Treasury Attacks Estate and Entity Planning Techniques With Proposed Valuation Regulations

Over the past few decades, valuation discounting through the use of family-owned business entities has become a popular estate and gift tax planning technique. If structured properly, the courts have routinely validated discounts ranging from 10 to 45 percent. Valuation discounting has proven to be a very effective strategy for transferring wealth to subsequent generations. It is a particularly useful technique with respect to the transfer of small family businesses and farming/ranching operations. Similar, but lower, valuation discounts can also be achieved with respect to the transfer of fractional interests in real estate.

The basic concept behind discounting is grounded in the IRS standard for determining value of a transferred interest – the willing-buyer, willing-seller test. In other words, the fair market value of property is the price at which it would changes hands between a hypothetical willing-buyer and a willing-seller, with neither party being under any compulsion to buy or sell. Under this standard, it is immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller. Thus, there is no attribution of ownership between family members that would change a minority interest into a majority interest.

Now, IRS has issued new I.R.C. §2704 regulations that could seriously impact the ability to generate valuation discounts for the transfer of family-owned entities.  The proposed regulation was issued by itself, and not also as a temporary regulation, and does not have any provision stating that a taxpayer can rely on it before it is issued as a final regulation. The effective date of the proposed regulation reaches back to include valuations associated with any lapse of any right created on or after October 8, 1990 occurring on or after the date the proposed regulations is published in the Federal Register as a final regulation. This would make it nearly impossible to avoid the application of the final regulation by various estate planning techniques.

So, what is the IRS concerned about?  While the IRS has won a number of court cases involving discounting in the context of family limited partnerships (FLPs), it has lost some very significant ones.  The courts have validated discounts associated with FLPs where the FLP was formed for legitimate business purposes and state law formalities have been followed closely.   From my sources both inside and outside of the IRS, the IRS is apparently still encountering situations involving FLPs that are not established in accordance with state law, don’t adequately document the business reasons for forming the FLP and have inaccurate or incomplete asset appraisals.  They think that the revenue loss is large as a result of the technical non-compliance with I.R.C. §§2036 and 2704.   Consequently, the new proposed regulations eliminate the ability to value an interest in an entity (in the aggregate) at an amount less than the value of the value of the property had it not been contributed to the entity.  The IRS view is that the lower value of the property as contained in the entity is an inappropriate way to avoid transfer taxes. 

Clearly, the Treasury can write regulations that specify that certain restrictions on transfer can be disregarded when determining the value of an interest in an entity to a family member of the transferor.  However, without legislation allowing it, the IRS cannot simply ignore discounts for lack of marketability or lack of control (minority interest).  Long-standing interpretations of I.R.C. §2704 by the Tax Court and the Circuit Courts support valuation discounts when the transaction is done properly.  As a result, the Courts may have a different view than the IRS with respect to the proposed regulations based on the longstanding Congressional intent to allow discounts in a family context. Having discretion does not mean that Treasury has discretion to determine value as it pleases.

The new regulations will have to be analyzed and paid attention to. Comments on the proposed regulation are due by 90 days from August 4, 2016.  You can read the proposed regulations here:  https://www.regulations.gov/document?D=IRS_FRDOC_0001-1487