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Potential limitations on valuation discounts could have a significant tax impact

August 14, 2015

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Background

For years, high net worth families have used family-controlled entities as key vehicles for advanced gift and estate planning. These family-controlled entities are Family Limited Liability Companies (FLLCs) or Family Limited Partnerships (FLPs). Historically, a member of the FLLC (or a partner in the FLP) transferred, either by sale or gift, non-voting, non-marketable FLLC or FLP interests to beneficiaries and claimed a valuation discount due to the restrictions on the ownership interest transferred.

It appears the Treasury Department may soon be publishing regulations limiting the use of valuation discounts in these types of transactions.

Valuation discounts

There are two typical valuation discounts reconciled by the IRS: 1) the minority interest discount and 2) the lack of marketability discount. The minority interest discount is due to restrictions on control of the entity, while the lack of marketability discount is due to restrictions on the ability to sell the interest to an unrelated third party.

These two discounts can individually range from 15% to 40% or more. Together they can produce significant tax savings by permitting a transfer of an ownership interest for less than pro rata value. For example if an FLP is worth $100 million and a 10% interest ($10 million) is transferred at a 40% discount, the 10% interest is transferred for $6,000,000. In a gifting context the $4,000,000 discount saves $1,600,000 in gift tax.

The perceived abuse

The IRS is frustrated with families taking discounts on entities that hold assets that are substantially liquid, like marketable securities portfolios. Specifically, the IRS objects to the application of discounts to the transfer of fractional interests in asset portfolios in which the assets’ market value is readily determinable from the publicly traded market. The IRS is searching for a way to curb the perceived abuses.

Anticipated IRS action

The IRS has recently signaled, through various public comments by IRS officials that the Treasury Department intends to issue proposed regulations that will address the perceived abuses. The Treasury Department has not released specific details on the proposed regulations; however, for several years the Obama Administration has provided fiscal year revenue proposals, and one of those proposals describes restrictions on the use of discounting. In summary, the proposal recommends creating a gateway of restrictions that would be disregarded in valuing an interest in a family-controlled entity. The required “disregarding” could result in the minimization or elimination of minority and lack of marketability discounts.

The Treasury Department has further indicated that the proposed regulations could be issued as soon as the first week of September 2015, and that the issuance date could also be the effective date. Among the many unknowns is what constitutes a family-controlled entity and whether operating business assets will be subject to the same special rules as readily marketable securities.

What to do now?

Currently, there is a significant amount of uncertainty about: when the proposed rules will be issued, when the proposed rules will be effective, what constitutes a family-controlled entity, how restrictive the limitations on discounts will be, and if the Treasury Department even has the legal authority to institute these rules.

What can be said with certainty is that if you are considering transferring an ownership interest in an entity that may be impacted by the expected rules, it is in your best interest to accelerate your decision making and be prepared to take action sooner rather than later. For guidance as you evaluate your options, reach out to your Clark Schaefer Hackett advisor.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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