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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

New Proposed Regulations Restricting Valuation Discounts for Family-Controlled Entities

By: Julia Weaver, J.D., Director, Family Office Services and The Trust Company of Oxford and
Kara Talbott, CPA/PFS, CFP®, Senior Wealth Strategist and Scott Simmons, J.D., LL.M., Wealth Strategist

Highlights and Planning Considerations

  • On August 2, 2016, the Treasury Department issued its proposed regulations under Section 2704 that, when and if finalized, could greatly alter the availability of valuation discounts for family-controlled entities.
  • In our January, 2016, article, "Estate Planning Freeze and Squeeze Strategies", we mentioned the Treasury had publicized its intentions to issue these restrictive regulations. After months of silence, it finally released these long awaited proposed regulations that are much more restrictive than originally anticipated.
  • The impact on many current and future estate planning strategies could be significant and would greatly impair the ability to receive valuation discounts on interests in a family-controlled entity. This could potentially cause a significant increase in some families federal estate exposure.
  • Several estate planning considerations should be assessed in determining the proper course of action for each client's unique situation.

The current strategy of transferring discounted interests in a family-controlled entity typically enables more overall wealth to be transferred to heirs, free of estate taxation. By way of example, consider the following: Rather than passing only $10.9 million worth of actual value with the $10.9 million exemption (for 2016), it is far better to pass $15.5 million of interest (reduced by a 30% valuation discount), thereby “squeezing” more value through the $10.9 million exemption portal.

Simply put, less of the taxpayer’s gift and estate tax exemption is utilized when transferring a discounted value of interest, leaving more exemption remaining to apply to subsequent transfers. Valuation discounts also serve to potentially reduce the taxable value of the estate.

Key Provisions in the Proposed Regulations
Immediate reactions to the proposed regulations include concerns that nearly all minority and lack of control discounts could be disallowed in certain circumstances, and that operating entities may be impacted as well as investment entities. The following is a summary of five things you should initially know about these proposed regulations.

1. Certain restrictions that previously resulted in valuation discounts on interest in family-controlled entities would be disregarded when valuing a transferred interest. This provision could cause the interest to be valued at a minimum value which could potentially be the fair market value of the property held within the entity, reduced only by outstanding obligations.

2. Certain transfers of interest in family-controlled entities occurring within three years of the transferor's death would be treated as a lapse of voting and liquidation rights occurring on the transferor's date of death. This would cause the value of the reduction attributable to the minority status to be includible in the gross estate.

  • Example – John gifts, after the regulations are finalized, 20% of the Family Limited Partnership to each of his three children. John dies two years later. The value reduction is brought back into John's estate.

3. Certain interests held by non-family members would be disregarded unless they meet specific requirements.

  • The non-family member must have held the interest more than three years.
  • The interest must be more than 10% of the value of equity interest or capital and profits interest.
  • The interest held when combined with other non-family interests must total more than 20% of equity interest or capital and profits interest.
  • The non-family member must have the right to "put" the interest to the entity and be paid the minimum value as determined under the regulation, in cash or other property, which cannot be a note issued by the entity, holders of interest in the entity or a person related to the entity or any holder of interest in the entity.

In the case of an entity engaged in an active trade or business, if 60% or more of the entity's value consists of non-passive assets of the trade or business and the liquidation proceeds are not attributable to passive assets then proceeds may include a note.

Families with operating businesses should discuss with legal and tax counsel to verify that buy-sell agreements comply with the proposed regulations.

  • Example 1 – John and his brother's wife, Dana, own an active business equally. However the proposed regulations would treat them as family members forcing John's estate at his death to value his business interest without regard to discounts for lack of control.
  • Example 2 – John, Bill and Susan are not related by blood or marriage. Each own 1/3 of an active business. Their buy/sell agreement calls for the entity to repurchase a deceased owner's interest and issue a promissory note over a five year period. They executed this agreement in order to allow for the continued viability of their business without burdening its cash flow. They should consult with legal and tax counsel to determine if their entity value and assets comply with the regulation as finalized. If not, it is possible that no lack of control discount would be available for their 1/3 interest at their death.

