Proposed Regulations on Valuation Discounts Could Impact Gift Planning

By John H. Schapiro

The estate planning community is abuzz over a recent statement by a lawyer from the Treasury Office of Tax Policy that the Treasury expects to propose new regulations on valuation discounts by the middle of September. So, what might those regulations include and, if we aren’t sure, what can be done now?

There may be an effort among estate planners to raise a little panic here. Summer is otherwise a slow season, and it would be great to motivate clients to undertake major transactions right now in advance of regulations that will probably take effect retroactive to their proposal date, perhaps sometime around Labor Day. The regulations may not have a radical impact, but there are reasons for people who have already been planning gifts of equity in family businesses or family limited partnerships – especially family limited partnerships that hold investment assets – to complete their transactions in the next month.

Valuation discounts are a critical feature of estate planning, especially for families whose closely-held businesses represents a piece of the family wealth. The basic idea is that a minority interest in a private business is actually worth much less than the minority percentage multiplied by the possible purchase price. Simply put, an arm’s length purchaser would never pay $2 million for a 20% interest in a $10 million business. This is because a minority shareholder has no control over the business strategy or its ultimate sale and because it is difficult to find a purchaser for private stock if the owner wants or needs to sell. In addition, most non-public companies are governed by shareholders agreements, bylaws, or similar rules that make selling an interest to third parties difficult or impossible. These disadvantages to ownership in private businesses lead to the “minority interest” and “lack of marketability” discounts commonly applied to valuations.

Courts have repeatedly held that valuation discounts are appropriate when calculating the value of a gift that is subject to gift tax, or the value of a business interest held by a decedent’s estate subject to estate tax. The IRS regularly accepts discounts for lack of control and lack of marketability that aggregate 20-25% of the value of an underlying business (and regularly challenges discounts of much more than 30%). Nevertheless, the IRS and the Treasury have always insisted that the appropriate discount must be determined on a case-by-case basis, effectively forcing taxpayers to pay for expert opinions if they want to claim valuation discounts.

It’s difficult to tell just how far Treasury will go in creating new regulations. This is another case of the Obama Administration using regulatory authority to accomplish policy goals it originally pursued through legislation. The Treasury lawyer indicated that the new regulations would be consistent with legislation the Administration had proposed repeatedly. That was itself a delegation of authority to the Treasury to come up with a set of standard default assumptions about minority shareholder rights that would apply for valuation purposes. More severe restrictions in by-laws or shareholder agreements would be disregarded, at least if members of the same family and others likely to agree with them would collectively have the power to change or to waive those restrictions. The forgone legislative proposal also invited Treasury to create a safe harbor for valuation discounts. Finally, the Treasury may attempt to eliminate any sort of valuation discount that applies to an entity like a family limited partnership, substantially owned and controlled by members of a single family, that primarily holds investment assets.

What are the tax policies at stake in valuation discounts?

First, discounts favor taxpayers, ensuring that part of the estate and gift tax base always escapes taxation. Parents may take a valuation discount when making lifetime gifts of business interests to their children, and their estates may take discounts on whatever the parents hold when they die. But if the children are able to sell the business as a whole at full price following the parents’ deaths, whatever portion of the value was represented by valuation discounts has been passed from one generation to the next without taxation.

More importantly, for the past 20 years or so, taxpayers have taken advantage of valuation discounts where they seem counterintuitive. Suppose, instead of an operating business, parents take a portfolio of publicly traded stocks and bonds, which could easily be sold at market price in a single business day, put it in a family partnership, and call it a business. Then they give their children transfer-restricted, nonvoting limited partner interests in that partnership. For gift tax purposes, the parents would likely discount the value of the gift to reflect the lack of control over the family partnership and non-marketability of the partnership interests.

This is a transaction the IRS and the Treasury hate, but against which they have had only mixed success in litigation. The government’s losses in some of these cases have made some taxpayers willing to take a risk in using the family limited partnership technique to avoid gift and estate taxes.

Although it may be difficult to predict how far the new regulations would go in restricting existing practices, now is a good time for families to complete transfers for which valuation discounts are useful.

For more information on the proposed regulations and how they could affect your estate planning, please contact John Schapiro at [email protected] or 215.496.7234.