Calfee, Halter & Griswold LLPBusiness Valuation Discounts in the Context of Estate and Gift Tax Planning Nearing Extinction

October 3, 2016

On September 11, 2015 we published a First Alert warning of the “imminent” issuance of proposed Treasury Regulations by the Internal Revenue Service (IRS) in the context of Chapter 14 of the Internal Revenue Code which are commonly referred to as the “Estate Freeze” rules. It was widely anticipated that the regulations would be aimed at limiting the availability of business valuation discounts resulting from the lack of marketability and lack of control associated with minority interest ownership in the context of family business entities.  At the time, we posited that we could not be certain as to when the Regulations might be published, the scope of the Regulations, or their effective date.  As a result, we suggested that anyone contemplating a transaction reliant upon receipt of valuation discounts should act before the opportunity was gone. As of August 2, 2016, the rules that were “imminent” and uncertain in September became real when the IRS issued the long-anticipated proposed regulations under Internal Revenue Code Section 2704.

Those proposed regulations are poised to essentially eliminate all valuation discounts attributable to lack of marketability and lack of control associated with minority interest ownership of family-owned businesses in the context of estate, gift and generation skipping taxes. The regulations mount a powerful attack in response to previously failed attempts by the IRS to limit such discounts.  The IRS consistently lost in the courts when challenging valuation discounts by attempting to establish control based on family attribution.  In response, the proposed regulations refocus on family attribution, and elevate concepts such as the lapse of voting and liquidation rights associated with transfers occurring within three years of death, and disregarding restrictions when valuing the interest transferred, to effectively impose control and liquidity. 

The regulations, therefore, allow the IRS to achieve their desired result of severely limiting valuation discounts related to business interests transferred among family members who control those interests. The regulatory pronouncement allowing the IRS to disregard restrictions related to liquidation or redemption on transfer effectively recognizes an affirmative right of liquidation or redemption on the part of the person holding the interest to be valued (a “put” right), whether or not such right actually exists, unless such a restriction is actually mandated by state law. The good news is that the current regulations are merely proposed, and do not take effect until they become final or 30 days later, depending on the provision.  We are currently in a ninety day public comment period, and there is a hearing regarding the proposed regulations scheduled for December 1, 2016. 

There also remain some questions as to whether the IRS has overstepped its authority by promulgating such restrictive regulations if it can be established that such promulgation is contrary to Congressional intent  in enacting the underlying Internal Revenue Code Section 2704.  So it appears that the regulations will not become effective until December 31, at the earliest, but more than likely sometime next year.  And even then, the final regulations may not reflect the provisions of those proposed. 

At this time, however,  we will reiterate our earlier suggestion that if you are considering a business transition strategy, the perceived success of which could be measured by the magnitude of the business valuation discount, it may be time to consider action.  We encourage you to contact any member of our Estate and Succession Planning practice to discuss this matter further.

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For additional information and discussion on this topic, please get in touch with your regular Calfee contact or one of the attorneys listed below: Joseph M. Mentrek 216-622-8866 jmentrek@calfee.com Marcia J. Wexberg 216-622-8858 mwexberg@calfee.com James A. Singler 513-693-4875 jsingler@calfee.com  

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