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Family owned businesses: The IRS seeks to eliminate the discounts

On August 2, 2016, the Department of Treasury (IRS) issued long-awaited Proposed Regulations affecting Section 2704 of the Internal Revenue Code (“Proposed Regulations”) with respect to restrictions on the liquidation of an interest in certain family controlled corporations and partnerships. Advisors in the tax and estate planning community have been expecting these Proposed Regulations for some time; however, the magnitude of the changes has surprised many, which begs the question of whether the IRS has overstepped its authority.

The Proposed Regulations attack the well-established practice of transferring interests in family owned businesses using appropriate minority interest and marketability discounts. For example, assume that a senior generation member with three adult children owns a company with a fair market value of $10 million. If he or she decides to transfer the equity value of the company to children, restrictions in a shareholder agreement (corporation) or LLC operating agreement (LLC) permit a valuation professional to discount the value of the equity interests. These discounts typically range in value from 25% to 45%. So in our example, assuming a 30% discount, the value of the equity discounted for minority interest and lack of marketability, would be $7,000,000 permitting the business owner to transfer a greater amount of equity to children or other descendants free of estate and gift tax. The Proposed Regulations would minimize or eliminate this $3,000,000 “discount.”

The Proposed Regulations use several different lines of attack, including:

• Establishing a new three-year rule that ignores any discounts associated with the transferor's right to liquidate the entity if the transfer occurs within three years of the transferor's death;

• Removing the “applicable restriction” exception in Section 2704(b) based upon limitations included in a state statute;

• Creating a hypothetical “put right,” which disregards restrictions in a shareholder or LLC agreement that limits the ability of the holder to liquidate the interest for less than “minimum value;” and

• Disregarding any interest held by a nonfamily member unless it meets certain holding period and ownership percentage tests.

The Proposed Regulations contain extensive background information and detail, but share the common theme of reducing or eliminating discounts that the IRS has failed to defeat in litigation with taxpayers under the existing statute and regulations.

The IRS has invited comments to the Proposed Regulations, which are due by November 1, 2016; absent any other change or challenge, the Proposed Regulations would take effect as early as December 1, 2016.

For those readers contemplating transferring interests in a family business, now is the time to act. You should consult with your accounting, legal and valuation advisers on an appropriate strategy. Unlike 2012, when increases in the estate and gift tax did not materialize, the Proposed Regulations will take effect at some point in the near future. Any transfers completed prior to the effective date of the Proposed Regulations should avail of discounts under existing law, although this view should be confirmed with professional advisers, particularly in light of the new “three-year rule” introduced in the Proposed Regulations.

• Ken Clingen specializes in business counseling, tax and succession planning at Clingen Callow & McLean LLC, a full-service business law firm of advisers and counselors with offices in Lisle and Geneva. You may contact Ken at (630) 871-2608 or clingen@ccmlawyer.com.

The information in this article is intended for general purposes only and does not constitute legal advice. Readers should not act upon the information in this article without individual professional counseling.

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