Proposed IRS Regulations Could Impact Family Owned Businesses

In 1959, the IRS defined fair market value as:

the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.[1]

This definition has stood the test of time and has been utilized in estate and gift tax valuations for over 60 years.  A critical element of this definition has been that it assumes a hypothetical willing seller and willing buyer.[2]  On August 4, 2016, the IRS issued proposed regulations attempting to overturn nearly 60 years of valuation precedent.   In short, the IRS is proposing to eliminate valuation discounts for family owned businesses for gift and estate taxes.

The IRS has proposed amendments to Section 2704 of the Internal Revenue Code that will have a substantial impact on future transfers of family member’s interest in family businesses. The IRS is proposing that there be no valuation discounts for inter-family transfers of interests in closely held companies owned or controlled by a family.  In addition, the IRS is proposing limiting the use of promissory notes to fund the buyout of family members’ interests.

Our position:

The proposed regulations are ignoring empirical market data that the economic value of a minority interest in a family business is less than its pro rata share.  This same principle is true in family, closely held and publicly held businesses.

For example, closed-ended funds share similar characteristics to Family Limited Partnership (FLP’s) as investors of each lack control over the underlying assets invested in by the entity. The overwhelming majority of closed-ended funds trade at a discount to their net asset value. The majority of this discount is attributable to the lack of ownership control of the fund’s assets, and a smaller portion is attributable to a lack of liquidity.

What this means:

There will be a public hearing on the proposed regulations in December 2016 and it is possible that regulations could be enacted shortly thereafter.

What Lurie is doing:

Lurie is submitting a response to the IRS prior to the hearing addressing our concerns with this proposed regulation and its lack of economic support.

What you can do:

If you have been planning to transfer an interest in your family owned business we strongly recommend you put those plans into action immediately.  Once (and if) final regulations are issued, it will be too late to utilize discounts. If you have any questions or would like more information on a valuation or on your estate plan, please contact your trusted advisors at Lurie, LLP.

 

[1] Revenue Ruling 59-60.
[2] E.g. would a hypothetical willing buyer and seller agree to transact in a 10% interest in a company for the same per share value as 100% interest in a company?
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