Bradley & Riley PC

In August, the Internal Revenue Service announced proposed regulations that would effectively increase taxes imposed on lifetime and post-death transfers of ownership interests in family businesses. These proposed regulations would impact high net worth clients who own family-controlled corporations, Limited Liability Companies (LLCs), Family Limited Partnerships (FLPs), and similar entities.  For purposes of this article, we consider high net worth clients to be those who have an individual net worth in excess of $3.5 million or a combined net worth with their spouse in excess of $7.0 million.

If implemented, the proposed regulations would restrict the customary court-approved practice of "discounting" the value of such ownership interests for lack of marketability, lack of control, and similar discounts. Restricting the ability of family business owners to take legitimate discounts when valuing transfers of their ownership interest would result in increased federal gift and estate tax liability to the business owner.

The deadline for submitting written comments to the proposed regulations was November 2nd.  The IRS has a public hearing on the proposed regulations scheduled for December 1st.  If events transpire according to the original IRS plan, the regulations will be finalized some time after the public hearing and will become effective 30 days later.  However, due to the backlash from business owners and their legislators, and due to the outcome of the presidential election, it is currently not clear whether the IRS will attempt to finalize and adopt the regulations before President Obama leaves office, or whether the IRS might abandon their efforts to implement these regulations.  Because of the short 30 day window between finalizing the regulations and the effective date of the regulations, planning ahead is still the wiser choice for high net worth family business owners.

Under Internal Revenue Code Section 2704, the related regulations, and court decisions, valuation discounts have routinely been applied to the transfer of family business ownership interests that are subject to built-in restrictions on liquidation. Many entities have intentionally been structured to include liquidation restrictions for the very purpose of making these discounts available.  The proposed regulations target these valuation discounts, as the IRS argues that use of valuation discounts allows taxpayers to understate the true fair market value of transferred ownership interests.

The proposed regulations have been widely criticized as an undue burden on family owned businesses. Prior to the election, two separate bills were introduced in the U.S. House of Representatives seeking to nullify the proposed regulations.  No action is expected on either of these bills before the end of the year.  Some experts believe that with the election of Donald Trump as President and with Republican control over both the U.S. House and the U.S. Senate, the proposed regulations might never be finalized.  Others fear that the IRS may try to rush the implementation of the proposed regulations through while President Obama is still in office.

In light of these proposed regulations, high net worth clients with family-controlled business may decide to accelerate any pending plans to transfer ownership interests to other family members. Accelerating and completing the gifting plans now would ensure that these clients are able to take advantage of the valuation discounts that have been routinely applied in the past.  Clients who elect to accelerate their gifting plans should be aware that special disclosures are required on their gift tax returns to alert the IRS to the fact that the taxpayer is taking valuation discounts that are contrary to the position set forth in the proposed regulations.  Failure to make these special disclosures may extend the three year deadline available to the IRS for auditing and challenging the values reflected on the gift tax return.

If the proposed regulations are enacted, family business owners should have their business documents reviewed to be certain that any restrictions contained in the By-Laws, Operating Agreements, or other company governing documents still make sense in light of the new regulations. In particular, clients should consider whether the valuation formula set forth in the governing documents should be adjusted to more closely reflect the value that will be imposed on that business interest for estate and gift tax purposes.

If the proposed regulations are enacted, family business owners should also have their estate planning documents reviewed to be certain that they still accomplish the desired result. One particular area of concern involves the tax payment provisions in the estate planning documents.  Under a scenario in which a family member receives the family business interest at a discounted price, but the decedent's estate is taxed at a non-discounted price, clients should consider who should be responsible for payment of the additional tax.  As most documents are currently written, that additional tax would be charged against the shares passing to all of the client's children, rather than against the share for the child who received the business.

Although there is a great deal of uncertainty regarding the proposed regulations, we believe it will still be in the best interests of high net worth family business owners to forge ahead with plans to transfer their ownership interests to the next generation. For more information, please contact an attorney in the Estate Planning Practice Group at Bradley & Riley PC at 319-363-0101.

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