IRS Regulations Could Derail Estate Planning Technique
Written by Jacque Mingle
If you have an estate that is large enough to be subject to estate tax, you might want to be paying attention to some new IRS rules that could kick in by the end of the year – particularly if you are a business owner. Estates currently subject to the tax are those that exceed $5.45 million for single people and $10.9 million married (adjusted annually for inflation).
The regulations curtail or eliminate what are known as business valuation discounts. Discounts can make sense, but the IRS believes they have been abused by clever tax planners and lawyers.
For gift and estate tax purposes, the fair market value of property is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
In other words, the value of a thing is what someone will pay for it. Seems simple enough.
It’s not so simple, though, when you are talking about a fraction of a family business. Because of the fraction, the value is considered to be less than it would be otherwise, and it gets a “discount.” Discounts are applied for the following reasons:
Lack of Marketability. Family businesses cannot be easily sold and converted to cash because there is no open market for the interest. It’s limited to other family members.
Lack of Transferability. Even if there were a market, a holder of an interest can’t easily transfer it because other family members often have to approve the transfer, either under state law or in the business agreement.
Lack of Control. The holder of a minority interest also is at the mercy of other family members when it comes to controlling the business. This devalues the interest.
Discounts for these types of restrictions can be as high as 50%. Say an estate includes a business worth $20 million. Mom and Dad can break it up into pieces and gift minority interests to the children. With 50% discounts, they could gift twice as much as they could without the discounts. They’ll still control the business, but some of the value is no longer in their estates.
The technique has been used for tax avoidance, and that’s what the IRS is aiming to stop. Basically, families form a business when there really isn’t one in order to get the discount. (Technically, a business entity must be formed for a legitimate business purpose.) An entity is formed to hold “regular assets” (such as ordinary real estate or marketable securities), and because they are technically held in a family business, each minority interest is entitled to discounts. These entities and discounted transfers are sometimes done close to death – “deathbed transfers” – and the parent then often retains a fractional interest – getting a discount for himself as well.
The new regulations say that these discounts can’t be applied. More detail can be found here.
To give an example, let’s say you have $1,000,000 worth of Microsoft stock at a given time. For tax purposes, or any other purposes, there’s no question what it’s worth. But now, let’s say you put all that stock into a Family Limited Partnership, and you give 40% of that Limited Partnership Interest to your child. The Limited Partnership Interest doesn’t give the child any right to control the Partnership or the assets, and they are effectively a silent partner.
So, what would that 40% Limited Partnership Interest be worth? This is how you determine the value of a taxable gift or the value for estate taxes. The IRS now wants to say, “You got rid of 40% of $1,000,000, so that’s $400,000.” But the argument always has been, what sensible business person would pay $400,000 to buy 40% of a business entity with $1,000,000 in assets, over which they have no direct control? They could go buy $400,000 worth of the stock on their own with no restrictions or limitations. So to convince someone to buy that interest, they’d need to get a very good deal. Hence, the discount.
One of the main complaints against the new regulations is that they will apply to entities holding “regular assets” that were formed for tax-reduction purposes AND to entities with active family businesses.
Christopher Pegg, a regional wealth planning manager for Southern California at Wells Fargo Private Bank, admitted to the New York Times that there have been abuses. “Like when families took a $100 million of marketable securities and wrapped them in a family limited partnership wrapper and took a discount.” But, he added, “what happens if it’s a $100 million corrugated steel company and the family owns it and Mom dies with a 20 percent stake? The new regulations say that stake is worth $20 million. That’s not what it’s worth.” Furthermore, he said, “we cannot assume that one family acts together. It’s worse in many cases being in with family than with strangers.”
The IRS is currently taking comments on the regulations at (website), and there will be a public hearing December 1. It would not be wise to rely on robust opposition to the regulations; if this planning strategy sounds like something you might want to employ, start talking to your advisers now.