Window Closing on Discounts for Intra-family Gifts

We've been quiet for a couple of weeks, something we intend to avoid in the future, however today's blog addresses the Proposed Regulations announced yesterday by the Treasury Department and the IRS with respect to the ability to claim a discounted valuation for Intra-family gifts. If you or your clients are considering transferring partial ownership of a family business on to children it may be beneficial to do so sooner, rather than later.

In previous blogs we discussed the strategy of using a Family Limited Partnership or Family L.L.C. to transfer interests in either family owned businesses or other types of assets, such as real estate, to children while allowing parents to retaining control of the entity during their lifetime. A major benefit of such transfers is the ability of the parent to claim a significant discount in the valuation of the transferred assets for the purposes of Gift Tax liability. On Tuesday August 2, 2016, the Treasury Department and the Internal Revenue Service announced Proposed Regulations that address this strategy and, if put into effect as written, will significantly reduce the ability of family business owners to take advantage of this strategy.

Under current regulations, it is possible for a parent to transfer interests in a family business to the other family members while retaining operational control of those businesses. The transferred interest does not contain voting rights and specifically indicates that the family member does not have the right to sell or otherwise alienate the interest. The lack of control over the operation of the business and inability to sell the interest reduces the value of the interest and allows for a discount in the value for purposes of gifting. This discount allows the client to transfer a greater value of assets to their loved ones at a lesser cost for gift tax purposes. When it has challenged transfers of this nature in court, the IRS has consistently argued against the size of the discounts. 

The Proposed Regulations generally provide that if a parent transfers an interest in a corporation that the parent controls to any other member of the family any "applicable restriction" shall be disregarded in valuing the transferred interest. The Internal Revenue Code defines “applicable restriction” as “any restriction that effectively limits the ability of the entity to liquidate, but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or any member of the transferor’s family, either alone or collectively.” In plain English, the Proposed Regulation provides that if a parent transfers an interest in a family owned business to their child with the restriction that the child cannot alienate their interest in the business without the parent’s permission, that restriction is ignored for purposes of valuing the transferred interest. The removal of such restrictions from consideration in valuing the interests transferred will have a significant impact on the strategy of transferring interests in family owned businesses.

While the Proposed Regulations will significantly limit the valuation discount available to clients when making transfers of family-owned businesses, it does not entirely eliminate the benefits of such transfers. Until these regulations go into effect and are tested in real-world situations, it is unclear what level of discount the IRS will argue is reasonable with respect to other restrictions placed on interests transferred to children that do not relate to the child's ability to alienate the interest. Additionally the strategy of transferring minority or non-controlling interests in family businesses to children is still very beneficial, especially when those business interests contain assets that are likely to appreciate significantly in coming years. Such transfers are also still relevant in the context of succession planning for family businesses, as an equity interest in the family business is often necessary to ensure that future generations are fully invested in the operation of that business before they are given control of the company.

There is still an opportunity to take advantage of the valuation discount, but the window for doing so may be closing. Before these Proposed Regulations can go into effect they must first go through a 90-day public comment period, after which there may be changes, but even if there are no changes, portions of the regulations will not take effect until 30 days after the government issues a final version of the regulations.

The strategy of using a Family L.L.C. to obtain a discount in the valuation of assets transferred to children is a complex legal strategy that business owners should not attempt without consulting an attorney and accountant who are familiar with the process. Avoiding significant issues with the IRS in implementing this strategy requires sound valuations of the business and working with advisors familiar with the process of justifying such valuations. If you have additional questions, concerns, or interest in discussing whether this strategy may be appropriate for your circumstances, or the circumstances of one of your clients, we encourage you to contact us quickly, as the time available to take advantage of this strategy is very limited.

Alan and Matt