Proposed Treasury Regulations To Affect Family Wealth Transfers

On August 2, 2016 the U.S. Treasury Department issued proposed regulations addressing transfers between family members of interests in family-controlled entities (e.g., corporations, partnerships and LLCs).  If enacted, these rules will eliminate most valuation adjustments for lack of liquidity and marketability (i.e. “minority interest discounts”) for gift and estate tax purposes.  Hearings on the proposed regulations are scheduled for December 1, 2016, and the final regulations may be effective thirty days later.

Background

Currently, a taxpayer might hold a business, marketable securities or real estate in an entity (e.g., a partnership, LLC or corporation).  A gift or sale of the taxpayer’s non-controlling interest in the entity to his children or grandchildren, or a trust for their benefit, is typically appraised at a value that reflects minority interest discounts.  These discounts arise from the recipient’s inability to control the entity and to freely transfer or “cash out” of the transferred interest.  Under the proposed regulations these minority interest discounts would be largely disregarded for gift and estate tax purposes.

Examples

1. Outright Gifts: Spouses previously formed an LLC with $20 million of assets.  They gift a 20% LLC membership interest to a separate trust for the benefit of each of their 3 children and their descendants.  An independent appraiser applied a 30% minority interest discount to each of the gifted interests in the LLC.Under current law, each gift would be valued at $2.8M (instead of $4M if undiscounted).  Similarly, the remaining 40% held by Spouses would be included in the survivor’s taxable estate at $5.6 million (instead of $8M if undiscounted).  Thus, the total value of the LLC that is subject to gift and estate tax is $14M, which is $6M less than the undiscounted value of the LLC assets.

   This results in a savings of $2.4M in gift and estate tax compared to the tax if no gifting had been done.  Further tax savings may occur as the appreciation and growth on the gifted assets is outside of the Spouses’ taxable estates.

2. Sale: Another way that this transaction can be accomplished is by the sale of each Spouse’s LLC membership interests to a trust in exchange for a promissory note.  In that transaction, the sale would be at the discounted value and the note could be repaid at a low interest rate (e.g., currently as low as 1.18% for a 9-year note).  Spouses may retain the cash flow from the assets in the LLC as the interest and principal is repaid on the note.Again, the potential estate tax savings to the family could be as much as $2.4M.  In this example all of the appreciation and growth above the interest rate on the note will also be outside the Spouses’ taxable estates.

Under the proposed regulations, the minority interest discounts would essentially be disregarded under both examples.  The resulting gifts, or the sales price, would be at the full $20M undiscounted value, and the potential $2.4M in gift and estate tax savings would be unavailable.

Take-Away

Clients who have an appropriate asset profile, and have contemplated lifetime gifts or sales to descendants, or trusts for descendants, should accelerate their consideration of this planning.  The favorable valuation principles under current law may be unavailable as early as the end of 2016.  Several months are often required to properly consider, document and implement such gifts.

Note:  This article is only intended as an information alert, and a general summary of how the new proposed treasury regulations could impact estate planning opportunities.  The application of these proposals in a particular client situation will vary, and should be discussed with qualified advisors to determine if further action is appropriate.