Years of established legal precedent has stipulated that transfers of property, including non-controlling interests in family-controlled entities, must be valued without regard to the identity of the transferee. A gift of a minority interest in a family business is currently valued at its fair market value between an arms-length purchaser and seller, taking into account any applicable discounts for lack of control and lack of marketability. For tax purposes, the proposed regulations would ignore restrictions on a minority owner’s ability to withdraw from an entity if the family controls the entity. Consequently, if the regulations are finalized as proposed, the availability of minority interest discounts in estate planning will be severely handicapped.

Key factors in which the Treasury Department is proposing:

• Currently under Section 2704, the lapse of an applicable restriction results in a deemed transfer of the value attributable to the lapse. For example, if an owner’s ability to liquidate an entity lapses upon his or her death, the reduction in value resulting from the lapse of the liquidation right is itself a transfer and shall be treated under the transfer tax. To avoid the current rules, taxpayers look to reducing their controlling interest in the entity to that of a non-controlling interest shortly before death. The Treasury Department proposes regulations to treat transfers occurring within three years of death that result in the lapse of a liquidation right as transfers occurring at death for the purposes of Section 2704.
• The measure of a restriction to be more restrictive than state law is determined based on whether the state law restriction is mandatory or merely a default law. No state law is likely to prohibit the formation of an entity in which a minority interest holder has the right to withdraw. Additionally state law will not be deemed to contain such a prohibition if the entity could have been established under another state law without such a restriction. Therefore, default state law will no longer determine whether a restriction will be given effect for valuation purposes. The proposed regulations describe a new class of restrictions described as “disregarded restrictions.” A disregarded restriction includes one that:

1. Limits the ability of the holder of the interest to liquidate the interest,
2. Limits the liquidation proceeds to any amount that is less than the proportionate net asset value attributable to the interest,
3. Defers the payment of the liquidation proceeds for more than six months, or
4. Permits the payment of the liquidation proceeds in any manner other than cash or other property, other than certain notes (which generally does not include a promissory note issued by the entity or other owners of the entity).

The proposed regulations also maintain that the interest held by a nonfamily member shall be disregarded unless:

• The aggregate interests of nonfamily members is at least 20 percent,
• Each nonfamily member interest is at least 10 percent,
• The interest of each nonfamily member has been held for at least three years, and
• Each nonfamily member has a put right in exchange for a proportionate share of net asset value.

The proposed regulations do not discriminate between entities that own passive investments, like portfolio of marketable securities or passive real estate interests, and active investments, such as operating family business. There is one exception: an active business may be able to fund the “put” right with a note. Therefore, entities with operating family businesses and passive investments will be subject to the same valuation rules.

The Treasury Department has set a public hearing date of December 1, 2016, to hear debates on the proposed regulations. The proposed regulations shall take effect 30 days after the date these regulations are published as final regulations.

Individuals and their planners should anticipate the regulations to become effective in early 2017. Individuals and families with existing family-controlled entities, wishing to take advantage of the valuation discounts under current rules, should consider implementing transfers of interest in the family-controlled entities prior to the effective date of the regulations. Effective estate planning to reduce transfer taxes under current law would include outright gifts of minority interest in the family-controlled entities to family members or trusts for family members, or sales of interest in the family-controlled entities to family members or trusts for family members.

Please contact FFG Valuations for more information and how we may be able to assist you with your valuation needs.