Edward Koren is a Partner in our Tampa office. Kevin M. Bergesen is an associate in our Boston office. Robert B. Berselli is an associate in our Portland office. Patrick J. Duffey is an associate in our Tampa office. Patrick C. Emans is an associate in our Miami office.
Earlier this month, the U.S. Department of the Treasury unveiled its long-awaited proposed regulations targeting valuation discounts commonly used in estate planning, thereby overturning decades of settled law. As drafted, the proposed regulations would severely limit or even eliminate the use of certain valuation discounts on transfers between family members of interests in closely held businesses, including family limited partnerships, real estate ventures and similar enterprises.
Until the proposed regulations in their final form are adopted, transfers of interests in closely held businesses have the ability to be discounted substantially for transfer (estate, gift and generation-skipping transfer) tax purposes with proper estate planning. If adopted as drafted, the proposed regulations are expected to significantly impact the valuation of closely held entities, including:
- Eliminating Discounts to Formerly Controlling Interests Retained by Transferors. The proposed regulations would limit or significantly diminish lack of control or minority discounts for transfers within three years of death, where the interest transferred causes a "lapse" of voting or liquidation rights. In those cases, the entire value of those voting or liquidation rights – which "lapsed" because of the transferor's relinquishment of a controlling interest – will be subject to estate tax at the transferor's death.
- Disregarding Most State Law Limitations on Liquidation. The proposed regulations would ignore, for valuation purposes, any restrictions on the liquidation of the entity that are not expressly mandatory under applicable state or federal law.
- Disregarding Limitations on Liquidation Contained in Governing Documents. The proposed regulations would limit or significantly diminish lack of control or minority discounts for any transfers to a family member who, after the transfer, does not have the unfettered ability to vote or liquidate his or her entire interest for cash (or, in limited cases, a note) with six months' notice.
- Disregarding the Ownership Interests of Most Non-Family Member Owners. In determining whether minority ownership discounts may be applied to family-owned interests, the proposed regulations would largely ignore the ability of non-family members to affect management of the entity, unless each of them own a substantial interest (at least 10 percent) for more than three years prior to the transfer, are part of a significant bloc of non-family members (at least 20 percent), and possess the unfettered ability to vote or liquidate their entire interest for cash (or, in limited cases, a note) with six months' notice.
- Expanding the Scope of Affected Entities. The proposed regulations would expand the definition of what constitutes a covered entity to include not only corporations and partnerships, but also limited liability companies, S corporations, and other entities and arrangements regardless of their classifications for tax purposes.
These changes, if adopted in their current form, would significantly limit the availability of discounts for transfers of interests in a closely held business to family members and cause more of the value of a closely held business to be subject to estate, gift and generation-skipping transfer taxes. In some instances, the proposed regulations may even tax "phantom" interests that do not exist.
The Treasury Department is in the process of collecting comments for 90 days, after which it will hold a public hearing on Dec. 1, 2016. Thereafter, the Treasury Department will issue the regulations in their final form, along with an effective date for their application.
The Bottom Line
If you are contemplating making a transfer of an interest in a closely held business to family members or a trust for their benefit, you should take action and consult with your estate planning attorney immediately.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.