“You can’t always get what you want, but if you try sometime you find you get what you need” – from the Rolling Stones’ hit song, You Can’t Always get What you Want
Bruce H. Bokor and Nicholas J. Grimaudo
Trusts and estates practitioners have utilized discounts in family entity transfers for a substantial period of time in order to accelerate “value transfers” from one generation down to subsequent generations. These discounts include a “minority interest discount”, which would be present when the transferred interest constitutes less than a majority ownership interest of an entity, and “lack of marketability discount” which is almost always present for a family enterprise that is not publicly traded. A minority interest generally lacks control of the family entity, and this allowed business entity appraisers to apply “discounts” to the interest transferred to a family member. Estate planners have been using these discounts to achieve estate freezes and save estate and gift taxes for their clients.
Proposed Treasury Regulations addressing these discounts have recently been issued. These Regulations have been expected for a substantial period of time, and many practitioners believe that the Regulations have gone beyond related provisions of the Internal Revenue Code. These Proposed Regulations are intended to eliminate all valuation discounts for transfers of interests in family-controlled entities, irrespective of the transfer being a gift or sale during the transferor’s lifetime or at the transferor’s death. We will see what happens when hearings on these Regulations commence in December.
What are we talking about? Assume that you are the 100% owner of a successful family enterprise which you wish to transfer to one or more of your children and grandchildren (or other future generations) or trusts for any of these descendants. If the value of the fair-market value of your family business is $2 million, a transfer of a 5% interest would initially be valued at $100,000. However, business entity appraisers, (normally well-trained in valuation of business enterprises) would apply a minority interest discount or a lack of control discount for approximately 25%. Thus, the transferred 5% interest will be valued by the appraiser at $75,000. If you have two children and five grandchildren, the transfer of a 5% interest to each of them (or to trusts benefitting these individuals) will move 35% of your company to these recipients. In essence, you would be transferring ownership interests which you could value at $500,000 (the position espoused by the IRS), but with a gift tax cost of only $375,000. You have effectively given for “no gift tax value” $125,000 in assets, which reduces your potential estate tax liability and further helps accomplish your goal of moving ownership of your company to the next generations.
Practitioners have not only advised on transferring interest in operating entities, but also have worked with families to set up a limited liability company into which senior generations would transfer marketable securities, real estate interests, interest in other closely-held entities and even intellectual property. The senior generation would then gift membership interests in the LLC to younger generations. Again, the business entity appraiser would apply a minority interest control discount/non-marketability discount of those transferred membership interests.
The Internal Revenue Service challenged these entity transfers utilizing many theories, but often the Service would settle on a negotiated discount amount in lieu of bringing a case to court.
Congress passed Internal Revenue Code section 2704 to address these “discounting” gifting techniques utilized by taxpayers. Congress felt like these taxpayers had artificially reduced the value of these interests which were controlled by family members, especially where there was no business purpose for such transfers. Code Section 2704 provided that these valuation discounts should be disregarded when determining the fair-market value of a transferred interest in a family entity where: (i) restrictions limited the availability of the entity to liquidate; and (ii) either the restriction lapses (entirely or partially) following the transfer, or, the senior family member or his or her family could remove the restrictions. Although this Code provision did provide sufficient ammunition for the Internal Revenue Service to challenge these gifts of family enterprises, practitioners were able to structure these gifts so that the proscriptions of Code Section 2704 could be successfully addressed by a taxpayer.
These Proposed Regulations are not yet effective but could become final 30 days after the final public hearing in December. Therefore, if you are considering any type of gifting of an interest in a family enterprise and you are potentially facing Federal estate taxes (each person currently has an estate tax exemption of $5.45 million which will generate a $10.9 million estate tax exemption for a married couple), you should immediately initiate discussions with your tax advisors.
What happens if these Proposed Regulations become final Regulations? These discounts have effectively been a great enhancement to gift-giving and the elimination of a portion of the senior generations’ assets from gift taxation and estate taxation. Even without these discounts, the gifting of an asset or assets to future generations where these assets are expected to appreciate, is still a valuable tool for estate tax savings. A gift of an asset worth $1 million which appreciates at 5% for 20 years would remove almost $650,000 from the transferor’s estate. The results are more dramatic with a greater appreciation percentage and/or for a longer period of time. Gifting of assets is the prime tool for estate tax savings. If you have the ability to do so, you should utilize your annual gift tax exclusion amounts (currently $14,000 per recipient), and you should consider giving more based upon the removal of these future appreciation amounts from your federal gross estate.
The time to act is now, irrespective as to when these Proposed Regulations become final. You may find that “you get what you need”.