Sidestepping Courts and Congress, IRS Proposes New Rules on Transfers of Closely Held Business Interests

On August 2, 2016, sidestepping what it contends are a number of unfavorable court decisions and an unresponsive Congress, the Internal Revenue Service (IRS) released new proposed regulations that would essentially prevent taxpayers from applying most minority interest discounts for intra-family transfers of family-controlled businesses. With the proposed regulations, the IRS is trying to strengthen the existing intra-family transaction rules contained in Internal Revenue Code § 2704. IRS officials have indicated § 2704 has not been effective in preventing abuses in many cases. They believe that the IRS has the power to implement the new rules without Congressional action.

The IRS has scheduled a public hearing for December 1, 2016 to consider public responses to its proposed new regulations. Many tax experts say public criticism isn’t likely to change the Service’s mind; there likely will be no meaningful changes to the regulations as currently written.

Valuation Discounts: What Are They?

In true arm’s length negotiations, when it comes to valuing closely held businesses, the “whole is worth substantially more than the sum of the parts.” Phrased a different way, a prudent investor would never pay $1 million for a 20 percent interest in a closely held business valued at $5 million. He or she would not do so for at least three reasons:

  •  The investor would have little, if any, actual control over the firm’s business operations
  •  In a pinch, it would be difficult, perhaps impossible to liquidate the investment
  •  There exists no ready market for the minority interest in the business, should the prudent investor desire to sell

Valuation Discounts Have Been Powerful Estate Planning Tools

For quite some time now, estate planners have applied this same sort of valuation discount concept for wealthy small business owners by structuring gifts of minority interests either directly to family members or to trusts created for their benefit. In essence, use of the discount rules allows one generation to transfer important family-owned assets to the next generation at a lower tax cost. The Service has pushed back, but has usually been defeated in court, based on current readings of § 2704.

Of particular concern for the IRS are so-called “deathbed” transfers of minority interests. The proposed regulations deal with these transfers with a clenched fist: Valuation discounts will not be applicable to any transfer of equity to family members that occurred within three years of a taxpayer’s death. Moreover, the value of the valuation discounts taken when the gift was made will be added back to the value of the estate.

Proposed Regulations Are Drawing Criticism

The proposed regs are drawing criticism, but most of that criticism is falling on deaf ears within the Treasury Department. IRS officials contend that it makes sense to treat intra-family transfers differently from those involving unrelated third parties. They say that even after the gift or transfer involving the minority interest, the family’s ownership and control essentially remains the same, since most families act cooperatively when it comes to running “the family business.”

What Should Closely Held Business Owners Do?

While the regulations will not become effective until at least January 1, 2017, the three-year-look-back provision mentioned above should cause many small business owners concern, particularly if they have made gifts of minority interests to family members in recent years. In many cases, a thorough review of one’s entire estate plan is in order.

Romano & Sumner: Skilled, Experienced Attorneys

Texas BarToday Top Ten BadgeThe attorneys at Romano & Sumner, LLC have more than 20 years of combined experience providing expert legal assistance to clients in all types of taxation, wealth management, and estate planning. We have expertise in the creation of all sorts of Texas trust documents and stand ready to assist you in managing your important assets, including interests in closely held businesses. Cookie cutters are for bakers – not wealth management and estate planning attorneys. At Romano & Sumner, we listen to you and offer multiple alternatives that will help you maneuver through the complicated tax and legal arena. We pride ourselves upon our professionalism and client service. We keep our clients informed, returning your calls within 24 hours. We’re ready to assist you as you make the important decisions that affect your family. Call us at 281-242-0995 or complete our online contact form.

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