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Estate Tax Update – Proposed Regulations to Limit Valuation Discounts

Posted on by George Munro


On August 2, 2016, the Department of the Treasury circulated proposed regulations under Section 2704 of the Internal Revenue Code which significantly reduce a taxpayer’s ability to claim lack or marketability and lack of control “discounts” when valuing property for purposes of the federal gift and estate tax.  These new rules, if and when they are finalized in the coming months, will very likely increase high-net-wealth individuals’ gift and estate tax burden.  Therefore, high-net-wealth individuals should consider making gifts before these new rules go into effect.

Under current law for tax year 2016, a taxpayer is allowed to gift up to 5.45 million dollars during his or her lifetime before incurring a gift tax liability.  Once the total sum of a taxpayer’s lifetime gifts exceeds 5.45 million, then the taxpayer must pay gift tax on all subsequent gifts.  Under current federal law, gifts are taxed at a maximum marginal tax rate of forty-percent.

Under the current gift and estate tax regime, the taxable value of all gifts are based on the fair market value of the gift at the time of the gift.  For instance, if a taxpayer gifts 100% of a LLC that holds a million dollar piece of real estate, then the taxpayer must report a taxable gift of one-million dollars on his or her gift tax return.  However, if a taxpayer were to gift a minority interest in the same LLC (less than 50%), then applicable law allows the taxpayer to claim valuation “discounts” for factors such as the minority ownership, lack of control, and lack of marketability.

For instance, if a taxpayer were to gift a forty-percent interest in the above-mentioned one-million dollar real estate LLC, under current law, it’s entirely possible that the forty-percent LLC interest would be valued at substantially less than $400,000.  Instead, that forty-percent LLC interest could potentially be valued in the realm of $240,000 to $280,000 for federal gift tax purposes.  This reduction in value is due to many factors including the fact that it’s difficult to sell a minority interest in an LLC and a forty-percent LLC interest would give the minority interest owner  little to no control over the LLC as a whole.

The ability to reduce gift and estate tax valuation through the transfer of fractional interests in property (rather than transferring the entire property) is a powerful tool that has been used by estate planners for many years.  Congress has long sought to curtail this practice, and the newly-issued proposed regulations purport to do just that.

The newly-proposed treasury regulations attack valuation discounts on numerous fronts.  One way that the new rules reduce a taxpayer’s ability to claim discounts is by deeming that most business interest gift recipients hold a 6-month put-right immediately following the gift.  If the minority interest member is deemed to hold a put-right for gift tax purposes, then the minority interest member has an available and captive market to cash out his or her newly-received business interest.  Therefore, these new rules significantly curtail the very rationale for valuation discounts for reasons such as lack of marketability.

The new rules are not in their final form, and there are many stakeholders who actively oppose the new rules.  Therefore, it’s impossible to know when the rules will be finalized and the form these new rules will take when they are finalized.  What is clear is that the treasury department is making a concerted effort to curtail this estate-planning practice.  These proposed regulations could go into effect as early as December 2016, but it’s possible the proceedings will slow as stakeholders voice their concerns and questions.  Overall, estate and gift tax valuation discounts are threatened by newly-proposed regulations; therefore, high-net-wealth individuals should consider accelerating any planned gifts before the new rules are finalized and become effective.