By Tax Services Department
I once had a wealthy client who was a private business owner that wanted to gift a vacation home to his children. Based on prior gifting, to transfer the property outright, he would have incurred a 40% gift tax rate on a portion of the value of the home because the fair market value was in excess of their remaining gift tax exemption. 
As his advisor, we had discussed his long-term financial goals and created an Ohio limited liability company so the vacation home could be deeded into the LLC. Since the home was now an LLC asset, he had a qualified professional perform a valuation of the LLC.
Assigning several “discounts” for the value of the LLC , when he transferred the LLC ownership to the children, he was able to reduce the fair market value of the vacation home by using a 30% discount per the valuation. This simple planning allowed him to transfer the vacation home to his children without incurring any gift tax.
Needless to say, valuation discounts are a very important and significant component of estate planning. The two main discounts are lack of control and lack of marketability.
Lack of Control
Typically, when ownership of a family business is gifted to family members of a lower generation, the control stays with the older generation by the use of voting and non-voting stock. While the IRS originally maintained that valuation discounts for minority interests (lack of control) were not available, the IRS changed its position in 1993, in Revenue Ruling 93-12.
Lack of Marketability
In addition, a discount for a lack of marketability has been allowed because the Family Limited Partnership (FLP) units are not sold in the stock or other open market and are not easily valued. The lack of marketability discount is available because of the difficulty of selling “hard to value” assets. This opened the door for FLPs and family limited liability companies (FLLCs) to become very useful estate planning tools.
- Benefits and Drawbacks of a Discount
Discounts, sometimes as much as 30%, allow family members to pass valuable ownership of family businesses to younger generations while preserving lifetime gift and estate tax exemptions (currently $5.43 million for 2015). - The increased use of FLPs has also increased the number of IRS challenges for abusing discount amounts.
- The IRS has challenged discounts based on various legal theories, notably Internal Revenue Code (IRC) Section 2036 (transfers with retained interests and powers); Section 2703 (buy-sell agreements); gifts on formation of the FLP or LLC; and indirect gift and step transaction. The IRS has had very limited success with its challenges.
- One other legal theory used by the IRS in its challenges is IRC Section 2704. Under Section 2704, if there is any transfer of an interest in a corporation or partnership to a family member, and if the transferor and members of his or her family control the entity immediately before the transfer, then certain restrictions (called “applicable restrictions”) are disregarded in determining the value of the transferred interest.
Legal jargon aside, the IRS challenges relying on IRC 2704 are directly related to valuation discounts for lack of control and lack of marketability. Though the IRS also has had limited success with this challenge, rumors of proposed regulations may give the IRS the ammo it needs.
Why is this important?
Section 2704 states that the Secretary of the Treasury may provide, in regulations, that other restrictions shall be disregarded in determining the value of a transfer to a family member. Recent speculation suggests that regulations may be released by mid-September that would prevent minority interest (lack of control) and lack of marketability discounts for certain family owned entities. In fact, in May 2015, Cathy Hughes of the Treasurer’s Office of Tax Policy confirmed proposed Section 2704 regulations would be issued by early fall, 2015. The release of the rumored, proposed regulations that would disallow valuation discounts would delete the ability for taxpayers to transfer private investments to family members and take a discount, typically 20%-30%. The typical 20% -30% discount allows a taxpayer to transfer a lot more value to family members while preserving his gift and estate exemption.
For example, if a taxpayer had private investments with a fair market value of $10 million in an FLP and wanted to transfer a portion to his children, he could essentially transfer $6,787,500 to other family members, taking a 25% discount, and not exceed his gift and estate tax exemption of $5,430,000.
What does this mean for you?
Valuation discounts are, and should be, used as an estate planning tool for any taxpayer whose net worth exceeds the current lifetime gift and estate exemption.
We can help you understand how valuation discounts can be included in your estate plan and the benefits you could receive. If you have already used valuation discounts for family owned entities, you may have limited time to continue the proposed tax law changes.
Contact us at info@zinnerco.com or 216-831-0733. I’m ready to explore your scenario to position you and your company for a solid financial future.
About the Tax Services Department
Led by partner Howard Kass, CPA, CGMA, AEP, the taxation department team works with individuals and businesses to ensure compliance, planning, and strategies encompassing all financial matters. The team guides and counsels clients in federal, state and local taxation in addition to sub-specialty area’s within taxation, including business tax, individual tax, IRS matters, estate, gift and trust services and international tax planning.
