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IRS Proposes New Rules for Valuing Interests in Family-Owned Businesses

August 24, 2016

By Andrew S. Rusniak

Earlier this month, the IRS issued long-awaited proposed regulations under Section 2704 of the Internal Revenue Code that, if adopted, will have a substantial impact on traditional estate planning techniques commonly utilized by business owners to shift equity in their businesses to their families. If finalized, these proposed regulations will substantially increase the estate taxes paid by the estates of owners of family-owned businesses.

The new rules are intended to address what the IRS perceives to be abuses in the way in which family-owned businesses are valued for estate, gift, and generation-skipping transfer tax purposes. Specifically, the proposed regulations severely limit the use of valuation discounts for any type of transfer of a family-owned business where the family, including trusts established for the benefit of the family, will retain control of the business both before and after the transfer occurs. Where a family will retain control of a business both before and after a transfer of an interest in the business, the proposed regulations deny the use of traditional valuation discounts, such as discounts for lack of control and lack of marketability, which have historically been used to reduce the value of a business owner’s estate, by requiring such restrictions to be disregarded when computing the value of the business interest for estate, gift, and generation-skipping transfer tax purposes.

By way of an example, assume that D is the sole shareholder of a family business that has 10 shares of common stock issued and outstanding and which has a fair market value of $15 million. Prior to the issuance of the proposed regulations, a common estate planning technique would be for D to recapitalize the business to create one class of voting, common stock and one class of non-voting, common stock. By recapitalizing the business, the majority of the equity in the business would be moved into the non-voting shares while control of the business would be retained by the voting shares. After the business is recapitalized, D would sell or gift a portion of the newly created non-voting shares to D’s descendants or to trusts established for the benefit of D’s descendants. For purposes of valuing the sale or gift of the non-voting shares, D would engage the services of an accredited valuation professional who would prepare a valuation report. The valuation report normally would provide for valuation discounts for lack of control and lack of marketability. Although the size of the discount is often debated among practitioners, the IRS routinely accepted valuation discounts of up to 40%. As a result, through the use of valuation discounts, D’s non-voting shares could be discounted to about $9 million. The proposed regulations aim to curb the use of these traditional valuation discounts by disregarding the lack of control and lack of marketability restrictions for purposes of determining the value of the transferred interests.

The proposed regulations are broad and apply to corporations, partnerships, limited liability companies, and all other business entities. A public hearing on the regulations is scheduled for December 1, 2016, which is required before the regulations are made effective. It cannot be predicted when, or if, the proposed regulations will be made final or whether the IRS will make any additional changes. However, if you own a family-owned business and have been contemplating shifting equity in the business to your family members or descendants, we encourage you to contact your advisors as soon as possible to discuss whether the proposed regulations will apply to your transfer.

© 2016 McNees Wallace & Nurick LLC
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