One of the many challenges faced by owners of closely-held businesses is how to transfer ownership of the business to children and grandchildren in a tax efficient manner. With federal gift and estate tax rates at 40%, some families are forced to sell their business simply to pay the applicable tax. For many years, however, families have been able to soften the blow of such taxes by taking advantage of so-called “valuation discounts”, which reflect the fact that an interest in a family-owned business is not readily convertible into cash. An owner of a minority interest in such a business has been able to discount the value of the interest to reflect the reality that he or she does not have the voting power to compel a dividend or force a redemption. Similarly, an owner in such a business has also been able to claim a further discount for “lack of marketability,” reflecting that persons outside the family are generally reluctant to purchase an interest in another family’s business. With the use of such discounts, taxpayers have been able to keep family businesses in the family and avoid unwanted sales.

However, proposed regulations issued by the IRS on August 2, 2016, could severely limit the use of such discounts. These regulations purport to clarify Section 2704 of the Internal Revenue Code, which provides, among other things, that when valuing property for estate and gift tax purposes, certain restrictions on the ability of an entity to liquidate are disregarded. The regulations, if adopted, would reverse scores of court decisions, which have long permitted such discounts. The proposed regulations cover transfers between family members of interests in family controlled corporations, partnerships, LLCs and other entities, regardless of whether such entities have an active operating business.