Regulations recently proposed by the U.S. Treasury Department could adversely affect a commonly used estate planning technique that has been available to help reduce gift and estate taxes. Each U.S. citizen and non-citizen resident currently has a $5.45 million exemption amount that can be utilized during life, at death, or a combination of the two, to give or otherwise transfer assets free of transfer tax (gift, estate, or generation-skipping). “Valuation discounts” are often used to maximize the use of the exemption amount, thereby making estate tax reduction planning more tax-efficient.
For example, an individual seeking to make a gift of an interest in a family-controlled entity – such as a corporation, partnership, or limited liability company – could value the gift using many of the same limitations on the value of the interest that would apply in negotiating an arms-length sale to a third-party buyer, including the fact that a minority interest in the business could not be readily converted to cash on the open market (“lack of marketability”) and that a stakeholder could not control managerial decisions because of her less than 50% ownership stake (“lack of control”).
As a further example, if a parent gave a 10% non-voting interest in a $10 million company to her grown child, that 10% interest is arguably worth significantly less than $1 million because of the lack of voting power, and, therefore, the parent should be considered as having expended less of her exemption than $1 million. Even families without an active operating business – such as family members pooling together their funds in a family LLC or family limited partnership – could historically take advantage of valuation discounts.
The IRS has generally recognized the validity of such discounts (though they have been subject to challenge; for example, if the discounting was overly aggressive). However, if finalized in their current form, these new regulations would reduce, if not eliminate, the ability to successfully utilize valuation discounts in wealth transfer planning, which could mean that gifts or bequests would have to be valued on a dollar-for-dollar basis, as would family-controlled entity interests in an estate. The results could range from increased transfer taxes to the need to liquidate family businesses or sell off an interest to an outsider to raise sufficient capital to cover the resulting tax obligations.
The IRS has scheduled a public hearing on December 1, 2016, after which final regulations are likely to be issued -- meaning there could be a brief window within which U.S. citizens and non-citizen residents might still use discount planning option as part of their estate plans.
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