Which would you rather receive: a check for $1 million or a one-tenth interest in a private company worth $10 million – an interest over which you would have minimal control and which you would have limited ability to liquidate?
Both are ostensibly worth $1 million, and most people would not turn down either gift. However, almost everyone would take a million-dollar check if they had a choice, because a check offers immediate access to the funds, control over how and when the money is spent, and no need to deal with the complications of owning a private business. This fact has allowed many Americans to transfer fractional shares in private businesses for less than their proportional values. Incidentally, the same concept is one of the reasons why public companies are often bought out at a premium to their share price: The whole is worth more than the sum of its tiny parts.
These concepts make sense to most people, but new regulations proposed by the Treasury Department and the Internal Revenue Service assert that, if the company in question is family-owned, these economic realities should be ignored and both gifts should be worth the same amount for tax purposes.
Business valuation experts will often discount the value of an interest in a privately held business under certain circumstances – for instance, if the share represents a minority, noncontrolling interest or if there is no readily available market in which beneficiaries could liquidate their interest. If two unrelated parties come to an agreement based on these discounts, the proposed regulations will generally continue to allow for them. There is nothing for the government to lose in these situations. When the federal gift and estate tax comes into play and transactions are among related parties, however, the IRS takes a different view.
Although there are several nontax reasons to form a family investment holding company, valuation discounts led some families to set up family limited partnerships (FLPs) and family limited liability companies (FLLCs) primarily to minimize estate, gift and generation-skipping transfer taxes. The older generation established the “wrapper” entity and contributed marketable securities or real estate, and later made gifts of minority partnership interests to the younger generation. The gifts were valued at a discount because the interests lacked marketability, control or both. But given the family relationship among the involved parties, the younger generation can sometimes in practice have nearly unfettered access to the full, undiscounted value of their share of the company.
The IRS has argued for years that this technique is abusive, so many estate planners expected a regulatory change to arrive eventually. Mark Mazur, the assistant secretary for tax policy at the U.S. Treasury Department, recently vilified this technique, saying that “certain taxpayers or their estates owning closely held businesses or other entities can end up paying less than they should in estate or gift taxes.” Up to this point, the IRS has mainly disputed the size of the discounts taxpayers have claimed, but the newly proposed regulations would sharply limit the use of valuation discounts for intrafamily transfers at all. Moreover, the changes are set to apply to transfers of both holding companies and operating companies such as a consulting company, real estate development firm or a local family-owned restaurant or store.
These changes only really affect those who expect to make lifetime gifts or transfers at death that exceed the federal gift and estate tax exemption (currently $5.45 million for an individual or $10.9 million for a couple). As The Wall Street Journal reported, the estate tax currently applies to only about 0.2 percent of Americans each year; in 2014, that worked out to about 5,200 estates nationwide.
If you are among those who need to consider the federal estate tax, many experts have urged immediate action in light of the new rules. The Treasury has said the regulations will not apply retroactively, and a hearing on the proposed rules is not scheduled until December 1, meaning the final regulations would not apply to transactions occurring before the beginning of 2017 at the earliest. This leaves a distinct but relatively brief window to take advantage of existing rules.
That window will mostly benefit people who already have a family partnership or business in place. For families who already included such transfers in a long-term estate plan, it will likely make sense to step up the time frame and complete the transfers before year-end if possible. But the new regulations should not be the only factor in this calculation. You will want to weigh other considerations too. For instance, you could be forgoing a possible step up in basis if you held the business until your death. You could also trigger unintended negative consequences, such as fragmenting control of the business or exposing assets to the younger generation’s creditors. In addition, the older generation will need to consider whether they can afford to part with the assets sooner than they originally planned. Simply securing tax benefits could be offset by drawbacks posed by some or all of these other factors.
For families who do not already have a closely held entity in place, it probably will not make sense to rush into setting one up just to try to capture the existing benefit. Establishing a partnership is complicated, and it is not the only estate planning method available. If you handle all of the steps required to form a company and transfer interests to a younger generation in quick succession, the IRS is more likely to disallow the discounts and look at the overall planning as a sham to avoid taxes. For many people, there are alternative ways to eliminate their estate tax burden while transferring assets to younger generations; consider whether a less risky technique would better serve your needs.
If you own a family business and are looking to transition ownership within the family at a discounted value, it is prudent to at least explore your options before year end. If the regulations are finalized and the “loophole” is closed, family business owners will be penalized for keeping a company all in the family.