IRS Releases Proposed Regulations That Will Affect the Ability to Transfer Your Family Business to the Next Generation

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August 4, 2016

On Tuesday, the IRS released proposed regulations that will prevent owners of interests in a family business from being able to value those interests at a discount when transferring them to the next generation of owners, either through lifetime gifts or transfers at death.  Under current law, a typical planning scenario with a family-owned corporation (it could also be a partnership or a limited liability company) involves the owners (let’s say it’s the parents, George and Mary) exchanging their shares of stock for an identical percentage of a small number of newly issued voting shares and a large number of newly issued non-voting shares.  George and Mary retain control of the business by retaining their voting shares.  They are able to efficiently transfer a significant percentage of the business, and all future appreciation on that percentage interest, by gifting or selling their non-voting shares to their children or to trusts established for their children.  The efficiency results from the fact that under current law, the non-voting shares can be valued at a discount from full market value because they lack voting rights.  This discount is called a lack of control discount.

A brief review of U.S. transfer taxes may be helpful to fully appreciate the impact of the proposed regulations on George and Mary.  Each year, George and Mary may transfer assets up to the annual exclusion amount (currently $14,000) to as many individuals as they want without incurring any transfer tax liability.  In addition, each may transfer assets up to the lifetime exclusion amount (currently $5,450,000), either through lifetime gifts or transfers at death, without incurring any transfer tax liability.  Except for transfers to each other (because they are married), any transfer by George or Mary in excess of the available annual exclusion amounts and the lifetime exclusion amount is subject to a 40% transfer tax (either a gift tax for a lifetime transfer or an estate tax for a transfer at death).  Accordingly, for purposes of transferring interests in their family business to the next generation of owners, the lower the discounted value of George and Mary’s non-voting shares, the more they can transfer (either during their lifetimes or upon death) without the imposition of a transfer tax. The proposed regulations remove the ability of business owners like George and Mary to value their non-voting shares at a discount for gift and estate tax purposes.  Instead, non-controlling interests in a family business will be valued the same as controlling interests, in other words at full market value.  Thus, depending on the value of the family business, it will be more difficult to transfer ownership to the next generation without incurring either a gift tax or an estate tax.  Moreover, if parents like George and Mary decide to sell their interests to the next generation of owners, rather than transfer them by gift, the sales price will be higher under the proposed regulations because non-controlling interests may not be valued at a discount.

There is still time for family business owners to take advantage of current law, which allows non-controlling interests to be valued at a discount for transfer tax purposes.  Before the final regulations will be published, the IRS provides opportunities for public comments and a public hearing.  The public hearing is scheduled for December 1, 2016, and the final regulations are not expected to be published before the end of the year.  Therefore, family business owners should be able to complete gift and sale transactions before the end of the year taking advantage of valuation discounts allowed under current law.

If you have questions about planning for the transition of ownership in a family business, please contact any of the attorneys providing counsel on family business succession planning.

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