4. Also potentially disregarded would be certain restrictions created by transfers to an assignee rather than a partner, as well as certain restrictions that are imposed by state law.

5. The proposed regulations contain very broad family attribution rules, further impacting the use of closely held entities as a planning strategy for minimizing estate and gift taxes.

Control of an entity is defined as having at least 50% of the equity or capital and profits interest. It would also include any equity interest held with the ability to cause a full or partial liquidation. For determining control, interests held by members of the transferor's family, defined as the transferor's spouse as well as the transferor's ancestors, descendants, siblings and the spouses of all listed, are included in determining control.

It is important to note that the proposed regulations are not effective immediately. They will be effective after they have been adopted as final regulations. A public hearing has been scheduled for December 1, 2016, suggesting that December will be the earliest the new regulations would become effective.

Planning Considerations: Absence of Federal Estate Tax Exposure
Ironically, for many taxpayers the best planning strategy may be to simply do nothing at all. As we highlighted in our July article, "Income Tax Planning with Family Entities - The Quest for Basis Step-Up", many families have been relieved of exposure to the federal estate tax due to the increasing exemptions amounts since 2002.

As we stated, "[t]he focus for these families is squarely upon income tax planning [and the ability to obtain] a step-up in basis to the asset's fair market value on the date of death. Consequently, when the value of an asset is reduced by valuation discounts, the basis step-up potential is equally reduced... [S]hould heirs liquidate interest after Senior's death, the heir must recognize that difference as gain for income tax purposes."

In that article, we discussed strategies to eliminate valuation discounts in these certain circumstances. The Service, however, may have just provided the ideal mechanism to accomplish this strategy, to wit: do nothing at all.

Planning Considerations: Clear and Present Danger of Federal Estate Tax
For families where federal estate tax remains an ongoing threat to their legacy wealth, there are certain planning strategies that may be considered in light of this potential change in current laws. As always, any such strategies should be thoroughly discussed with legal and tax counsel.

In some respects, currently discounted family-controlled entity interest is somewhat akin to an appreciating asset. Once the regulations become final, the discounts may fall off, resulting in a rapid increase in the value of the interest. Various planning techniques may be structured so that this increase in value occurs outside of the taxable gross estate, thereby avoiding the 40% federal estate tax on the increase in value.

Such strategies may include sales to Intentionally Defective Grantor Trusts ("IDGTs") or Grantor Retained Annuity Trusts (GRATs), as well as some asset titling opportunities, all of which should be thoughtfully analyzed for each taxpayer's individual situation.

Additionally, the loss of discounts may cause a significant increase in a taxpayer's federal estate tax exposure. Taxpayers should consider having their federal estate tax analysis updated, along with a liquidity analysis for payment of any increased tax obligations.

Caveats and Cautions
As with any estate planning strategy, caution must be exercised to avoid structuring any potentially abusive transactions, including a transaction considered to have pre-planned "steps" to achieve tax avoidance. A good estate planning attorney should review any strategy so as to avoid this “step-transaction” doctrine, wherein the entire strategy would be collapsed.

Additionally, the proposed regulations contain a potential three (3) year claw-back period wherein any transfers made within 3 years of the transferor’s death could be treated as a lapse causing inclusion in the gross estate of the value of the reduction of the transferor’s interest attributable to certain previous discounts.

Next Steps
As discussed, there are vastly differing strategies for each taxpayer's specific situation, particularly depending upon whether there is current or anticipated federal estate tax exposure. Along with coordinating the appropriate legal and tax review of the issues discussed above, your Oxford advisors can assist with determining the proper course of action for each client's unique situation.

*The Federal Estate Tax Exemption for 2016 is $5.45 million per person/$10.9 million per married couples, above which all wealth is taxed at the rate of 40% upon any non-marital transfer.