by John Mlynczyk
The IRS has recently issued proposed regulations that may eliminate or significantly limit the ability to apply valuation discounts on transfers of business interests (such as corporations, partnerships, or LLCs) to family members.
By way of background, a time-tested tax and estate planning strategy has been for family business owners to transfer interests to the next generation during their lifetime. Oftentimes, these transfers represent less than a 50% interest in the company resulting in “minority interests” being held by the next generation. For example, suppose father owns 100% of the business, but during his lifetime sells his entire interest to each of his three daughters. The daughters would each result with a one-third interest in the company and those interests would be considered minority interests.
Minority interests are generally worth less than a majority (i.e. controlling) interest. Why? Minority interests have economic restrictions such as lack of marketability and lack of control of the company. For example, most family owned businesses will restrict minority members from selling their interests to an outsider. Furthermore, minority members typically don’t have control over operations nor do they control the decisions for making cash distributions. These economic restrictions result in valuation discounts with respect to the minority interest.
The IRS has recently issued proposed regulations that would limit the ability to apply valuation discounts on intra-family transfers of business interests. The proposed regulations are arguably the most significant regulations issued in recent years. The regulations are complex but they generally propose to eliminate or severely reduce valuation discounts. The bottom line is that if the proposed regulations are adopted as final, many family businesses would see an increased tax cost with respect to transferring their business interests to the next generation.
Sometimes proposed IRS regulation can take years to finalize. However, if the IRS makes this a high priority project, they could get them finalized as soon as next year. Moreover, a special 3 year rule could apply to transfers made before the regulations become finalized. Now is the time to visit with your CPA and attorney if you are thinking about transferring some or all of your business to the next generation.