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IRS Takes Aim at Common Family Biz Valuation Discounts

Discount season may be coming to an end for wealthy families.

Currently, many high net worth families use creatively structured family limited partnerships (FLPs) or family LLCs, including deliberately lapsed shareholder rights, to secure aggressive valuation discounts for tax purposes when transferring the assets via gifts or bequests to heirs. However, the Internal Revenue Service recently released long-awaited proposed changes designed to combat the practice. Advisors may have to help clients adjust.

The current regulations, under Internal Revenue Code Section 2704, were themselves passed with the intention of putting an end to abusive discounting of family entities. But according to the IRS, these rules have been largely declawed by years of court decisions, changes in state laws and creative use of estate planning techniques. The new proposal would create a series of restrictions that would greatly limit the valuation discount options available in just about any transfer of an FLP or family LLC where the family maintains control. Some think they go too far.

One of the main targets of the proposed regulations is the abuse of exceptions applying to the lapse of restriction or liquidation rights through deathbed transfers. Currently, it’s possible for a majority stockholder in a family entity to, for example, make a late-in-life gift to a family member of just enough shares of stock to break his majority. His estate can then claim a lack of control discount on his now-minority share of the company. The IRS maintains that such transfers have basically no economic effect other than to depress the assets’ transfer tax value. Accordingly, the proposed regulations contain a three-year look-back period during which any such transfers or lapses would be considered to happen at death, and would no longer trigger a minority discount.

Another bright line change is the creation of a new category of “disregarded restrictions.” Currently, certain restrictions that would normally trigger a valuation discount are ignored if the family maintains control and has the right to remove the restriction after the transfer (effectively making the restriction illusory). The proposal toughens the existing restrictions and expands this treatment to encompass a new, broader, group deemed “disregarded restrictions.” The effect is the effective elimination of most valuation discounts for any transfer subject to one of the categories.

The proposed regulations do make a small concession by permitting consideration of restrictions a lender or other financial partner may place on the entity or transaction. However, even this “Commercially Reasonable Restriction Exclusion” exception comes with myriad questions and potential pitfalls.

If these changes do come into effect, and there’s every reason to believe they will, then they represent a potential sea change in the tax treatment of FLPs and family LLCs. Advisors must be armed with innovative solutions to keep clients happy.

The proposed regulations are currently in a public comment period that runs through November 2. A public hearing will then be held on December 1.

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