Fast Action May Be Needed to Avoid Proposed Valuation Rules

November 02, 2016

On August 2, the IRS issued proposed regulations that, if made final, could result in substantial increases in gift or estate taxes for owners of interests in some family owned corporations, partnerships, limited liability companies (LLCs), or other business or investment companies.  

The new rules would restrict or eliminate discounts that previously had been allowed for gift and estate tax purposes. The increase in valuation may, in turn, result in higher gift or estate taxes when interests in a company are given or left to family members (or, in the case of a sale to a family member, will require that the sale be made at a higher price). However, a shareholder, partner, or LLC member who would otherwise be subject to the new rules can avoid that result by making transfers before the new rules take effect.

Will the New Rules Affect You?

The new valuation rules would apply to the transfer of an interest in a “controlled entity” to a member of the family that controls the entity. As such, they will not affect you unless you have an interest in a company that you or your family controls. If you do have an interest in a controlled entity, you may need to act quickly—possibly before year-end—to reduce or avoid the additional tax costs the rules may create.

Persons Subject to the New Rules

The proposed regulations define the term “controlled entity” differently for corporations, partnerships, and LLCs or other entities. You have an interest in a controlled entity if you and your family own, directly or indirectly, at least 50% of the total voting power or total fair market value of the equity interests in a corporation, or at least 50% of the total capital interests or total profits interests in a partnership, LLC, or other entity. You also have an interest in a controlled entity if you or any member of your family is a general partner of a limited partnership, or if you or any member of your family owns an equity interest in a business entity other than a corporation that gives you or the family member the ability to liquidate the entity.

The interests that are taken into account in applying those definitions include ones held by you, your spouse, and other family members, including your parents and grandparents, your spouse’s parents and grandparents, any lineal descendants of you or your spouse, any brother or sister of you or your spouse, and any spouse of any of those family members. They also include interests held indirectly through estates, trusts, or other entities. They do not include interests held by nieces and nephews.

Note that an entity can be a controlled entity with respect to some family members and not others. In determining whether you have an interest in a controlled entity, for example, interests held by your nieces and nephews are not taken into account. Those interests are taken into account, however, in determining whether the entity is a controlled entity with respect to your parents. As a result, an entity may be a controlled entity with respect to your parents but not for you, or it may be a controlled entity with respect to you but not for your children. Similarly, an entity may be a controlled entity with respect to you but not for your brother or sister, or it may be a controlled entity with respect to a brother or sister but not for you.

Because the definition requires “at least” 50% ownership, an entity can also be a controlled entity with respect to two different families (even if the families are unrelated) if each family owns a 50% interest in the entity.

Size of Your Estate

The new rules would have adverse effects only for persons who are subject to federal estate and gift taxes. There may be no adverse federal tax consequences for persons whose estates are below the threshold for federal gift and estate taxes (approximately $5.5 million for an individual or $11 million for a married couple, subject to future adjustments for inflation), although there might be adverse state tax consequences in states with lower thresholds. The new rules might instead provide a benefit for persons whose estates are below the threshold by providing for a greater, tax-free basis stepup for income tax purposes for assets passing through an estate. Keep in mind, however, that your estate may be larger in the future, particularly if you have an interest in a successful family company.

What Do the New Rules Do?

Under current law, interests in property are valued for gift and estate tax purposes under a “willing-buyer/willing-seller” standard that assumes that the buyer and seller are unrelated parties acting at arm’s length—even if they are not. Transfers of interests in family companies are typically eligible for a valuation discount (a discount for lack of marketability) because the lack of any ready market for such interests would make them unattractive to a hypothetical investor outside the family. A transfer of a non-controlling interest may be subject to a further discount (a minority interest discount) because the holder’s inability to control the company’s business activities, including the sale or investment of the company’s assets and the payment of dividends or other distributions, would similarly make such interests unattractive to an outside investor. Additional discounts may be available if, for example, there are restrictions on the ability to liquidate an entity. Discounts totaling 30% or more have often been allowed, even for companies holding only liquid assets, with higher discounts for interests in companies engaged in an active business or in real estate operations.

