Dr. Peter Venkman: This city is headed for a disaster of biblical proportions.

Mayor: What do you mean, “biblical”?

Dr Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath of God type stuff.

Dr. Peter Venkman: Exactly.

Dr Ray Stantz: Fire and brimstone coming down from the skies! Rivers and seas boiling!

Dr. Egon Spengler: Forty years of darkness! Earthquakes, volcanoes…

Winston Zeddemore: The dead rising from the grave!

Dr. Peter Venkman: Human sacrifice, dogs and cats living together… mass hysteria!

Mayor: All right, all right! I get the point!



What’s Going On?

In case you haven’t noticed, there has been a lot of press lately about the “imminent” issuance of proposed regulations by the IRS that, if adopted, may seriously impair the ability of a taxpayer who is transferring an interest in a closely-held business (whether by gift or by sale) to claim valuation discounts in determining the fair market value (FMV) of the interest.

Some of the commentary has gone so far as to urge taxpayers to make such transfers now, before the regulations are issued and the opportunity for a “favorable” valuation is foreclosed. After all, they say, the regulations will become effective for any transfers occurring after their adoption.

To all those people, I say: “Slow down, you move too fast.”

Goals of Gifting

The fair market value of property transferred, whether on the death or during the life of the transferor, generally is subject to estate or gift tax at the time of the transfer. Gift-money

Generally, a primary goal of gifting property to a child or other family member is not only to remove the value of such property from the transferor-parent’s estate, but also to remove any subsequent appreciation in the value of that property from the estate.

If the parent does not transferred the property during his or her life, the full value of that property as of his or her date of death will be included in the parent’s estate and be subject to transfer tax.

Another goal of gifting property is to position the remaining business interests held by the parent in a more favorable valuation posture for estate tax valuation purposes (for example, by putting the parent in a minority interest position).

Valuation – In General

If a transfer of a business interest is a completed gift, the amount of the gift (i.e., the amount on which the gift tax is imposed) is the FMV of the interest on the transfer date.

Generally, the valuation of property for gift and estate tax purposes is based upon the “hypothetical willing buyer and willing seller” standard. In other words, it does not consider the actual transferor and transferee, and their relationship to each other (e.g., family) does not matter. These hypothetical individuals are under no compulsion to buy or sell, and they are each deemed to have reasonable knowledge of all the relevant facts (including, in most cases, the fact that the other owners of the business may be related to one another).

In the case of stock in a closely-held corporation or partnership, however, the FMV of an interest depends on the relevant facts and circumstances of each case. The IRS has set forth many of the factors to be considered (e.g., economic outlook, earning capacity, goodwill, the size of the interest to be transferred, etc.). The courts have accepted appropriate discounts in valuing these interests where they represent minority positions for which there is no ready market.  Among these are the discounts for lack of control (LOC) and for lack of marketability (LOM).

Thus, if the interest being transferred by way of a gift is a minority interest in a closely-held entity for which there is no ready market, a hypothetical willing buyer will realize that he cannot easily realize the pro rata value of the entity to which the minority interest “entitles” him. Because he or she cannot force a dividend distribution, a sale or a liquidation, it will be difficult to convince another hypothetical party to purchase his or her interest. Under these circumstances, the courts and the IRS have recognized that various discounts may be applied to the so-called “normative” value of an equity interest in order to determine its FMV.

The IRS, Congress & Discounting

In accordance with these long-standing principles, taxpayers making gratuitous transfers of interests in closely held business entities have routinely claimed LOC (where appropriate) and LOM discounts on the valuation of such interests, and where the entity is engaged in an active business, the IRS has been willing to accept these discounts (though it may challenge the size of the discount claimed).

Many years ago, certain provisions were enacted into law to prevent the reduction of taxes through the use of “estate freezes” and other techniques designed to reduce the value of the transferor’s taxable estate and to discount the value of the taxable transfer to the beneficiaries of the transferor without reducing the economic benefit to the beneficiaries. Generally, under these provisions, certain “applicable restrictions” (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members.

The application of these special rules results in an increase in the transfer tax value of those interests above the price that a hypothetical willing buyer would pay a willing seller, because they generally direct an appraiser to ignore the rights and restrictions that otherwise would support significant discounts for lack of marketability and control.

According to the IRS, however, these special rules have fallen short of expectations in stemming abusive gift planning. Tax planners, the IRS says, have carried the above valuation concepts over into the family estate planning area, where it is now common for a taxpayer to contribute marketable assets to a family limited partnership or limited liability company and to make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

This disappearing value is illusory, the IRS says, because family members are not minority interest holders in any meaningful sense. Moreover, it is implausible that the donor would intentionally take an action (contribution of the property to an entity) if the donor really believed that such action would cause the family’s wealth to decline substantially.

Consistent with the IRS’s position, the Clinton administration proposed, unsuccessfully, to eliminate valuation discounts except as they apply to active businesses. Under its proposal, interests in covered entities would have been required to be valued for transfer tax purposes at a proportional share of the net asset value of the entity to the extent that the entity held readily marketable assets at the time of the gift or death. To the extent the entity conducted an active business, the reasonable working capital needs of the business would be treated as part of the active business (i.e., not subject to the limits on valuation discounts).

More recently, the Obama administration proposed (also unsuccessfully) to create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the transferor’s family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest and any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity. Regulatory authority would have been granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of the new valuation provisions if certain standards were met.

The IRS Reacts (?)

As a result of these legislative failures to curtail what it views as valuation abuses in the transfer of family-owned business entities, the IRS recently announced that it would be issuing regulations that may limit minority interest and lack of marketability discounts when valuing certain family-owned business entities.

At this point, it unclear whether the proposed regulations will target only family limited partnerships and limited liability companies that primarily hold readily marketable assets (or other passive investments), and not actual operating companies.

The adoption of such regulations, however, would effectively make it more “expensive” to transfer interests in family-owned business entities, in that it may result in greater gift or estate tax liabilities (e.g., by limiting the size of the interests transferred by way of gift).

What To Do?

At the moment, we know nothing of these regulations. Questions and, worse, speculation abound. These can only lead to some irrational responses. Remember 2012, when taxpayers gave away assets that were not “disposable” and that they tried to reacquire after the extension of the increased exemption amount?

Based on prior legislative proposals, we may surmise that there will be additional categories of restrictions that will be ignored in valuing the transfer of an interest in a family-controlled entity to a member of the transferor’s family. In addition, the regulations may a provide safe harbor to permit taxpayers to draft the governing documents of a controlled entity so as to avoid the application of the new valuation provisions. It is also possible that the regulations will not apply to operating businesses.

In any case, taxpayers must not lose sight of the fact that they are now dealing with an increased exemption amount (currently set at $10.86 million per married couple), one that is adjusted annually for inflation. They must recognize that zeroed-out GRATs and grantor trusts remain valuable vehicles for leveraging gifts of close business interests. They should also recall that defined value clauses have gained greater acceptance in the courts as a means by which to avoid a taxable gift.

Finally, taxpayers should be reminded of the primary directive that the tax consequences alone should not drive their decision to transfer interests in a family business. Such a transfer first has to make sense from a personal perspective and from a business perspective.