Proposed New Limits on Family Business Planning Opportunities


On August 2, 2016, the IRS announced proposed new regulations seeking to limit, if not disallow, valuation discounts in transfers of interests in family controlled business entities for gift, estate and generation-skipping transfer tax purposes.

Historically, the IRS and the courts have recognized that fractional interests in real property and closely-held business interests should be valued at a discount, recognizing that the market does not recognize fractional interests at full value due to lack of control and inability of the holders of the fractional or minority interests to liquidate and receive full cash value for their interests. Discounts have historically been recognized for lack of marketability, lack of control, fractional interests, restrictions on transferability and costs of partition.

The IRS and Congress have long perceived potential abuses of the discount rules, particularly in the context of family limited partnerships and family limited liability companies, especially those invested in income-producing passive investments and securities, and those in which the original grantor remains in substantial control of the management of the entity.

One of these legislative efforts was enacted as part of the Omnibus Budget Reconciliation Act of 1990, which added Sections 2701 through 2704 of the Internal Revenue Code. Section 2704 was intended to curtail the aggressive use of valuation discounts in closely-held family vehicles, but adverse court decisions and the evolution of state laws governing the structure and management of limited liability entities have limited the effectiveness of Section 2704. Efforts to engage Congress to close the “loopholes” legislatively over the past fifteen years have not been successful.

The Treasury Department has therefore undertaken a new administrative approach to the issue by proposing new regulations that may severely limit the availability of discounts for gifts of interests in family-owned entities where the family will, collectively, retain control of the entity after the transfer.

The new proposed regulations would create Treasury Regulations Section 25.2704. They include a “look back” period to determine whether a minority discount should even be considered. This provision is a throwback to the old “gift in contemplation of death” rules and is intended to limit deathbed transfers to create minority interests. There is also a new concept of “disregarded restrictions” that will apply in cases where the “family” of the transferor will retain control after the transfer.

Proposed Regulation 25.2704-3(g) provides a series of examples to illustrate the types of transactions that would be affected by the new regulations. The examples are so broad that it appears that the use of lack of control and marketability discounts will not be available in most transfers of family business interests.

The proposed regulations were published on August 2, 2016, and must go through a 90-day public comment period. This comment period will be followed by a public hearing that will probably be held in December, and public comments will then need to be reviewed before final issuance of the new regulations. Thus, the new Regulations will likely not become effective until early 2017.

Note that the process does permit a window of time for families owning business entities to engage in discount planning before the new rules become effective. This might include creating a new family entity to commence a gift program or accelerating an existing program of giving shares or membership interests in a family business.

In considering such strategies, however, it is important to bear in mind that these issues will have most impact on those families who are exposed to estate taxes. For individuals with less than $5,450,000 or married couples with less than $10,900,000 (who would not be exposed to estate taxes under existing law), there might even be an advantage to eliminating valuation discounts to secure a basis step up at death. Consider the options carefully. If a giving plan is to be initiated, it would be best to get started quickly so that there will be adequate time to obtain appropriate qualified valuation appraisals to support any claimed discounts.