Trust Company Corner: The Countdown Begins on Limiting Key Valuation Discounts

New proposed regulations would largely eliminate valuation discounts when transferring an interest in a family-controlled entity.

Valuation discounts, generally for lack of marketability and lack of control, have long been an effective way for wealthy individuals to leverage the estate, gift and generation skipping transfer (GST) tax exemptions or reduce the estate, gift and GST tax burden on assets they transfer to family members. These valuation discounts have been used both when valuing a transferred interest in a family-controlled entity owning an active business or when valuing family-controlled entities holding passive investments. Because of their effectiveness, these discounts have been the target of legislative proposals and the IRS has not been secretive in its desire to curtail their use. After much anticipation, in August the Treasury Department released long-awaited proposed regulations, which are as severe as—or more severe than—many expected. If the proposed regulations are finalized after a December 1 public hearing, the new rules could become effective sometime in 2017.

The Current Framework

When transferring an interest in a family-controlled entity, a valuation is required to determine its worth because there is no public marketplace to determine the value. Frequently, a small fraction of the entity, a minority interest, is being transferred. Additionally, many family-controlled entities contain provisions limiting the owners’ ability to be paid out for their interest or otherwise dispose of the interest. As a result, when valuing the interest, a discount from the net value of the underlying assets owned by the entity will be taken to reflect that it is a minority interest (lack of control) and a further discount will be taken because of the restrictions on the owners’ ability to monetize the interest (lack of marketability). These reductions are applicable because a willing buyer (the standard used by the IRS) would likely require a discount to the interest’s proportionate share of the net value of the underlying assets because the buyer would have no say in management and limited ability to sell or otherwise dispose of the interest.

The New Landscape

The proposed regulations, if adopted in their current form, seem to basically eliminate these discounts for lack of control and lack of marketability in a family-controlled situation, regardless of whether the entity owns an active business or passive assets, such as a portfolio of marketable securities. The result would be that a transferred interest in a controlled entity would be valued at its proportionate share of the entity’s underlying net asset value. This valuation could substantially increase the estate and gift tax cost to transfer such an interest, and families who believed their estates were below the transfer tax exemptions (for federal purposes currently $5.45 million per individual) because of the availability of such discounts could now find their estates to be subject to estate taxes.

The effective date for most of these proposed rules is 30 days after the regulations become final. As mentioned above, a public hearing date has been scheduled for December 1, 2016, at which time comments to the proposed rules will be heard. It is possible that, after the hearing, the Treasury Department could make changes in response to the comments. Indeed, the reaction by some legislators and estate planning professionals has been largely negative—prompting one Treasury official to suggest that the proposed rules had been misunderstood. It was also stated that there was no intention to rush to finalize the rules before the current administration leaves office in January. However, it remains unclear whether or not the proposed rules will change in any meaningful way, or exactly how soon they could become effective. Notwithstanding the comments, it is possible that the final regulations could be issued shortly after the hearing and become effective early next year.

Estate Planning Opportunities Still Exist

Notwithstanding these sweeping changes, there are still very attractive strategies that can be used to transfer wealth to the next generation and beyond. Especially in this low interest rate environment, “GRATs,” sales to an intentionally defective grantor trust or charitable lead annuity trusts can be effective (see below). Additionally, it is important to work with your advisors to weigh the benefits of the step-up in basis you receive for assets owned at death versus the carryover basis the recipient receives with a gift.

Final Assessment

These proposed regulations, if finalized in their current form, will significantly impact planning for those with closely held entities. If you are considering a transfer of an interest in such an entity, you should be talk to your advisors soon to assess your options. If you do choose to proceed, it will be important to complete the transfer before the new rules become effective.