Treasury Proposes Regulations That Will Limit Valuable Asset Transfer Techniques for Families

Saul Ewing Arnstein & Lehr LLP

Saul Ewing LLP


On August 2, 2016, the Internal Revenue Service released proposed regulations under section 2704 of the Internal Revenue Code, which could cause dramatic changes to valuation discounts - one of the most valuable transfer techniques currently used by many owners of closely held businesses for estate, gift and generation-skipping transfer tax purposes.  

How Valuation Discounts Help Family Business Owners
Many families have used methods of transferring business ownership to succeeding generations that take advantage of valuation discounts.  The logic is simple: the business interest is transferred, but it cannot be resold on the open market and it represents a minority interest, so it must be worth less than the underlying value of what is transferred.  To support the discounted value, an expert opinion would be obtained by someone skilled in valuing not just assets, but also the appropriate discounts for lack of control and lack of marketability.  Business owners who made these types of transfers with the help of their lawyers and other wealth advisors were able to transfer assets using much smaller amounts of their gift/estate tax exemptions than they would have if no discount was applied, often saving millions of dollars in taxes.    

Treasury Seeks to Limit Use of Valuation Discounts
The IRS fought the use of such discounts, but generally lost when planning was done carefully and with appropriate valuation backup.  Now, the Treasury Department has issued proposed regulations that seek to eliminate many of the discounts that have been used in transfers of business interests within families.  

The proposed regulations accomplish their goal by providing that certain kinds of restrictions that were previously used as the basis for applying a discounted value to transfers will simply be disregarded.  Other rights that are given up might be subject to taxation if the transferor dies within three years of the transfer.  Although these proposals might be amended before they are finally adopted, it seems clear that the Treasury is determined to limit the ability of business owners to transfer ownership in a tax-advantaged way. 

When Will The Changes Take Effect – Short and Long Term Planning
The Treasury issues proposed regulations to give an opportunity for public comment.  At times, even though the regulations are issued in proposed form, they are to take effect on the date they are proposed.  That is not the case with these regulations: they will take effect only after there have been public comments and further review by Treasury officials.  The IRS has scheduled a public hearing on the proposed regulations on December 1, 2016.  The final regulations may differ from the proposed regulations due to commentary received by the IRS.  Additionally, some commenters have already questioned whether the proposed regulations are within the IRS’s statutory authority, and it is possible that taxpayers could challenge the new rules as an abuse of discretion by the IRS.  Therefore, the regulations might not be finalized until early 2017.  

That is very important, because it means that there is still time to do planning with the use of discounts, probably through the end of the year.  With the future use of the certain valuation discounts jeopardized under the threat of the proposed regulations, there are certain steps that business owners can take now to ensure they do not waste an opportunity to use these discounts in their estate plans:

  •  If you are contemplating making a lifetime gift that could be aided by valuation discounts, complete that gift now to avoid any possibility of losing the discount in 2017 or beyond.
  • If your estate plan relies on making testamentary transfers after your death that may rely on valuation discounts to reduce the estate tax owed, consider making those gifts during your lifetime (and preferably soon) to avoid the possibility that the discounts will be limited prior to your death (or, in some instances, within three years of your death).
  • As the final regulations play out, pay particular attention to provisions in existing and future operating agreements and other governing documents that may be affected by the changes under the proposed regulations.

We will continue to monitor developments with the proposed regulations.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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