Controversial proposed regulations issued by the Treasury and
the IRS on August 4, 2016, would change rules for valuing interests
in business entities of which a person or a family owns at least
one-half. The regulations would require using values for gift and
estate tax purposes that ignore some of the parties' legal
rights and liabilities. Thus, the regulations would inflate the
value of business interests beyond their true values and constitute
a back-door tax increase.
For years, taxpayers have been placing nonbusiness assets in
business entities. Because closely-held business entities are
illiquid and owners of certain interests lack control, the
ownership interests are often worth much less than a pro rata share
of the entities' assets. The IRS has had only limited success
trying to increase the value of closely held business interests to
a pro rata share of the entities' assets.
Fourteen years after losing a case in which the court suggested
that the government consider changing the regulations, the
government took action. Most practitioners assumed that the
regulations would attack entities specifically formed to hold
nonbusiness assets. However, the proposed regulations apply to
operating businesses as well.
They would ignore most restrictions limiting an owner's
ability to cash out in six months or to cause the business to
liquidate if and to the extent the owner or the owner's family
could remove those restrictions. Furthermore, they do not
distinguish between restrictions under the entity's governing
documents and restrictions imposed by state law. They respect
"a commercially reasonable restriction on liquidation imposed
by an unrelated person providing capital to the entity for the
entity's trade or business operations, whether in the form of
debt or equity." However, the regulations would not allow
consideration of contingent liabilities or draw a line between
business risks that affect the business' going concern value
and contingent liabilities.
Who will be affected?
Any person who owns, or whose family owns, at least half of the
entity would be subject to these rules. The proposed regulations
seem to imply that a person who owns (or whose family owns) at
least half of the entity will have his or her business interest
valued as if he or she could cash out.
The proposed regulations also includes in a decedent's
estate any level of control, part or all of which was transferred
within three years of death. However, the estate would not receive
a marital or charitable deduction reflecting that level of control,
because that level of control does not pass to the surviving spouse
The proposed regulations apply to restrictions created after
October 8, 1990, occurring either the day after or at least 30 days
after the proposed regulations are finalized, depending on the
particular restriction. Written comments are due November 2, and on
December 1 the government will hold a hearing, granting each
speaker 10 minutes. Whether the government will finalize the
regulations quickly or take its time is anybody's guess. Given
that a political announcement accompanied the proposed regulations,
the prospect of a change in Administration might affect the
Action items to consider in consultation with a qualified
Consider making transfers before the proposed regulations
become final. These transfers might be gifts, sales, or perhaps
using other estate planning tools.
Review buy-sell agreements to consider whether any additional
estate tax would apply under these rules and plan for who should
pay that tax. Exercise caution in changing any provisions that
existed on October 8, 1990.
When reviewing commercial loan agreements, carefully review any
covenants that affect the owners' ability to cash out and
document the extent to which these covenants require buy-sell
provisions to prevent cashing out.
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.
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