Proposed Estate Tax Rule

October 16, 2016

pic-farm-tractorIn August, the Department of Treasury issued long-awaited proposed regulations on minority discount valuations under section 2704 of the Internal Revenue Code, which would make sweeping and significant changes to the valuation of interests in many family-owned businesses for estate, gift, and generation-skipping transfer tax purposes.

The minority discount valuation issue deals with how the Internal Revenue Service (IRS) values a partial-ownership stake in, for example, a family-owned business. If the partial-owner does not own a controlling stake in the business—typically less than 50 percent—and cannot initiate a sale or liquidation of the business, then the value of the stake is given a “minority valuation discount.”

In 1990, Congress enacted section 2704 of the Internal Revenue Code, titled “Treatment of Certain Lapsing Rights and Restrictions,” in an effort to limit the valuation discounts for gift and estate tax purposes applicable in the case of intra-family transfers of interests in family-owned, or “closely held,” corporations and partnerships. If an individual and the individual’s family hold voting or liquidation control over a corporation or partnership, section 2704(a) provides, in general, that the lapse of a voting or liquidation right shall be taxed as a transfer subject to gift or estate tax. Section 2704(b) provides that when an interest in a family-owned corporation or partnership is transferred within the family, if a restriction limits the ability of the corporation or partnership to liquidate and that restriction can be removed by the family, that restriction is disregarded in valuing the transferred interest for gift or estate tax purposes.

Finally, in section 2704(b)(4), Congress authorized Treasury to issue regulations providing “that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”

The proposed regulations that were released in August would:

  • Treat as an additional transfer the lapse of voting and liquidation rights for transfers made within three years of death of interests in a family-controlled entity, thereby eliminating or substantially limiting the lack of control and minority discounts for these transfers;
  • Eliminate any discount based on the transferee’s status as a mere assignee and not a full owner and participant in the entity;
  • Disregard the ability of most nonfamily member owners to block the removal of covered restrictions unless the nonfamily member has held the interest for more than three years, owns a substantial interest in the entity, and has the right, upon six months’ notice, to be redeemed or bought out for cash or property, not including a promissory note issued by the entity, its owners, or anyone related to the entity or its owners;
  • Disregard restrictions on liquidation that are not mandated by federal or state law in determining the fair market value of the transferred interest; and
  • Clarify the description of entities covered to include limited liability companies and other entities and business arrangements, as well as corporations and partnerships.

Although section 2704, when it was enacted, referred only to corporations and partnerships, the proposed regulations would clarify that they also apply to limited liability companies and other entities and business arrangements, as well as corporations and partnerships.

If the final regulations are similar to the proposed regulations, taxpayers will have lost a significant estate planning technique, and the tax cost of transferring interests in family-owned entities will likely increase.

At the end of September, Senators Marco Rubio (R-Fl.), Jerry Moran (R-Kansas), and Jeff Flake (R-Ariz.) announced the introduction of the Protect Family Farms and Businesses Act (S.3436), legislation that would prohibit the Obama Administration from implementing its proposed regulations to unilaterally expand and raise the estate tax on family-owned small businesses. All three senators also joined 38 of their colleagues in urging U.S. Treasury Secretary Jacob Lew to withdraw the proposed regulations, writing that “they directly contradict long-standing legal precedent, create new uncertainty for taxpayers, and put family-owned businesses at a disadvantage relative to other types of businesses.” In the House, Rep. Warren Davidson (R-Ohio)) introduced the same bill (H.R. 6100), the Protect Family Farms and Businesses Act, that gained nearly 60 cosponsors, including members of the Ways and Means Committee and House Leadership.

This proposed regulation could significantly change family businesses’ succession plans and make it harder for family-owned businesses to transition to the next generation. These changes proposed to section 2704(b) would remove legitimate valuation discounts for estate, gift, and generation skipping taxes which businesses have used for the past two decades in order to prevent the IRS from overvaluing their businesses at death. These regulations will further add challenges to family-owned businesses who are already dealing with complicated and costly estate and gift taxes.

It is important that family businesses are vocal on how this rule will affect the future of your business. NSBA encourages you to submit comments to the Treasury Department before the end of the 90-day comment period deadline of November 1, 2016.

A public hearing on these proposed regulations has been scheduled for December 1, 2016, beginning at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC 20224. You must be on the building access list in order to attend the hearing, contact Regina Johnson (202-317-6901) to be placed on the access list to attend the public hearing.

NSBA has signed onto several letters expressing concerns for this proposal. Please click here to view a coalition letter to Treasury Secretary Jack Lew that had more than 3,800 signatories. Another letter has the support of more than 119 associations and companies.