.

Concerns have been raised regarding whether the proposed regulations have exceeded the Treasury Department’s authority under the Internal Revenue Code and whether the proposed regulations, as drafted, violate constitutional limitations on taxation. These issues are certain to be raised during the public comment period and at the hearing in December and may even be raised through litigation if the proposed regulations become final in their current form. However, clarity on these issues may not be achieved for several years.