Proposed Tax Regulations to End or Restrict Valuation Discounts for Family Gifts

UPDATE:  On October 2, 2017, the Treasury Department informed Pres. Trump that, as part of its review to eliminate burdensome tax regulations, the proposed regulations discussed below will be withdrawn in their entirety.  It is expected that the withdrawal will occur in 60 days by publication in the Federal Register.
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On August 4, 2016, the Treasury Department issued long anticipated “proposed” tax regulations restricting the use of valuation discounts for gifts to family members.  The effective date is expected to be sometime in 2017 when final regulations are issued.  A public hearing on the proposed regulations is scheduled for December 1, 2016.  Already legislation has been proposed in Congress to nullify these controversial regulations.  However, it was Congress that gave Treasury the power to write these regulations in the first place.  When Code Section 2704 was enacted back in 1990, it was intended to eliminate the ability of taxpayers to use artificial means to depress the value of ownership interests in corporations or partnerships gifted to family members when the family retained control of the entity (and therefore the full economic value of the entity).  Congress left the details of how to implement the statute to the Treasury Department.

Valuation discounts are an important part of gift and estate tax reduction strategies.  Valuation discounts are allowed both for minority interests (lack of control) and for lack of marketability.  Over the years, creative advisors and friendly state legislatures have devised strategies and enacted local laws that have allowed taxpayers to get around the intent and reach of Section 2704.  Many court cases have sustained these strategies.  Taxpayers have for many years enjoyed making gifts at values discounted to true fair market value.  After years of trying to get Congress to amend the law to prevent avoidance of Section 2704, the IRS has taken matters into its own hands.  The pendulum now swings back in favor of the government because these regulations make the valuation for gift tax purposes greater than the true fair market value of the gifted interest.  Experts have said that gifts made within a family unit will be valued at a higher gift tax value than what the value of the interest would be if it were sold to an unrelated third party!  The regulations also have application to the estate tax value of retained interests held at death.

The regulations are quite complex and will have unintended consequences.  They are also not fully understood.  Some assumptions and commentary made by leading experts and practitioners may, in the end, not be totally consistent with the intent of the regulations.  Without getting into the technical weeds, some of the highlights include:

·         A transfer (gift) of a minority interest to a family member, where family members remain in control of the business on an aggregate ownership basis, will not qualify for valuation discounts.

o   Control is defined as ownership of at least 50% of capital or profits interests, or any equity interest that can cause the entity to liquidate in whole or in part, or any general partnership interest.

o   Family members, for this purpose, are broadly defined to include the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing.  This definition does not include nieces and nephews.

·         A new 3-year lookback period is proposed to prevent minority discounts created by transfers made before death.  For example, if father owned 55% of his business entity and made a gift of 6% to his children, his remaining 49% ownership would qualify for a lack of control minority valuation discount at his death.  But if the gift of the 6% occurred within the 3-year period ending on his date of death, his 49% ownership would be valued as if he still owned 55% (meaning no minority interest discount for the 49% he retained).

·         The introduction of “disregarded restrictions” where control remains within the family after the transfer that expand beyond the existing so-called “applicable restrictions” that have been ignored by taxpayers.  Restrictions targeted by these rules include those that:  1) limit the owner’s ability to liquidate his/her ownership interest for cash or property, 2) delay the timing of the liquidation payment for more than six months, 3) allow the liquidation payment to be anything other than cash or property, and 4) limit the liquidation price to an amount below minimum value.  These restrictions will be ignored for purposes of valuing the property that was transferred because they can “lapse” or be removed after the transfer by family members still in control of the entity.

o   Minimum value is defined as the fair market value of assets reduced by liabilities of the entity.

·         An exception to the elimination of the minority interest discount applies if, immediately before the transfer, a nonfamily member owns at least 10% of the entity and the sum of all nonfamily interests total at least 20%, the nonfamily member can redeem its interest for cash or assets with notice of no longer than 6 months, and the nonfamily members have owned their interests for at least 3 years.

·         An exception to the elimination of the minority interest discount also applies if each owner has an enforceable right to liquidate his/her ownership interest within 6 months either in cash or property at minimum value.

What should taxpayers do now?  If you are contemplating making gifts and engaging in estate tax planning strategies, you should do so soon, before publication of the final regulations which is expected sometime in 2017.  But, a gift made to a family member before the effective date to create a minority interest for the decedent will not be effective to create an estate valuation discount if the gift was made within 3 years of death and death occurs after the effective date.  The gift would have received the traditional discounts because it was made before the effective date, but the estate value of the retained interest would not be discounted because death occurred after the effective date and within three years of the gift.

Gifting and estate freezing strategies will still be very effective in reducing estate tax even after publication of the final regulations.  The final regulations will reduce part of the financial benefit of such strategies, but it is the post-gift appreciation outside of the taxpayer’s estate that brings the most financial benefit, and this benefit remains.  For smaller estates that will not incur estate tax, these valuation regulations may represent good news in that the value of retained business interests at death will have a higher value permitting a higher income tax basis under the so-called “step-up in basis” rules.  However, some commentators believe that a higher tax basis step-up because of these regulations is not assured.