Last August, the IRS launched its latest offensive against parents who want to transfer closely held family-owned business interests to younger family members free from estate tax.
Here is the typical scenario: Mom and Dad inherited and then successfully grew a small business, “Soup to Nuts”, a small town hardware store with a small bakery and popular lunch counter. Mom and Dad’s three children work for the company, operating four other “Soup to Nuts” in their hometowns, one in Pennsylvania, one in Arlington and two in Hampton Roads, Virginia. Mom and Dad recently visited with their family lawyer, Christie, who informed them that because business has done so well they now have estate tax exposure. The value of the business, which includes the real estate for the stores, is $12,980,000. She tells them that currently (in 2017) Mom and Dad may each transfer $5,490,000 to their children, free from transfer taxes (either gift or estate taxes), for combined exemptions of $10,980,000. Christie tells them that the $2,000,000 “excess” value of their business could cost their family $800,000 (current estate tax rate is 40%). Mom and Dad are not pleased. Christie explains the exemption amount is “indexed” for inflation, but Dad points out the business has been growing faster than inflation, and thus they will have increased estate tax exposure every year. What can Mom and Dad do?
Christie advised Mom and Dad that a common strategy is to give minority shares of stock or LLC interests to family members in various amounts using “market valuation adjustments”. These adjustments take into account the fact that the fair market value of a small percentage of “minority stock”, which cannot control the decision-making in the company, is worth less than a controlling interest. The same valuation reality means that “non-voting” stock is worth less than voting shares. Christie recommends Mom and Dad make gifts of “discounted stock” to their children, which may serve to eliminate the estate taxes. Mom and Dad are pleased with this option, however, Christie warns: HURRY, THIS OPPORTUNITY IS CLOSING, QUICKLY.
Christie is concerned with the new IRS proposed regulations under Internal Revenue Code 2704, which if finalized may significantly reduce the opportunities for “discounting” family gifts. The regulations, released on August 4, 2016, say the IRS will ignore when valuing Mom and Dad’s gifts, any restrictions on the transferability of the stock that reduce the value of the family-owned business. Specifically, the proposed regulations provide that a restriction may be disregarded if it: 1) limits the ability of the owner of the interest (e.g. the child) to liquidate the interest (e.g. sell the interest back to the company); 2) pays the owner an amount less than a minimum value (“full value”); 3) defers the payment of the interest for more than 6 months; or 4) allows the company to pay the interest on certain non-cash, non-property obligations. In addition, the IRS could disallow the discounts if the taxpayer dies within 3 years after making these gifts.
Christie is concerned because discounts for such transfers, in amounts up to 30%-50%, have been accepted by many courts over the last 20 years. She indicates the changes are too broad and it is overstepping by the Treasury. If the regulations are finalized and not successfully challenged, family-owned businesses may be faced with tax bills they cannot pay and be forced to liquidate their businesses.
The effective date of the regulations will be 30 days after the final regulations are published in the Federal Register. The Treasury Department held a hearing on the regulations on December 1, 2016. As expected, opposition was significant. More than 3,800 family-owned businesses and trade groups have asked the Treasury Department to withdraw the regulations. Will the new Administration pull back the proposed regulations? On Friday, January 20, 2017, the President put a freeze on new regulations and temporarily postponed the implementation of existing published regulations that have not taken effect. We don’t know what the final result will be. There is a significant risk that the regulations will be left untouched as the new Administration shifts its concerns to a broader based tax cut.
BOTTOM LINE: If you want to avail yourself of the opportunity to avoid or help minimize your estate tax exposure with tax-advantaged gifts to younger family members, act now, this window appears to be closing.