In our third quarter 2015 issue of InvestorView, we reported that proposed regulations curtailing valuation discounts for family-controlled entities such as limited liability companies (LLCs) and partnerships were on the horizon. Although no one knew exactly what the regulations might say, experts speculated that valuation discounts ordinarily applicable to transfers (for example, gifts and bequests) of an interest in a family-controlled entity for gift, estate and generation-skipping transfer tax purposes would be substantially reduced or eliminated. On August 2, 2016, the U.S. Department of the Treasury issued these long-awaited proposed regulations, which, if finalized, may eliminate the valuation discounts applicable to family-controlled entities that have been the cornerstone of sophisticated tax and estate planning for decades.

Making gifts of interests in family-controlled entities, including family-owned operating businesses, has long been a popular and effective means of leveraging an individual’s transfer tax exemption amount (currently $5.45 million). In addition to moving assets, and the future appreciation on those assets, out of an individual’s taxable estate and into the hands of other family members, gifts of minority interests in a family-controlled entity have traditionally been subject to valuation discounts for lack of marketability and control. These discounts, which can often reduce a gift’s transfer tax value by as much as 40%, reflect the reality that minority interests in family-owned entities are often illiquid and carry no voting or control rights. The proposed regulations seek to eliminate the availability of these discounts by delivering a one-two punch that is especially problematic for owners of closely held businesses or family holding companies seeking to transfer interests in those entities to family members.

The first punch is a new rule that will apply to certain transfers made within three years of death. It is no secret that the IRS and Treasury Department view deathbed gifts of an interest in a family-controlled business entity as abusive transfers. For example, assume a terminally ill individual owns 90% of the shares of a corporation and transfers 25% of his shares to his daughter and 25% to his sister shortly before his death. After his death, his estate would likely claim a valuation discount for owning a minority interest in the company (the residual 45% of the corporation’s shares). The proposed regulations seek to prevent estates from taking valuation discounts in these situations and provide that transfers of an interest in a family-controlled entity made within three years of the transferor’s death that result in the transferor losing the ability to force liquidation of the entity or voting rights will result in a “recapture” of the value of the lost voting or liquidation right in the transferor’s estate.

Although it is unclear how this recapture will work in practice, it appears that valuation discounts on any gifts made within three years of death will be included in the transferor’s estate for estate tax purposes. If the proposed regulations, once effective, eliminate valuation discounts altogether, there will be no value to “recapture” in the transferor’s estate, with the exception of transfers made prior to the effective date of the regulations. For individuals considering making gifts prior to the effective date of the regulations, it is important to keep in mind that the three-year rule could still affect the estates of those who die within three years of making a gift.

In keeping with our boxing analogy, the second, final blow delivered by the regulations is a serious TKO (technical knockout). The proposed regulations provide that any restrictions limiting an owner’s ability to redeem or liquidate his or her interest for pro rata value within six months are completely disregarded. Unlike existing law, it does not matter whether the family imposed the restriction on liquidation in the governing agreement of the entity (such as a partnership or operating agreement) or whether the governing agreement is silent and the default provision of state law provides such restriction. The only restrictions that would be upheld are those imposed by state law that are mandatory and cannot be superseded by the governing agreements. Very few state laws impose mandatory liquidation restrictions.

This particular aspect of the regulations is far broader than most experts had anticipated. If the proposed regulations are finalized, gifts of an interest in a family-controlled entity may be valued as though that interest’s owner has the ability to redeem his or her interest for the pro rata value of the entity value for cash or a note with a term not to exceed six months. If an owner of a family-controlled entity has the imputed right to cash out his or her interest at virtually any time, it becomes difficult to make an argument that a valuation discount for lack of marketability is appropriate. While the new regulations would have a significant impact on the transfer tax valuation of an interest in a family-controlled entity, they ignore the reality that the owner of that interest could likely not sell his or her interest to a third party for his or her pro rata share of the entity’s fair market value.

There are a few exceptions to these new proposed rules, but they are neither clear nor broadly applicable. First, there appears to be an effort to exempt active businesses from the broad impact of the proposed regulations, but no formal exception is articulated. Most experts acknowledge that an actively run operating business is different than a family holding company that owns merely marketable securities. The former may legitimately need restrictions on transferability and liquidation to ensure the ongoing success of the business. The proposed regulations do include an important exception for commercially reasonable restrictions that are imposed by non-family members who provide capital to the entity – for example, restrictions that are required by virtue of a loan made to the company.

In addition, there is an exception for entities that are not wholly owned by family members. The proposed regulations and tax laws surrounding them are only intended to affect family-controlled entities. The legislative rationale for enacting these rules is that if a family can act together to create restrictions on control and transferability to artificially depress the business’s value for gift and estate tax purposes, then it could also immediately turn around and vote to undo such restrictions. If, however, one or more non-family members own a significant interest in the business and the family cannot remove such restrictions unilaterally, then the regulations would not apply. The proposed regulations apply a complex and stringent bright-line test to determine whether non-family members own a “significant interest,” which will not be met unless non-family members own at least 20% of the business.

As is typical when the Treasury Department issues a set of regulations changing a significant area of tax law, the regulations at this early stage are merely proposed and not yet effective. In order to become effective, they must be finalized by the Treasury Department after the public has had an opportunity to provide comments. Proposed regulations are often changed substantially before they become final, and their enactment could be significantly delayed or abandoned entirely. At the earliest, the regulations would become final in 2017, although no one can be certain when, or even if, they will become effective. As discussed, these regulations are particularly controversial because they seek to alter a fundamental principle of estate planning in eliminating valuation discounts. Some experts have questioned whether they are within the legal scope of the Treasury Department’s authority and speculate that they may not be valid at all. Considering the backlash the IRS faces from estate planning and tax professionals, it is likely that the regulations may not become final for some time.

While the regulations, if implemented, may impact the effectiveness of many tried-and-true estate planning techniques, a number of opportunities remain. First, individuals may consider making discounted gifts of interests in family-controlled entities until final regulations are issued. For those who have contemplated or are in the process of making such gifts, we strongly encourage you to initiate a conversation with your team of advisors immediately and potentially complete pending transactions right away. Depending on the situation, there are still many benefits to making gifts of interests in a family-controlled entity even if no discounts are allowed. Transferring an interest in such an entity to family members or other loved ones (or trusts for their benefit) before the value of the entity has fully appreciated may help to remove the appreciation from the transferor’s taxable estate. In addition, if the value of the family-controlled entity is not discounted for estate tax purposes, then its value for income tax purposes following death will be its full non-discounted value under the step-up in basis rules. Thus, those who receive the interest in the entity following death will pay less income tax when the entity is sold.

Some opportunities do remain, but time could be of the essence. If you own an interest in a family-controlled business entity, such as a partnership or LLC, please contact your BBH wealth planner or relationship manager as soon as possible to discuss a plan of action.


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© Brown Brothers Harriman & Co. 2016. All rights reserved. 9/15/2016.