October 6, 2016

Proposed Regulations Create Limited Window to Use Discounts for Family Gifts

The IRS has issued proposed regulations that, if finalized, will greatly restrict valuation discounts on transfers to family members. Currently, a transfer of an interest in a family entity, typically a LLC or a family limited partnership, can be reduced in value due to discounts allowed for “lack of marketability” and “lack of control.” These discounts have been disputed by the IRS for many years, but since the IRS has had little success with its argument in the tax courts, it is attempting to reduce or eliminate the discounts through new regulations.

Lack of Marketability Discount. The owner of an interest in an LLC, when making a gift to a family member, has been successful in taking a discount on the value of the interest under the theory that there is a limited “market” for the purchase of the interest. Many times the LLC operating agreement doesn’t allow for the transfer of an interest outside of the family line. This results in the interest, for gift tax purposes, being valued less than its percentage of the value of the entire LLC and correspondingly reducing the gift and estate tax exemption needed to gift the interest to a family member.

Lack of Control or Minority Interest Discount.  Similarly, the owner of a minority interest in a business entity does not have the ability to force the liquidation of the entity, to force distributions or unilaterally make other business decisions. Because of this “lack of control” the owner of such an interest has been able to take a “lack of control” discount on the value of the interest when it is gifted, even to a family member.

Changes by Proposed Regulations. The proposed regulations would greatly reduce, if not eliminate, both the minority interest discount and the lack of marketability discount. The IRS believes if the percentage of ownership by the family is the same before and after the gift, these discounts are “illusory.” The notion is that the family can vote their individual interests as a block and there was no real change by making the gift.

Window of Opportunity. There will be a hearing on these proposed regulations on December 1, 2016 and the soonest they will be in effect is as of December 31, 2016.

The per-person exemption from estate tax is currently $2,079,000 for Washington and $5,450,000 for federal estate tax (both of these will be adjusted annually for inflation).

If you are concerned your estate might exceed these exemptions and you own a business entity that you might want to gift to a family member, either outright or in trust, we recommend you reach out to a member of Foster Pepper’s Estate Planning group to discuss how acting soon could benefit you and what steps should be taken. Given the short timeframe before the new regulations may be in effect, we highly recommend you begin the discussion soon.

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