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Proposed Wealth Transfer Regs: What You Need to Know If You Have a Family Business
By: Ryan E. Scharar, JD, CPA

Editor’s Note: This article originally appeared in FWinc. magazine in January 2017 and is being republished by permission.

Historically, families have used various ways to transfer wealth among family members that minimize estate and/or gift taxes. One popular method involved setting up an entity that would be owned by multiple family members, some of whom received the ownership interest as a gift or inheritance, usually from a parent or grandparent. The entity would often be a partnership whose ownership interest was subject to certain restrictions on the right to control the partnership and that lacked easy marketability.  The existence of these restrictions allowed the partnership interest being transferred to be valued at a discount, thus saving gift taxes.

As this article goes to press, the Internal Revenue Service is conduction a hearing on the new proposed regulation under Internal Revenue Code §2704 that, if adopted, would drastically restrict or eliminate traditional valuation discounts available to family-controlled entities.

The regulations expand the types of entities affected by the valuation rules from partnerships and corporations to include other business arrangements, eliminate discounts for family controlling interests transferred within three years of the transferor’s death, disregard limitations on liquidation per state law of contained in governing documents, and further limit the relevance of no-family member owners in a valuation analysis. The IRS rules have seen significant political opposition in recent months, with legislation introduced in the House and the Senate to block funding for them.

The IRS issued the proposed regulations in an attempt to stem abuses under IRC §2704, but opponents say the regulations are too broad and prevent family businesses from applying discounts to transferred assets for legitimate purposes like lack of marketability and lack of control.

More information on the changes:

Expanded application of discount valuation rules to more types of business arrangements, as they will expand from applying to corporation and partnerships to also include S Corporations, qualified chapter S subsidiaries, LLCs, joint ventures, and other similar enterprises.

Transfers three years or less prior to transferor’s death may now need to be included on the estate tax return. If a person transfers their family business interest within three years of their death and the transfer results in the loss of liquidation or voting rights, then the value of the liquidation or voting right is included in the person’s gross estate at death.  Since the value of the rights would be “phantom value,” the rights would be ineligible for the marital deduction or as a charitable deduction. This is significant since the minority discount for lifetime transfer may now be added into the transferor’s gross estate if the transfer occurs within three years of death.  

More restriction will be disregarded under the proposed rule. The proposed regulations would disregard limitations on ability of the interest holder to liquidate the company if the limitation arises from state law, not expressly mandatory under state law. This means that state law limitations on liquidations, while in effect, would still be ignored if they were not plainly required under state law.

The proposed regulations also describe an entire class of other “disregarded restrictions” that would not be allowed as the basis of a valuation discount, such as restrictions that (i) limit the ability of the holder of the interest to liquidate the interest; (ii) limit the liquidations proceeds to less than a “minimum value”; (iii) defer the payment of the liquidation proceeds for more than six months after the date the holder gives notice of intent to have the holder’s interest liquidated or redeemed; or (iv) permit the payment of the liquidation proceeds in any manner other than in cash or property, subject to certain limitations.

Non-family members disregarded. The definition of “family members” changes so that nonfamily members are disregarded more often for valuation discount purposes, making the exception more difficult to meet. The new definition would disregard nonfamily member interests if the interest was held for less than three years; constitutes less than 10 percent of the entity’s equity interests or interest in profits and losses; constitutes less than 20 percent of the entity’s equity interests in profits and loses when all nonfamily interests are aggregated; or the nonfamily owner has no enforceable right to receive the minimum value (as defined in disregarded restriction) on no more than six months’ notice.

Once the regulations are finalized, these changes would be legally binding. Individuals are advised to consult their attorney or CPA.

Ryan E. Scharar, JD, CPA is an attorney with Scharar Law Firm, PC in Fort Worth. He can be reached at ryan@scharartax.com.