Proposed Treasury Regulations Regarding Valuation Discounts for Transfers of Family-Controlled Entities Would Apply More Broadly than Anticipated

September 08, 2016

After years of anticipation, the U.S. IRS recently issued Proposed Treasury Regulations that would, if enacted in their current form, substantially eliminate most valuation discounts for family-controlled entities and result in higher gift and estate taxes on transfers of family-controlled entities (even most entities with some non-family owners). The Proposed Regulations are more widely applicable than many estate planning professionals anticipated. Importantly, the Proposed Regulations apply to both operating and non-operating family-controlled entities (such as family limited partnerships funded with marketable securities) and contain a look back period for certain transfers completed within 3 years of death. There is a window of opportunity until at least December 1, 2016 for planning for individuals who wish to make gifts or other transfers of interests in family-controlled entities utilizing valuation discounts before the proposed regulations are finalized. If you would like to consider planning opportunities before the Proposed Regulations become effective, you should consult one of Dechert’s Private Client attorneys as soon as possible. 

Section 2704 of the Internal Revenue Code generally requires certain restrictions to be disregarded when valuing an interest in a family-controlled entity that is being transferred between certain family members, if after the transfer the restriction can be removed by the transferor or the transferor’s family. The Proposed Regulations are much more restrictive than the current law and significantly expand the applicability of Section 2704 by: 

  • Severely restricting the use of valuation discounts for lack of control and lack of marketability on transferred interests. 
  • Creating limited exceptions to the new restrictive rules that would allow for discounts only in specific situations that in practice will rarely be feasible. Even ownership of a significant minority interest by non-family members may not be sufficient to prevent the application of the new 2704 rules in most cases. 
  • Implementing a 3-year look back period for decedents dying after the effective date of the Proposed Regulations, including those who made transfers prior to the effective date. 

The effect of the Proposed Regulations is to severely restrict the use of valuation discounts resulting in higher gift and estate taxes on transfers of family-controlled entities. Consider the following example: 

  • Individual wishes to gift a minority interest in a family-controlled entity to a child. 
  • Value of the interest before any discounts is US$1 million. 
  • Individual has no exemption from gift tax remaining. 
  • Using current valuation methodologies, an appraiser might apply a 30% discount for lack of control and lack of marketability. 
  • Under the new proposed regulations, no valuation discounts would be allowed. 

Under the current law, the individual makes a gift of US$700,000 for gift tax purposes and pays US$280,000 in gift tax (at a 40% rate). Under the new Proposed Regulations, the individual would make a gift of US$1 million for gift tax purposes and would pay US$400,000 in gift tax (an increase of US$120,000). Although this is a simplified example that does not address the technical nuances of Section 2704, it illustrates the potential impact the Proposed Regulations may have if finalized in their current form. 

Based on the timing and the expected volume of comments to the Proposed Regulations, effective dates for the Proposed Regulations are anticipated to be in 2017, but certain provisions could become effective as early as December 2016. The scope of the Proposed Regulations may be challenged as exceeding the regulatory authority of the Treasury Department, and such a challenge could prolong definitive implementation of any regulations once finalized.

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