Currently, valuations of interests in family controlled entities for federal gift, estate and generation-skipping transfers can be reduced by discounts saving significant tax dollars, but this will change soon. It may be too late after December 1, 2016 to take advantage of the more favorable rules currently in effect.
Aggressive discounts were historically taken, thus reducing the value and the resultant tax of a transfer. Statutory authority has been in place since 1990 which was designed to reduce those valuation discounts. Nevertheless for years, the IRS has challenged these discounts in court unsuccessfully. Now they are exercising their statutory authority to issue new regulations.
The Treasury Department has recently issued proposed regulations under Section 2704 of the Internal Revenue Code, that if adopted would limit or possibly eliminate the ability to take advantage of these advantageous discounts. Transfers of interests in family limited partnerships, limited liability companies (LLCs) and corporations will be affected by these new regulations.
The discounts most impactful and commonly known, discount for lack of control (DLOC) and lack of marketability (DLOM), reduce the values of the interests transferred significantly thereby reducing the taxes due on the transfers. The International Glossary of Business Valuation Terms defines DLOC as an amount or percentage deducted from the pro rata share of value of one hundred percent (100%) of an equity interest in a business to reflect the absence of some or all of the powers of control, i.e. the power to direct the management and policies of a business enterprise. DLOM is defined as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability, the ability to quickly convert property to cash at minimal cost.
Let me give you an example. Assume Tom owns a one hundred percent (100%) interest in an S corporation valued at $5,000,000 before discounts. He transfers 40% to his son, Junior, which equates to a value of $2,000,000 before discounts. Under current law, discounts for lack of control and lack of marketability would be applied, let’s assume a combined discount of thirty percent (30%). That means that the value of the interest transferred for tax purposes would only be $1,400,000. Under the new proposed regulations, there would be no discounts applied and the value of the interest transferred for tax purposes would remain at $2,000,000. If Tom’s estate is a taxable estate, the potential additional tax under the new proposal assuming a forty percent (40%) tax rate would be $240,000.
Hearings are scheduled for December 1, 2016, after which, these new regulations can be modified or finalized. If you have been considering gifting interests in your business to family members, you should consider doing so before the new regulations are effective.
If outright gifts are a concern to you, you may want to consider gifts to a trust that could shield the business interest from such hazards as divorce and bankruptcy. Our firm can help you with your estate and gift planning needs. If you have any questions, please contact us.
Article written by Darlene Shaffer, CPA/ABV/CFF, CVA