October 2016 Bar Bulletin
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October 2016 Bar Bulletin

Proposed Regulations Impact Estate and
Gift Tax Planning for Family-Business Owners

By Jim Schneidmiller


On August 2, the U.S. Treasury Department issued new proposed estate and gift tax regulations, which, if finalized in their current form, will substantially restrict longstanding estate and gift planning strategies used by the owners of family-controlled businesses and by family investment entities (such as family limited partnerships).

Once the new regulations are effective, owners of family-controlled corporations, partnerships or limited liability companies who pass ownership to close relatives during life or through their estate after death, using the traditional methods, will do so at a possibly significantly higher gift/estate transfer tax cost.

These new regulations will primarily impact wealthy taxpayers (generally individuals with at least $5.45 million of assets and married couples with at least $10.9 million of assets). Their issuance is viewed by some as “closing a loophole” that should not exist.

A Closing Window of Opportunity Exists

A public hearing on the proposed regulations will be held on December 1, after which the Treasury Department will consider what modifications, if any, will be made before they are finalized. The soonest that these regulations could be issued in final form is December 31, and it may be into the first part of 2017 before they become effective.

The delay in the final regulations’ effective date creates a window of opportunity for transfers to be made under the current, more favorable rules. There are many business, personal, and tax factors that affect decisions as to whether, when and how (if at all) interests in family-owned businesses and investment entities will be passed to other family members.

We strongly recommend that clients consider whether ownership interests in their existing family-controlled businesses should be gifted or otherwise transferred to other family members before the new regulations become effective. In appropriate circumstances, we recommend that clients consider forming a family limited partnership or other entity prior to the effective date.

For planning purposes, clients should assume that the final regulations will be effective December 31, so time is of the essence.

Valuation Discounts Targeted

The proposed regulations are 49 pages long and highly complex, and raise many questions about their application. Even a cursory discussion of all their provisions is beyond the scope of this article. In general, the proposed regulations are drafted to reduce or completely eliminate valuation discounts applicable to transfers between family members of ownership interests in family-controlled entities.

An example of a transfer to which the proposed regulations would apply is a lifetime gift from a parent to her child of shares of stock representing a 10-percent ownership interest in a closely held, family-controlled corporation. (Assume that the parent owns 100 percent of the shares prior to the gift.) Current case law allows valuation discounts to be calculated for “minority interest” and “lack of marketability” when determining the value of this particular ownership interest for gift tax purposes.

The minority interest discount exists because in the typical situation the owner of a 10-percent interest in a corporation cannot compel distributions from the entity or realize the value of his interest via a forced redemption or forced liquidation of the entity. The Treasury believes that the minority interest discount is illusory in a transfer like this because both before and after the gift there is 100-percent control of the entity by this family.

The “lack of marketability” discount exists because in general there is no established market for selling interests in closely held entities and a seller will typically require significant time, and pay significant costs, in identifying a purchaser and consummating a transaction. The Treasury believes that the discounts for lack of marketability are mostly illusory and therefore are generally overstated in transfers between family members. Further, the Treasury believes that no marketability discount should apply if the only assets of the entity are cash and marketable securities, such as may be the case in a family limited partnership situation.

The proposed regulations say that an entity is “controlled” by a family if 50 percent or more of the capital interests or profit interests are owned directly or controlled indirectly by a taxpayer and his/her other family members. The taxpayer’s family members are defined for this test to include the taxpayer’s spouse; lineal descendants (children, grandchildren, etc.) and their respective spouses; lineal ascendants (parents or grandparents) and their respective spouses; and the taxpayer’s siblings (including stepbrothers and stepsisters), but not their spouses.

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