Article 08/13/2018

Proposed Changes to Estate & Gift Tax Valuation Rules

Jeffrey Conrad
Change on top of a calculator and a magnifying glass

The U.S. Treasury Department recently proposed major changes that could affect generally accepted estate and gift tax valuation rules.  If implemented, the changes could significantly increase the transfer tax costs associated with transferring family-controlled business interests between generations and hinder the orderly transfer of control and ownership.  The response to the proposed regulations has ranged from disagreement to legislative threats. 

Current Law

In general, estate and gift tax valuations apply a hypothetical willing buyer-willing seller test based on the price an interest’s willing buyer and willing seller would agree to, each with no compulsion to buy or sell and knowing all facts and circumstances.  Additional valuation rules also apply within certain circumstances to transfers and transactions between family members under Chapter 14 of the Internal Revenue Code §2701 to §2704.

Based on more than 50 years of judicial decisions and other guidance, the application of the willing buyer test to an operating trade or business interest has included valuation discounts for lack of marketability and minority interests.  Marketability discounts reduce the purchase price to reflect that the purchaser has no readily available means (market) to sell the interest.  Minority discounts reflect that the purchaser of a minority interest would have no ability to direct business operations, including distributions and liquidation.  Consider this example:

Corporation X has 100 shares of stock issued and net assets worth $1,000, or $10 per share. Person A intends to purchase one share of Corporation X.  Person A may demand a 20 percent discount for lack of marketability, reducing the value to $8 (10 x .8).  Person A also may demand a 20 percent minority discount, reducing the value to $6.4 ($8 x .8).  While the percentages have been heavily debated, the U.S. Congress, IRS and courts have generally accepted both discounts.

The Chapter 14 restrictions, first introduced in 1990, require further analysis for transfers between family members.  In general, transfer restrictions that conform to state entity (partnership, LLC and corporation) laws avoid the Chapter 14 restrictions.  Entity restrictions that attempt to go beyond state law and significantly increase valuation discounts tend to run afoul of this rule.

New Proposed Regulations

In August, the IRS released proposed regulations under §2704.  The regulations largely eliminate marketability and valuation discounts by expanding and refining restrictions on lapsing rights and liquidation that are ignored in determining a family-controlled entity interest value.  More specifically, the new proposed regulations effectively require an entity interest to include a “put right” at the fractional interest value of entity assets that must be paid no more than six months after exercise to avoid the limitation.  Consider the previous example within the new proposed regulations:

Same facts as the previous example, except the new “put right” at a minimum value eliminates the marketability discount since the interest could be immediately liquidated.  The minority discount also is eliminated.  As a result, one share’s value would be $10.

Response to Proposed Regulations

Response to the regulations generally was negative.  While highly unusual for legislators to involve themselves in proposed regulations, members of Congress believe these represent a major departure from current law and would significantly affect closely held businesses; they have introduced bills to nullify the regulations if finalized.

The estate planning community also negatively responded.  Commentators focused on inconsistencies between the proposed regulations and legislative history, which provides Chapter 14 wasn’t intended to eliminate valuation discounts.  Further, many drew parallels to Chapter 14’s predecessor, 14 §2036(c), which Congress ultimately repealed.

Many business community groups and individuals voiced objections to the proposed regulations, citing additional complexity and compliance costs.

What Should Be Done?

The proposed regulations aren’t effective until published as final.  With the Administrative Procedure Act, the earliest this guidance can be finalized is January 2, 2017. 

It’s difficult to predict what Treasury will do next.  Based on increasing public pressure, the regulation project could be withdrawn (and effectively canceled) at any point.  On the other hand, Treasury may push to finalize the regulations as soon as administratively possible.  Regardless, the regulations likely are the first indicator that Treasury intends to implement changes.

Based on all factors, anyone contemplating transfers of interests in family-limited partnerships and other family-owned entities should discuss and consider executing these plans before the year’s end. 

For more information on the proposed regulations under §2704, please read the BKD alert.