Often, closely-held business owners will choose to transfer the business to younger family members during life or at death. The goal being to keep the business in the family. The Federal estate, gift and generation transfer tax rules can make these transactions difficult as taxes must be paid on the value of the business transferred.
To mitigate this problem, it has been common practice to reduce the value of partial interests in closely-held businesses and investment entities through valuation discounts. The two most common discounts are for lack of control over the entity and lack of a market for the interest being valued:
Discount for Lack of Control
Courts have long recognized that ownership in a closely-held entity which represents a minority interest is usually worth less than a proportionate share of the value of the entity as a whole. A discount is recognized because the holder of a minority interest lacks control over many aspects of the business. Conversely, a controlling shareholder enjoys many benefits that are not shared by a shareholder who lacks control. The value of control depends on the shareholder’s ability to exercise any or all of a variety of rights typically associated with control.
A major difference between an interest in a closely-held entity and publicly traded companies is restricted liquidity. Unlike a public company, one cannot decide to sell the stock of a privately held company and receive the cash in three days. All other things being equal, an investment is worth more if it is marketable than if it is not, since investors prefer liquidity to lack of liquidity.
These discounts are supported by a number of studies and have been upheld in the courts as legitimate reductions in value that can be utilized when transferring closely-held business interests through gifts and bequests. In fact, the use of these discounts has expanded to reduce the value of cash and marketable securities by placing them in a family limited partnership or similar vehicle that has restrictions on control and transfer of interests.
The Internal Revenue Service has challenged the use of these discounts through the courts for many years with very limited success. However, the government has recently issued proposed regulations that would significantly limit the use of discounts for both investment entities and closely-held operating businesses.
The proposed regulations, released on August 2, 2016, attempt to eliminate perceived valuation abuses in several ways.
Requiring that Certain Restrictions be Disregarded — Current law already requires that certain “applicable restrictions” be disregarded in determining value. These “applicable restrictions” include restrictions on the entities ability to liquidate that are more restrictive than state law. The proposed regulation expands “applicable restrictions” to include restrictions under state law if the entity could modify or override those restrictions through agreement. The proposed regulation does not stop there. It continues to create a whole new category of “disregarded restrictions” which would be ignored in valuing an interest in an entity for estate and gift tax purposes. “Disregarded restrictions” include:
- Any restriction or limitation on the ability of the holder to liquidate their interest;
- Any restriction limiting the amount received by the holder to less than a minimum value;
- Any provision permitting deferral of redemption proceeds for more than six months; and
- Any provision that permits repayment in anything other than cash or property. A promissory note is not an acceptable repayment method unless a number of tests are met including a requirement that the entity be engaged in an active trade or business, payment of a market interest rate, and adequate security is provided.
Currently, these types of restrictions are commonly used to support the discount taken on transfers of closely-held entity interests.
Three Year Rule — Under current law, a gift or bequest is generally valued without regard to the overall family ownership. For instance, if a father gifted 30% interests in a business to each of his two sons and retained the other 40%, discounts would be available on both 30% transfers when made and the 40% interest retained upon his death. The proposed regulations would require that the father’s estate include the “lost value” attributed to the father’s loss of the ability to control liquidation of the business interest if he dies within three years of the original transfers.
Ignore Interests Held by Non-Family Members — Under the proposed regulations, certain interests held by non-family members will be ignored when applying these rules. This includes interests held less than three years or consisting of less than 10% of the equity in the entity.
Effective Date and Planning
The proposed regulations will not take effect until they are finalized. The government is currently seeking comments and will hold a public hearing on December 1, 2016. It is expected that final regulations could be issued shortly after that hearing or early in 2017. Therefore, there is a window of time available to consider completing transfers before the new regulations take effect.
However, taking advantage of the possibility of obtaining lower valuations under current law should be weighed against the benefits of obtaining a step-up in income tax basis later and the possibility of being caught under the three year rule discussed above which will likely apply to transfers made prior to finalization of the regulations as well.