Proposed IRS Regulations Target Valuation Discounts in Gift and Estate Planning– August 16, 2016

The IRS released proposed regulations (I.R.C. 2704) on August 2, 2016, that, if adopted, would significantly reduce or potentially eliminate the valuation discounts used by many high-net-worth taxpayers to minimize transfer taxes (such as gift and estate taxes) when transferring interests in a closely held family business. 

Highlights of the Proposed Regulations

As currently drafted, the proposed regulations would materially reduce the discounts currently available in valuing non-marketable and non-controlling (minority) interests in family controlled entities — regardless of whether the investment is passive or active. Specifically, the proposed regulations impact the following areas.

“Deathbed Transfers”

The proposed regulation imposes a look-back for any transfers made within three years of the transferor's death. Any transfers made within three years of death that result in a liquidation right lapse would be treated as testamentary transfers.

In practical terms, let’s assume that “Bob” owns 51% of a family controlled entity. On Bob’s deathbed he gifts 2% of the stock to his children. The value of the 2% gift along with the remaining 49% of the stock (upon Bob’s death) would be reduced because each interest lacks control (minority interest). Under the proposed regulation, if the 2% gift was made within three years of Bob’s death the minority interest discount of the remaining 49% would be eliminated (requires the valuator to assume the 51% interest is still present).

Quantifying Discounts for Lack of Control and Marketability

When quantifying discounts for lack of control and marketability, valuators consider a variety of factors, including the nature of the company’s underlying assets, historical and expected income distributions, market conditions, rights and restrictions granted in the company’s agreement, state laws and legal precedent. The proposed regulations would significantly limit the provisions that could be considered when discounting a family business interest:

Under the proposed regulations, certain restrictions previously included in a company’s agreements (such as the ability to liquidate or redeem an interest) are in essence disregarded, while other restrictions (such as an effective put-right) are essentially “written” into the governing documents. The effect of these “changes” to the corporate records are expected to significantly reduce the lack of marketability and lack of control discounts that valuators are able to justify.

Transfers to Non-Family Members

The proposed regulations also tackle the treatment of the transfer of an interest in a family business to a nonfamily member. The IRS believes that taxpayers have avoided the applicable restriction rules by transferring a nominal interest in their family business to a nonfamily member, such as a charity or an employee, to ensure that the family alone doesn’t have the power to remove a restriction. Under the proposed regulations, the existence of such an interest would be recognized only if the transfer meets certain "bright line tests” (ownership percentages and lack of put-rights). If all nonfamily member interests are disregarded, the entity is treated as if it’s controlled by the family.

Below is an illustrative example of the potential reduction in discounts as a result of the proposed regulations:


Timing & Action

The IRS faces an uphill battle against many taxpayers, estate planning advisors and some lawmakers when it comes to closing the door on this gift and estate planning tool. Opponents argue that the IRS may have overstepped its authority in issuing these proposed regulations. The IRS might be persuaded to water down its proposal before finalizing it.

A public hearing on the proposed regulations has been scheduled for December 1, 2016, and the regulations won’t take effect until at least 30 days after they’re finalized, which likely would not be until sometime in 2017 at the earliest. The current rules still exist for now, but there are a few action steps you can take:

  1. Be aware that these regulations exist and significantly alter the transfer tax planning landscape;
  2. Consider accelerating transfer tax planning by taking advantage of the current regulations in applying valuation discounts ahead of the release of final regulations;
  3. Work with your advisors closely for assistance in structuring transfers and applying discounts in a way that will pass muster with the IRS.

Contact a member of your service team with estate tax planning questions or Aaron Caya at with valuation questions. 

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.