Tax

IRS Issues Proposed Regulations Limiting Valuation Discounts

August 2016
Author:  Damien Martin

Damien Martin

Director

Tax

BKD Family Office
Private Client Services

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The IRS released proposed guidance on August 2, 2016, intended to largely eliminate a common wealth transfer technique used to lower the taxable value of transferred interests in family-owned entities for estate, gift and generation-skipping transfer tax purposes. These highly anticipated proposed regulations under Internal Revenue Code §2704 take aim at the use of valuation discounts on interests in family-owned entities by expanding and refining the restrictions on lapsing rights and liquidation that are ignored in determining the value of these interests.

The Proposed Regulations

BKD’s August 2015 article provides a background discussion on §2704 and the regulations thereunder which were enacted to address perceived abusive structures related to the tax treatment of certain restrictions and lapsing rights on the value of an interest in family entities. The Treasury Department and the IRS believe the current regulations under §2704 are ineffective in implementing the intent of the statute. In response, the recently issued proposed regulations:

  • Clarify the regulations apply to all entities under state law regardless of their classification for federal tax purposes
  • Narrow the exception in the definition of a lapse of a liquidation right to transfers occurring three years or more before the transferor’s death that do not restrict or eliminate the rights associated with the ownership of the transferred interest, i.e., deathbed transfers
  • Refine the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law
  • Provide a bright-line test to disregard the interest held by a nonfamily member that:
    • Has been held less than three years before the date of the transfer,
    • Constitutes less than 10 percent of the value of all of the equity interests,
    • When combined with the interests of other nonfamily members constitutes less than 20 percent of the value of all of the entity interest, and
    • Lacks a right to put the interest to the entity and receive a “minimum value”
  • Add new “disregarded restrictions” in the case of a family-controlled entity.

Planning Opportunities

The proposed regulations are not effective until published as final, so there is time to act before the proposed limitations on the ability to leverage valuation discounts go into effect.  Taxpayers contemplating transfers of interests in family limited partnerships and other family-owned entities should discuss and consider executing these plans before the end of the year.

With the federal estate tax exemption now at $5.45 million for individuals (nearly $11 million for married couples), the majority of families will not owe federal estate tax and may not be concerned with tax strategies to reduce their federal taxable estate, including utilizing valuation discounts. Still, the proposed regulations may provide an income tax benefit to these families by driving a larger “step-up” in basis at death due to higher, undiscounted values for interests in family-owned entities. Modifications to the ownership structure of family-owned entities and real estate may allow families to better avail themselves of this additional step-up in basis.

To learn more about how the proposed regulations may affect your tax situation or to discuss planning opportunities, contact your BKD advisor.

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