In August, the U.S. Treasury Department released proposed regulations that will have a considerable impact on the tax consequences of transfers of interests in family-controlled entities. In particular, the new rules would substantially reduce and potentially eliminate most valuation discounts for estate, gift and generation skipping transfer (GST) tax purposes, thereby dramatically limiting the effectiveness of this estate-planning technique. The end result is that a useful estate-planning tool may be lost and the tax cost of transferring interests in family-controlled entities could increase significantly.
The use of a family-controlled entity such as a family limited partnership (FLP) to hold, manage and control family assets has been a popular estate planning tool because of the potential to transfer interests in the FLP to family members at a reduced transfer tax by discounting the value of the transferred interest based on certain limitations, such as, lack of control or lack of marketability. The lack-of-control discount reflects a minority owner’s limited ability to control the entity, while the lack-of-marketability discount reflects an owner’s limited ability to convert the interest to cash by way of a liquidation, redemption or sale. These valuation discounts, which could amount to roughly 30% of the net value of the transferred interest, reduce the tax cost of transferring interests in closely-held entities to other family members, such as children and grandchildren.
The proposed regulations would, in many circumstances, significantly reduce or eliminate the valuation discounts that currently are allowed when a person transfers an interest in a family-controlled entity to another family member (or to a trust for a family member) during life or at death. As a result of the potential loss of valuation discounts, the gift and estate tax consequences of such a transfer could increase substantially.
The following example, while simplified for the purpose of this discussion, should help illustrate the potential impact of the new rule. Assume that a parent makes a gift of a limited interest in an FLP to a child. The value of the FLP interest is $1 million and the parent has no exemption from gift tax remaining. Using current valuation methodologies, a 30% discount might be applied to the transferred interest for lack of control and lack of marketability. This would result in a gift of $700,000 for gift tax purposes and $280,000 in gift tax (at a 40% rate). Under the proposed regulations however, the discount for lack of control and lack of marketability could be eliminated. In that case, the parent would be deemed to make a gift of $1 million and would pay $400,000 in gift tax on the transfer, an increase of $120,000.
At this point, the proposed regulations are just that: proposed. The new rules will only become effective after a public comment period and formal adoption process, which is expected to occur no earlier than the first quarter of 2017.
Despite the potential impact of the proposed regulations it’s important to note that the new rules will generally only be relevant for those who have estate tax exposure in the first place (i.e., those with assets exceeding $5.45 million individually or $10.9 million as a couple). As a result, families that are below this threshold probably won’t need to worry about the new rules at all. It’s also important to remember that many other valuable planning techniques will continue to be effective despite the proposed rules. For example, arrangements designed to shift the appreciation on transferred assets outside of the transferor’s taxable estate should be successful even without valuation discounts.
Although it is feasible that the proposed regulations, if adopted in their current form, could be challenged as going beyond that which Congress originally intended, it is unclear to what extent such a challenge would be successful. Fortunately though, the new rules would only apply to transfers that occur after the effective date. This means that high net-worth families with significant wealth centered around a family business still have time to engage in planning before the new rules take hold. This may include initiating current gifts of shares of a family business or possibly even forming a family-controlled entity to facilitate intra-family transfers.
Individuals who might be impacted by the proposed rules should consult with their legal and tax advisors as soon as possible to evaluate their particular circumstances.
If you have questions about how the proposed rules might impact your situation please contact us at 402-397-4700.