One of the most discussed tax issues in 2016 was the proposed IRC Section 2704 regulations released in early August 2016 that are designed to limit estate valuation discounts for minority interests. The proposed rules are broad in scope, and would apply to family-owned operating businesses. Family-owned manufacturing companies may be among the most harmfully impacted by the proposed IRS rules.
Transfers of closely held businesses among family members are typically minority interests. There are two types of discounts commonly applied to a business’s overall estimated value to reflect elements of control and marketability: (i) the discount for lack of control, and (ii) the discount for lack of marketability.
The economic logic behind the discount for lack of control is that a minority interest shareholder does not have the ability to manage or control the company, such as setting operational and strategic policies, declaring dividends, liquidating or merging the company, or acquiring business assets. As a result of this inability to control the operations of the business, a discount from the business value is necessary. Appraisers commonly rely on statistics from publicly announced mergers, acquisitions, and divestitures involving operating entities to determine an appropriate discount for lack of control.
Family owned businesses do not trade freely on the open market like a stock on the New York Stock Exchange. Without access to the public markets, a non-controlling shareholder does not have control to time potential gains or avoid losses. A publicly traded stock can be traded almost instantaneously. In contrast, the sale of an interest in a family owned business is risky, difficult, and costly. As a result, the lack of marketability requires a discount adjustment to the value determination. Appraisers will typically rely on empirical studies to determine the appropriate adjustment for lack of marketability.
Despite the real world difficulties of selling a non-controlling interest in a family owned business and the economic logic behind the application of discounts, the proposed regulations, as written, would severely limit the use of such discounts for transfers among family members of minority interests in their business.
For 2016, the federal estate and gift tax exclusion amount is $5.45 million for an individual and $10.9 million for a married couple. Based on estimates provided to Bloomberg BNA, the vast majority of manufacturing businesses are likely to be impacted by the valuation discount rules.
Take as an example a manufacturing operation-started by a husband and wife-that was recently valued at $20 million. The husband gifted 35% of the business to a trust and his wife gifted another 35% to a separate trust with the objective to have future appreciation of the business out of their estates. The indicated value of the two gifts before discounts is $14 million [(35% + 35%) x $20 million]. However, because they are gifting minority interests under the current tax law, the value of their interests in the family business are worth less than the pro-rata value of the business. Assume that an appraiser determined a 15% discount for lack of control and a 15% discount for lack of marketability is appropriate. Each trust gift is thus estimated to be worth $5,057,500.
|Proportionate Value of a 35% Interest||$||7,000,000|
|Less: Discount for Lack of Control (15%)||(1,050,000)|
|Indicated Value on a Non-Control, Marketable Basis||5,950,000|
|Less: Discount for Lack of Marketability (15%)||(892,500)|
|Fair Market Value of a 35% Non-Controlling, Non-Marketable Interest||$||5,057,500|
The gifts would use up $10,115,000 of the couple’s gift tax exclusion under the current regulations, leaving room for an additional $785,000 in tax exclusion. However, under the proposed regulations, the discounts would be disallowed and the combined gifts would be valued at $14 million. Under this scenario, the full $10.9 million exemption would be used up, and the couple would owe federal tax on $3,100,000 at estate and gift tax rates of 40% for 2016. The additional tax burden on the shareholders of this manufacturing operation may reduce their ability to expand their operations, potentially resulting in job cuts.
We cannot predict the final outcome of the proposed regulations. A public hearing was held on December 1, 2016, and there was a record turnout by business valuation professionals, trust and estate attorneys, and family business owners. Those speaking against the proposed regulations argued that the rules are so broad and complicated that they should be permanently withdrawn or revised. However, as of this publication, the IRS has yet to make an announcement on the fate of the proposed regulations, so they could go final as-is.
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Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.
 Allyson Versprille, “Family Businesses, Jobs Seen Thwarted by Proposed IRS Rules,” Bloomberg BNA Daily Tax Report, August 22, 2016.