The Clock Strikes Midnight: IRS Issues Proposed Regulations Limiting Discounts on Transfers of Closely-held Interests

On August 2, 2016, IRS issued long-awaited proposed regulations pertaining to valuation discounts on transfers of closely-held family entities. Such interests include closely-held interests in corporations, partnerships, and other entities.

The proposed regulations would affect the value for federal tax purposes of transfers of interests to family members. In general, they aim to limit the amount of discounts that can be factored into the value of the transferred interests.

As part of estate, gift and generation-skipping transfer tax (transfer tax) planning, taxpayers who hold interests in closely-held entities frequently transfer all or a portion of their interests during their lives, to younger family members. Such a transfer has two benefits: first, it removes the asset from the taxpayer’s transfer tax base, and second, any increase in value of the transferred asset will not be subject to the transfer tax for the taxpayer who has transferred the interest.

The entity’s governing documents and/or state law frequently impose certain restrictions that reduce the overall value of the interest for transfer tax purposes. Frequently, the restrictions limit the ability of a transferee to transfer or liquidate their interest which, in turn, results in various discounts that apply when the interest subject to those restrictions is valued for transfer tax purposes. After applying the discounts to the value of the property transferred, the transfer tax liability associated with the transfer can be significantly reduced. Examples of discounts include valuation discounts for lack of control (own a minority interest in the entity) or lack of marketability (no readily available market for selling the interest to unrelated third parties), voting rights restrictions, and restrictions on the ability to liquidate the interest. Although generally losing on the issue, IRS has long argued that for purposes of valuing family entities, families should be considered one unit with respect to control of these entities, thereby eliminating many of these discounts.   

In 1990, Congress added Sec. 2704 to the Internal Revenue Code which was designed to limit valuation discounts for transfers of interests in closely-held family entities to other family members. However, due to certain exceptions in the statute and various changes to state laws, which impacted rights with respect to entity control, IRS has argued that Sec. 2704 and its regulations were rendered ineffective in limiting these discounts. As a result, the Treasury Department has proposed a new set of regulations that are intended to significantly affect the value of transfers of closely-held family entities to other family members.

If the proposed regulations are finalized in their current form, certain restrictions would no longer be considered in determining the value of the transferred interest. Without these restrictions, the value of the transfer would be greater for transfer tax purposes. This increased value would likely produce a significantly greater transfer tax liability than would occur if the interest were transferred under the current regulations.

The mechanism by which these proposed regulations would eliminate discounts is to force an assumption that each interest holder in a family-controlled entity has a put right that would enable the holder to force a redemption of their interest for cash or a very short-term note (six months) in an amount equal to a pro rata share of the entire value of the underlying assets of the entity. Essentially, IRS is doing by regulation what they could not do through litigation, namely treating the family entity as if it were controlled by each member of the family.    

Additionally, the proposed regulations would apply to any transfers between family members, regardless of whether there was any donative intent. This application would have the effect of potentially imposing gift taxes on transactions that are negotiated at arms-length between owners of a family enterprise simply because they are related. For example, suppose an interest in a family business is left to two siblings, one of whom is involved in the business and one of whom is not. The non-participating sibling then sells the interest to an unrelated third party. In that case, discounts for lack of control and marketability would be taken into account in determining sale price. If the non-participating sibling sells that same interest to the participating sibling (a common fact pattern), those discounts would not be taken into account and either the selling sibling would have to charge more for the interest, or be charged with making a gift.  

The proposed regulations are subject to a 90-day public comment period. The Treasury Department has scheduled a hearing on the regulations for December 1, 2016. With some exceptions, the regulations would apply to transfers of closely-held interests to other family members after the regulations are issued as final regulations. Therefore, taxpayers who are considering transferring interests in their family-owned entities should consider making those transfers as soon as possible.