Proposed Changes to Closely-Held Business Valuation
by Robert Hodges >
Proposed Changes to Closely-Held Business Valuation (Download a PDF of this article)
Estate and gift tax concerns the transfer of assets (usually from an older generation to a younger one). The goal of estate and gift tax planning is to transfer assets effectively and efficiently for the lowest tax cost. If the assets being transferred are not easily valued, the taxpayer needs to value those assets in a manner acceptable to the IRS. Valuation concerns usually arise with family business entities.
Currently, there is a robust body of Treasury Regulations, court rulings, and academic studies used by valuation experts to provide an opinion as to the value of an interest in a closely-held business. A recent proposal by the IRS may impact the methods utilized to value interests in family businesses on estate and gift tax returns. The uncertainty generated by the proposed rules means the next few months may be an opportune time to transfer interests in a family business to the next generation.
On August 4, 2016 the IRS published proposed regulations that could significantly alter the landscape for family business valuation. Family control of an entity generally means at least fifty percent (by vote or value) of a corporation; fifty percent of a capital or profits interest in a limited liability company or partnership; or any ownership interest with the ability to cause liquidation. As such, there are many entities that may be impacted by the IRS proposal. It is important to note, however, these proposed regulations are not final. A hearing on the proposed regulations is scheduled for early December and the implementation date, if any, should not occur until early 2017. Given the amount of confusion the muddled language of the proposed regulations has generated, our assessment is the final rules may vary significantly from the proposed language. Further, we anticipate substantial litigation if these proposed regulations are implemented as currently drafted. The proposed regulations have even garnered enough publicity that Congressional bills have been introduced to outlaw them.
The concept under siege pursuant the IRS’ proposed regulations is what is known as “valuation discounts.” In a nutshell, valuation experts often opine that an interest in a family business without a wide market for ownership and without the ability to control the larger entity is worth less than a proportionate slice of the family entity. These “valuation discounts” enable more ownership to be transferred to successive generations for a lower tax cost. Like many areas of tax law, some practitioners have been particularly aggressive in designing passive business structures formed to take particular advantage of “valuation discounts.” This is especially true when a family-controlled business has no assets beyond marketable securities and does not have any active business. Our belief is that the proposed regulations are a broad-side attack on entities created solely to take advantage of valuation discounts.
The reality, however, is the language of the proposed regulations provides more questions than answers. The scope and operation of the new rules is unclear and the estate planning community’s opinions on the impact of the rules diverge widely. The proposed rules affect entities that are operating businesses, not just those designed to solely take advantage of valuation discounts. Frankly, it is uncertain if the wider implications were even intended by the IRS. At best (from an estate tax planning view), the proposed regulations will provide little impact to operating companies controlled by a single family and a modest impact to family entities whose only asset is marketable securities. At worst, the valuation discounts that have been used widely for many years will no longer be available to any entity controlled by a single family. We believe the impact to operating companies formed for reasons other than minimizing estate taxes are more likely to be modest. Regardless, the valuation experts who provide an opinion of closely-held business interests for estate and gift tax reasons will need to revise their methodology. This may drive the expenses associated with a valuation higher after the proposed rules become effective.
Given the shifting sands regarding valuation of family-controlled business interests we recommend the following:
- Closely monitor the situation
- Consider making transfers before the proposed regulations become final to take advantage of discounts that may not be available in the future.
- Be aware that if you value and report a gift using valuation discounts and then pass away within three years of making the gift, part of the gift may be includable in your taxable estate.
- Forecast the impact of the proposed regulations on your estate and determine if changes to your estate plan are necessary.
Robert D. Hodges is an associate attorney at BrownWinick and practices primarily in the areas of taxation, estate planning, and business law. You can reach Bob at (515) 242-2465 or firstname.lastname@example.org.