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Updated: Gift and Estate Tax Discounts Not Likely to Shrink After All
Important update: 12/6/16
The U.S. Treasury Department and the IRS have not publically indicated any departure from the Section 2704 regulations or the timeline as reported here. However, it is widely believed that the regulation will not be in place in January 2017 in its current form. In addition, President-elect Trump’s administration is expected to rescind or make significant alterations to the proposed regulatory changes. We will continue to monitor this matter and make updates as more details are released and we invite you to contact us with questions or concerns.
For many years it has been common for estate planners to advise an owner of a closely held business to gift or sell minority and noncontrolling interests to children and other related parties at discounts to their pro rata value. These discounts, consisting of a discount for lack of control (DLOC) and for a lack of marketability (DLOM), often combined for a discount of 35 – 45 percent or more in some cases. This has been a great way to leverage the gift tax exemption by transferring $1 of stock while reporting that value at significantly lower values for gift tax reporting purposes (e.g., 60 cents or 65 cents in many cases).
But that changed in early August 2016, when the IRS issued proposed regulations to Internal Revenue Code Section 2704. The changes will reduce the ability to take these discounts when valuing the transfer of minority interests between family members. If these regulations are finalized as written, the thought among many professionals in estate planning and valuation is that the DLOC for these types of transfers will be essentially eliminated.
The Far Reaching Impact of Proposed IRC 2704 Regulations on Gifting and Sales of Closely Held Businesses
There are some safe-harbor exceptions involving the presence of a nonfamily owner in the business that would allow the discounts to be applied. But stipulations apply:
- The nonfamily member must own at least a 10 percent interest
- The nonfamily ownership block needs to be at least 20 percent
- The ownership needs to be held for at least three years
- Ownership must be given a “put” right to allow the nonfamily member to request payment for the shares at any time
- Ownership must be paid within six months at “minimum value,” which is essentially pro rata value of the business as a whole
Obviously, qualifying for this safe harbor would be very difficult in most closely-held business entities.
Some valuation professionals, ourselves included, believe there are still opportunities to apply both the DLOC and the DLOM for intrafamily transfers of closely held stock and partnership interests; the discounts would be less than those taken prior to the proposed 2704 regulations, if finalized as written.
Consider a gift or sale before January 1, 2017
Given the likelihood of these proposed regulations going through, it would be wise to review your estate plan. We can help you determine whether the gifting of closely-held stock or partnership interest to family members makes sense from an overall estate planning perspective, and whether these transfers should be made prior to January 1, 2017, which is the earliest the regulations can become final. By transferring the shares prior to the finalization of the regulations, the discounts should be allowed under the current regulations and relevant case law.
Read our white paper for a detailed view of what’s being proposed, including the background of IRC Section 2704, its contents, and its far reaching impact on gifting and sales of closely held businesses.
A candid message for business owners
CLA Principal Jamey Rappis takes to the airwaves with a candid message for business owners related to 2704: Now is the time to have a conversation with your children about the transfer of your business.
View the video from an episode of The Growth Minded Podcast, hosted by Todd McLees.