Valuation Discounts Under Attack

Last year, we informed you that the IRS was in the process of issuing new regulations that would substantially limit valuation discounts for estate and gift tax purposes.   As anticipated, on August 2, 2016, the IRS finally released those proposed regulations.

The proposed regulations would substantially change the valuation discounts available to high net worth individuals.  Usually, estate planning for high net worth clients involves creating family entities, such as family limited partnerships, limited liability companies and Intentionally Defective Grantor Trusts, to take advantage of minority and marketability valuation discounts.  These valuation discounts are a reduction in value of an entity based on restrictions within the entity’s bylaws, operating agreements, or buy‑sell agreements that limit the ability to sell the business interest and restricts the transferee’s ability to participate in management of the entity.  Properly structured, valuation discounts can result in the immediate reduction of 30‑50% of value of an entity for gift tax, intra‑family transfers and estate tax purposes.  By using discounts, an entity that has a real value of $20,000,000 is only valued for gift / estate tax purposes between $10,000,000 and $14,000,000 with properly structured discounts.  In this example, the use of discounts allows $6,000,000 to $10,000,000 in value to disappear from a high net worth individual’s taxable estate.  And since the estate tax and gift tax rate is 40%, the discount represents an immediate tax savings of $2.4M to $4M.  These discounts are now being scrutinized by the IRS and will likely be severely restricted.

The proposed regulations would amend Internal Revenue Code Section 2704(b)(4), which currently provides the mechanism to create restrictions in entity agreements that enhance valuation discounts based upon lack of control and lack of marketability.  Even though the IRS regularly challenges the discounts, over the past several years, the Courts have generally ruled in favor of taxpayers whose entity valuations included discounts based on well-drafted restrictions.

While the proposed regulations have not yet been finalized, and may not apply retroactively to transfers made prior to the proposed regulations becoming final, we do encourage all of our high net worth clients (unmarried / widowed over $5.0 million, married over $10.0 million) to schedule an appointment with our office to discuss their planning options prior to the proposed regulations becoming final.

There is a public hearing on the proposed regulations set for December 1, 2016, and the proposed regulations would go into effect just 30 days after the regulations become final.  Prognosticators are projecting that the proposed regulation will be finalized some time in 2017.

For high net worth clients, there should be a sense of urgency in regard to their estate planning.  Transfers among family members or specialized trusts created for the benefit of family members must be in place within 30 days of when the IRS adopts the proposed regulations as final.  If you are unmarried and your estate is over $5.0 million, or married over $10.0 million, please contact Michelle Glenn to schedule an appointment with Mark S. Drobny to discuss your estate planning options before year end.

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