The new valuation rules proposed by the IRS are intended to cut back or eliminate those types of discounts for transfers of interests in companies coming within the definition of a controlled entity. The precise effect the regulations would have is not clear at this point, but the regulations seem to be designed to reduce or eliminate discounts in valuing interests in a controlled entity and may require that such interests be valued at an amount that the regulations refer to as the “minimum value” of the interest—i.e., a pro rata share of the net value of the entire company (the fair market value of the company’s assets less its liabilities).

If the regulations are adopted as final in their current form, they could result in substantial additional gift or estate tax costs, even in situations where valuation discounts are warranted by the facts. Assume, for example, that an individual owns a 10% interest in a company whose assets could be sold for net proceeds of $10 million. Under current law, that unmarketable, minority interest might be valued for gift and estate tax purposes at about $700,000 (a 30% discount) if the assets are liquid investment assets, or about $550,000 (a 45% discount) if the company is an active business. Under the new rules, the interest might instead be valued at its “minimum value” of $1 million (10% of the net, assumed sales proceeds of $10 million). The resulting tax treatment can be summarized as follows:

Current Law

Minimum Value Rule

30% Discount

45% Discount

Estate Tax Value

$ 700,000

$ 550,000

$ 1,000,000

Estate Tax Cost

$ 280,000

$ 220,000

$    400,000

Why Is This Happening?

In recent years, many taxpayers have created and funded entities solely to discount the value of their assets for gift and estate tax purposes. In the example above, the entity holding $10 million of liquid assets might have been created for the sole purpose of allowing members to make transfers for gift or estate tax purposes at the discounted value. In extreme cases, taxpayers have retained as much as a 99% interest in such an entity and sought to pay estate taxes on less than $7 million, even though the taxpayer’s family had control of the entity and could ultimately enjoy the benefit of the full $10 million of investment assets.

Although the IRS has had some success in challenging extreme cases, it has not had much success in challenging valuation discounts in many other situations. The proposed regulations are a response to perceived abuses of the estate and gift tax valuation rules. While they may address some legitimate concerns, the new rules go overboard in taxing the owners of a family business on values that do not exist unless the business is sold.

What Can Be Done?

With one minor exception, the new rules should not have any adverse effect on transfers that are completed before the rules come into effect. In particular, while there might be some uncertainty about the future effect of the rules, a transferor can rely on the current valuation rules in making outright sales or gifts of interests in companies before the new rules come into effect. In the current environment of low interest rates, sales for deferred payments can be particularly attractive as a way of transferring value without incurring substantial gift tax costs.

The one potential exception relates to a situation where a family member currently holds interests that give the family member the right to liquidate a family owned company (e.g., the holder of 70% of the voting shares of a corporation that can be liquidated by a two-thirds vote). Although the rules are not entirely clear, there may be adverse consequences if the shareholder makes a transfer of interests that eliminates the liquidation right and dies within three years after the transfer. However, even in that situation the result may be no worse than it would be if the transfer had not been made.

What Is the Timetable?

Under the proposed regulations, the new rules would not take effect until 30 days after the regulations are adopted in final form. Because there is a hearing scheduled for December 1, 2016, the regulations cannot be adopted until after that date. It is unlikely that the IRS would change the effective date provision at this point, so any transactions completed by the end of the year should be safe.

The proposed regulations are controversial and will be subject to comments at the December 1 hearing. By the November 1 deadline for submitting written comments, the IRS had received more than 8,000 comments. There will be further comments at the December 1 hearing. These comments and the change in the US Presidential administration could result in a substantial delay in the issuance of new rules, significant changes in those rules and, possibly, the withdrawal of the rules. After the first of the year, however, there may at any time be a window of as little as 30 days to complete any transfers under current law.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

George P. Mair
Sara A. Wells

Daniel R. Cooper
Christina Mesires Fournaris
Francis J. Mirabello