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Proposed Regulations under Section 2704 Severely Limit Valuation Discounts for Transfers of Interests in Family Entities, Wealthy Taxpayers Should Plan ASAP

August 30, 2016

On August 2, 2016, the Treasury Department issued Proposed Regulations under Section 2704 of the Internal Revenue Code that dramatically limit valuation discounts of family-controlled partnerships, limited liability companies and corporations (so-called Family Entities) for gift, estate and generation-skipping transfer tax purposes.

Families have long used Family Entities to manage family assets and businesses. Under the current law, when a minority interest of a Family Entity is transferred by gift, bequest or sale, the value of the minority interest can be substantially discounted, often by 20% to 40%. The discounted value is because of restrictions placed on a minority-interest holder, which can include the lack of control over the Family Entity and the restrictions on the holder’s rights to transfer the interest in the Family Entity or to sell the interest back to the Family Entity for cash.

For example, under the current law a 30% minority interest in a family-controlled limited partnership owning assets worth $1 million is worth less than its proportionate value of $300,000. Since there is little to no demand on the open market for a minority interest in a non-public business, the value of the minority interest for federal gift and estate tax purposes could be somewhere between $180,000 and $240,000. The difference between the proportionate value of the underlying assets of $300,000 and the discounted value of the minority interest, say $225,000, or $75,000, could essentially pass gift- and estate-tax free.

For years, the IRS has sought to curtail these valuation discounts, and the Proposed Regulations accomplish just that. The IRS will hold a public hearing on the Proposed Regulations on December 1, 2016, and opposition is expected to be fierce. No one knows when the Regulations will become final, or when they do become final what they will say. We do know that the Proposed Regulations, in their final form, will become effective 30 days after they are finalized. We also know that significant change is coming, and that, whatever the Regulations may provide in their final form, the change will not be to the advantage of those who may otherwise be inclined to use an existing or newly-formed Family Entity for estate and tax planning purposes.

Importantly, the Proposed Regulations do not apply to any transfers by gift, bequest or sale that occur before the Regulations become final. Now is a good time to contact us to discuss how the upcoming changes to the gift and estate tax treatment of interests in Family Entities might affect your situation. It is also a good time to consider some of the other available wealth transfer options that may be appropriate for your situation and that are not affected by the IRS’ attack on Family Entities.

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