By Emilee H. Scheeff, Esq.
The Internal Revenue Service has issued proposed regulations that could drastically change the rules regarding transfers of family business interests.
In addition to many other business purposes, taxpayers routinely use limited partnerships and limited liability companies to allow older generation family members to control and manage a going business or family assets while transitioning the ownership interests to one or more younger generation family members. These entities, coupled with a strategy for gifting non-controlling interests, are widely used to transfer wealth in the form of family businesses from one generation to the next. Although not as widely used in this context, family businesses may also be held in corporations, and these new rules apply to them as well.
In addition to providing a method to slowly transfer the business or assets to a younger generation, these entities have an added tax advantage by allowing the person selling or gifting the non-controlling interest to take advantage of significant discounts involved in the valuation of the gifted interests. Non-controlling ownership interests in limited partnerships and limited liability companies where ownership is concentrated in one family are generally not highly sought after by the general public. Thus, any valuation of a non-controlling ownership interest in such an entity being sold or gifted must account for the lack of marketability and lack of control inherent in such an interest.
The IRS has been trying to close this perceived hole in the estate and gift tax system for years, apparently driven at least in part by the belief that all families get along and always work in perfect harmony to the sole detriment of the IRS.
In 1990, Congress enacted section 2704 of the Internal Revenue Code to limit the availability of discounts for gift and estate tax planning purposes especially in the context of family-owned or closely held entities. Section 2704 provides that if an individual and the individual’s family hold voting or liquidation control over a corporation or a partnership, any lapse in a voting or liquidation right is taxed as a transfer subject to gift and estate tax. Essentially, any such restrictions have to be real and not merely illusory, which also seems to mean that such restrictions are real and not merely illusory unless they are designed to artificially lapse at some future date.
Additionally, section 2704 disregards certain restrictions limiting the ability of a limited partnership or limited liability company to liquidate if the restriction can be removed by the family members, acting either alone or collectively. Despite this, the use of section 2704 by the IRS is rarely effective on this point. The IRS has been successful in setting aside claimed valuation discounts where there is a weak business purpose for creating the entity, unsupported discounts, or retention of too much control over management and enjoyment of the assets by the transferor.
However, to date the IRS has been mostly unsuccessful in its attempts to set aside all discounts in the family business context. It is difficult to argue that a non-family member will or even should pay net asset value to become a limited, non-controlling, non-family owner in an otherwise family owned business. In other words, you might pay $100,000 for 10% of an asset worth $1 million, but would you pay the same $100,000 for a 10% nonvoting interest in a limited liability company owning the same asset worth $1 million but knowing that you have no control over investments or cash flow, you cannot unilaterally liquidate your ownership interest, and you are not a member of the controlling family?
The proposed regulations issued by the Treasury assume that the answer to the question above is a resounding yes. The proposed regulations make it almost impossible for taxpayers to used valuation discounts in this context. The bottom line is that the Treasury is attempting to eliminate almost all discounts on transfers of non-controlling interests in any family businesses simply because it is a family business and because the transferee is related to the transferor. This seems to completely ignore economic reality (and existing law?), but that’s what these proposed regulations do.
The IRS has scheduled a hearing on these proposed regulations on December 1st of this year, and the Treasury has stated that the final regulations won’t be effective until at least 30 days after they become final, meaning they will not become final before January 1, 2017. However, the proposed regulations will likely become effective for all transfers of ownership interests in family businesses soon after the end of this year.
Anyone with any sort of family business, whether that business is organized as a limited partnership, limited liability company, or even a corporation, should consider transferring some or all of their ownership interests in such a family business to appropriate family members or trusts before the end of 2016. As with any such matter, several estate and gift tax provisions as well as several income tax provisions come into play, so please give us a call so we can evaluate your situation and help you make any plans to transfer such interests before the end of 2016. If you wait until November or December of this year, there is no guarantee that we will have time to assemble all the pieces that would be required to make the transfers work.