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Proposed Changes to IRS Valuation Rules would adversely affect Gift and Estate Planning Strategies

on Tuesday, 8 November 2016 in The Closer - M&A, Securities & Corporate Counsel: Kevin P. Tracy, Editor

The Proposed Regulations in a Nutshell.

In August, the IRS issued complex, proposed regulations that would change the way we value closely held business interests for estate, gift, and generation-skipping transfer tax purposes. Section 2704 of the Internal Revenue Code has long instructed that certain restrictions found in the governing documents restricting liquidation of a closely held family business are to be disregarded for valuation purposes. In Section 2704, Congress granted broad authority to the IRS to issue additional regulations to disregard other restrictions that might depress the value of a closely held business interest upon transfer if the restriction “does not ultimately reduce the value of such interest to the transferee.”

The proposed regulations seek to eliminate nearly all restrictions in family business operating agreements, buy-sell and stock restriction agreements, partnership agreements, and other arrangements that would result in a lack of marketability or minority/lack of control discount for valuation discounts upon a transfer to a family member.

What Do Valuation Discounts Do?

The proposed regulations seek to eliminate valuation discounts commonly used to transfer interests in family-owned and closely held companies. Valuation discounts are meant to reflect the price a willing buyer would pay for a business interest from a willing seller. The following is an example of how a closely held family company might be valued:

Husband and wife own 100% of the membership interests in an LLC that they believe will appreciate significantly. They fear that if 100% of the appreciated membership interests are included in their estates at death, they will be subject to estate tax. They desire to make a gift of a 20% membership interest in their LLC to each of their three children. A valuation of the LLC indicates it has a total current value of $5,000,000. The value of the membership interests to each child would be calculated as follows:

Total Enterprise Value of LLC   $5,000,000
Undiscounted value of 20% of LLC $1,000,000
Discount for lack of marketability (15%) ($ 150,000)
Value of 20% interest on non-marketable basis $ 850,000
Discount for lack of control/minority interest (15%) ($ 127,500)
Value of 20% LLC interest on non-marketable, minority basis $ 722,500


The child’s interest is discounted for two reasons. First, the LLC interest cannot be sold immediately for cash on a public market. Indeed, a typical buy-sell agreement would severely restrict the ability of the child to convert the LLC interests to cash. This causes the value of the LLC interest to be discounted for lack of marketability. Second, the child only controls 20% of the voting interests of the LLC, so the child cannot exercise meaningful control over the governance of the LLC. This lack of control further reduces the value of the LLC interests a buyer would pay.

Why Does the IRS Care?

The IRS has long opposed valuation discounts because the discounts reduce the value of closely held interests for gift, estate, and generation skipping transfer (“GST”) tax purposes. In the IRS’ view, a family-controlled company should be treated as if the family governs the company as a family unit, rather than as individuals.

In addition, some families have contributed publicly traded securities to family LLCs and then taken marketability and minority interest discounts upon the subsequent transfer of LLC interests to or for the benefit of family members, converting an asset that would not normally receive marketability and minority discounts to one that does.

How Do These Proposed Regulations Affect Me?

These regulations, if finalized, will affect the valuation of nearly all interests in a family-owned business. If you anticipate that you may have a taxable estate and would like to utilize discounting when transferring assets to family members, you should be aware of how these rules might affect you.

In addition, if the proposed regulations are finalized, the amount you may receive under a buy-sell agreement upon death may be significantly less than the amount that will be included in your estate for estate and GST tax purposes. This could result in a tax on phantom assets—a tax on assets you never received!

Who Should Worry Most?

Those who could have estates subject to estate tax ($5,450,000 for an individual, $10,900,000 for a married couple for 2016) should be the most concerned. This often affects:

• Family business owners;
• Holders of stock or interests in a family-owned company who would receive less than fair market value of the underlying assets pursuant to a buy-sell agreement upon death;
• Farmers, ranchers, and others with significant real estate holdings who desire to make gifts to family members; and
• Holders of passive assets that desire to utilize discounting to make family gifts.

What Can be Done to Avoid These Rules?

If the proposed regulations become final, your options will be limited. However, the proposed regulations will not take effect until they are finalized. A public hearing on the regulations will take place December 1, 2016, and by law the regulations cannot be finalized before the end of the year.

Because of the complexity and broad scope of the proposed regulations, we anticipate that the IRS will receive a large number of comments (reportedly, the IRS has received over 8,000 comments) from the public opposing the regulations or seeking clarification.

Jesse D. Sitz

1700 Farnam Street | Suite 1500 | Omaha, NE 68102 | 402.344.0500