Proposed Changes to Estate Tax Liability Calculation
Loopholes are closing that have allowed for reduced valutions of closely held family businesses for estate and gift tax purposes.
On August second of 2016, the U.S. Department of the Treasury announced a new regulatory proposal to close a tax loophole used to understate the fair market value of closely held family businesses and similar assets for estate and gift tax purposes. If accepted, this change will reduce the ability of taxpayers and their estates to use such techniques solely for the purpose of lowering their estate and gift taxes. 1
The proposed regulation is expected to impact property valuation of intrafamily transfers of ownership interests in closely held businesses. While ownership restrictions like liquidation, voting rights or lack of control have allowed heirs to take a minority interest discount to reduce the value of the property for estate and gift tax purposes when the ownership interest is being transferred. 2
Valuation of such interests is governed by Sec. 2704 which the IRS believes have been made ineffective by changes in state laws, court decisions, and various estate planning techniques that avoid the application of Sec. 2704(b), under which certain liquidation restrictions are disregarded. The proposed regulations would amend Regs. Sec. 25.2701-2 to address what constitutes control of a limited liability company or other entity or arrangement that is not a corporation, partnership, or limited partnership, effective when the rules are adopted as final. 3
They would also amend refine the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law in Regs. Sec. 25.2701-2 and modify Regs. Sec. 25.2704-1 to address deathbed transfers that result in the lapse of a liquidation right and to clarify the treatment of a transfer that results in the creation of an assignee interest, and add a new section to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family. These changes would apply to lapses of rights created after Oct. 8, 1990, occurring on or after the date the regulations are published as final. 3
Here is an example of how a family farm may have been transferred through the generations using a Family Limited Partnership (FLP): Assume a family held asset (business, real estate, farm etc.) had a value of $100,000,000. If the owner of the asset died, tax liability would be about $40,000,000 (estimate). An FLP allowed for the asset to be placed in the partnership under ownership of the original owner (let’s pretend it is mom and dad). As sole owners, they name themselves the general partner of the FLP, the general partner is the boss regardless of what percentage is owned. The FLP then devalues the asset to (40-50%) and gifts shares of the partnership to their children using their lifetime and annual gifting. ($5.45 million lifetime each and $14,000 annually per gift per owner). Over time, 99% of the non-general partnership assets are transferred to the children legally and without tax liability. Mom and dad are still 100% in control since they are the general partner, now they die. Their valuation has dropped from $100,000,000 to 50% of 1%. Their estate tax liability is nil. After their death, the children can end the partnership or continue it, up to them. They simply vote on a new general partner.4
Under new regulations, ownership transfers like this may have a higher valuation and the potential for tax consequences. The changes are not limited to FLP structured partnerships, but extend to S Corporations and LLC structured entities. If your estate planning includes closely held assets which you intend to transfer to your children or grandchildren, you may want to review and revise your existing plan.
1 - https://www.treasury.gov/connect/blog/Pages/Treasury-Issues-Proposed-Regulations-to-Close-Estate-and-Gift-Tax-Loophole.aspx
2 - http://www.thinkadvisor.com/2016/08/04/treasury-proposes-to-close-estate-and-gift-tax-loo
3 - http://www.thetaxadviser.com/news/2016/aug/estate-valuation-discounts-201614941.html
4 - http://www.annuity.com/big-changes-coming-to-estate-tax-planning/