Rumors have abounded in the estate planning community that the IRS was working on regulations designed to change the gift and estate tax rules applicable to valuing interests in family-controlled entities, such as corporations, limited partnerships and limited liability companies. Talk is that they'll be released soon.
The IRS generally has been unsuccessful in stemming a tide of taxpayer victories in the courts on valuation issues. Over more than two decades, taxpayers have successfully argued for discounts for gift tax and estate tax valuation purposes on limited partnership interests or minority, non-controlling member interests in LLCs.
Tax and estate planning advisers have long recommended that wealthy families create family limited partnerships to hold family investment assets and obtain appraisals that account for “lack of marketability” and “lack of control” discounts in valuing the LP interests. These discounted appraisals result in a reduction of gift or estate taxes paid on the transfer of wealth. In some cases, discounts have completely eliminated liability for any estate tax on estates that, but for the creation of the FLP, would have exceeded the applicable exemption and been subject to tax.
TAX LAW HISTORY
Tax legislation enacted in 1990 was designed to prevent valuation reductions through the use of entities owned by family members that had governing documents that placed restrictions on the ability of an owner to transfer his or her interest in the entity or that placed restrictions on the ability of the entity (partnership or corporation) to liquidate. These types of restrictions were known in the legislation as “applicable restrictions.” Applicable restrictions under these special valuation rules would be disregarded in determining the value of interests in the entity (for transfer tax purposes) unless these restrictions were no more restrictive than applicable default state or federal law that would otherwise apply to the entity.
In response to the 1990 tax legislation, many states (with the urging and assistance of tax and estate planning professionals) changed their default laws to allow restrictions on liquidation that reinvigorated the use of entities with such restrictions (in conformance with default state law) to obtain valuation discounts for gift and estate tax purposes.
The Obama White House has repeatedly proposed legislation to define additional restrictions that would not be taken into account in valuing an interest in a family-controlled entity that is transferred from one family member to another. These legislative proposals were geared at fighting the successes that estate planners and their clients had been able to achieve in obtaining valuation discounts.
Now it appears that the Treasury Department is working on regulations to define additional types of restrictions that would be disregarded in valuing family entity interests for gift and estate tax purposes and thus reduce or eliminate discounts. This regulatory approach would presumably give the IRS the authority to curb valuation discounts without requiring legislation that was unlikely ever to be passed by a Republican-controlled Congress.
WHAT TO DO NOW
It is expected that any forthcoming regulations will apply to family entities that are holding vehicles (FLPs and FLLCs that hold marketable securities, venture capital or hedge funds, and other portfolio investments.) Conversely, it may be the case that family-owned operating companies may be exempt from the new regulations since these have not been viewed as abusive by the IRS.
Although it may be too late to form a new entity to beat the new regulations, families that have holding vehicles in place but have not fully completed their intended transfers of interests in the entity might consider accelerating gifts or sales of interests to beat the effective date of new regulations. It's likely that any transfers completed prior to the effective date of new regulations will be grandfathered.
James R. Cody is managing director of estate, trust and philanthropy advisory services at CTC | myCFO.