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Estate and Gift Tax Planning Alert—Valuation Discounts in Family Transfers May Be Disappearing

The clock may be ticking on the ability to take valuation discounts when transferring ownership interests in privately held businesses to family members. After years of hinting that this change may be coming, the U.S. Treasury Department issued proposed regulations under Internal Revenue Code § 2704 on Aug. 2, 2016 that may do just that.

The current regulations effectively allow for the consideration of applicable valuation discounts for lack of control and lack of marketability in determining the fair market value of an ownership interest in a privately held company. These discounts come into play because the fair market value of an ownership interest in a privately held company is determined from the perspective of a “willing buyer” and “willing seller,” both of which would consider the impact on value related to (a) not having control of the company if a non-controlling (minority) ownership interest is being transferred; and (b) the lack of a market to readily sell the ownership interest like those available for publicly traded companies. These valuation discounts apply to both operating companies and holding companies (including family limited partnerships (“FLPs”) and limited partnerships (“LPs”). Essentially, these valuation adjustments enable families to transfer ownership interests from one generation to the next on a discounted basis without losing control of the business.

A common estate and gift tax planning strategy for transferring wealth is to make gifts of minority ownership interests in privately held businesses to later generations of family members. In effect, the applicable discounts allow the transfer or to transfer a greater portion of his/her wealth and ownership in the company before exceeding the federal gift and estate tax exemption ($5,450,000 in 2016) and owing tax to the federal government.

The proposed regulations may effectively eliminate consideration of valuation discounts when gifting ownership interests to family members, which would significantly reduce the amount of wealth that can be transferred without incurring federal estate and gift taxes. This, coupled with Democratic policy favoring a reduction in the estate and gift tax exemption, is creating a situation similar to the “Fiscal Cliff” we experienced at the end of 2012 (when the estate and gift tax exemption was set to decline from $5.1 million to $1.0 million before new legislation was introduced early in 2013). In the current situation, as with the 2012 Fiscal Cliff, owners may be forced into a position to act quickly and transfer ownership interests via gift before the regulatory landscape changes and a greater portion of one’s wealth is made subject to federal estate and gift tax.

A hearing regarding the proposed regulations is scheduled for Dec. 1, 2016, and any new regulations will not be effective until 30 days after they are finalized. This means that the window on taking valuation discounts on gifts of ownership interests in privately held companies could close shortly after the end of calendar year 2016. It would be wise for business owners to discuss with their attorneys and valuation experts the impact of the proposed regulations on their personal financial situation and determine whether it makes sense to begin transferring ownership via gift on a discounted basis prior to these potential changes coming into effect.

For questions regarding estate and gift tax planning, contact Sean Saari, CPA/ABV/CVA/MBA at 440-449-6800 or email Sean.

Valuation Considerations When Buying or Selling a Business - Part 2

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