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The Vanishing Family Transfer Discount

Last Updated: November 1, 2016

Roughly 26 years after the law they represent was enacted, the Internal Revenue Service (IRS) has issued proposed regulations primarily designed to limit discounts on certain intra-family transfer transactions. The IRS issued the proposed regulations to prevent what they believe is the undervaluation on intra-family transfers of ownership interests for estate, gift and generation-skipping transfer tax purposes.

Temporary or final regulations represent the IRS opinion on how the taxation requirements of a particular Internal Revenue Code Section (IRCS), in this case section 2704, should be handled. These regulations are anticipated to be followed by taxpayers. Or, according to the IRS, taxpayers should have a good reason to not follow them. However, a proposed regulation is used by the IRS to alert taxpayers to how the IRS is interpreting an IRCS. But taxpayers are not required to follow a proposed regulation until it is moved to the higher level of temporary or final regulation. The IRS will typically use the proposed regulation period to request and discuss comments from taxpayers related to the proposed regulations before the IRS moves the proposed regulations to a higher level. The proposed section 2704 regulations follow this pattern but are very controversial and should result in many comments being received before a public hearing scheduled for Dec. 1.

Why are the section 2704 proposed regulations so controversial? As proposed, they will not allow an intra-family entity transfer to benefit from valuation reality. Rather, they will treat the family as a single taxpayer unit, not as individual taxpayers. Therefore, when a minority interest in a family entity is transferred to another family member, previously available lack of control and marketability discounts will not be allowed,
even though they would be part of the valuation process for a non-family member transaction.

To illustrate the proposed regulation change, consider the following: Many years ago, a parent purchased a few acres of land on the outskirts of a growing city, utilizing a single member limited liability company (LLC). The land is the only asset the LLC owns, but is now valued at $12 million. The parent decided to gift a child 10 percent of the LLC. The LLC documents clearly define the gifted 10 percent LLC interest as a minority interest, lacking voting control and having limited ability to be sold or transferred. Prior to the section 2704 proposed regulations, the gifted LLC interest would have benefitted from a control and marketability discount between 20 to 40 percent (or more), reducing the gift value from $1.2 million to between $960,000 and $720,000. Under the section 2704 proposed regulations, the gift value will be $1.2 million.

The section 2704 proposed regulations also introduce other changes, such as disregarding control by non-family members in certain cases, noting that the family entities covered will include limited liability companies and other similar entities and business arrangements (not just corporations and partnerships) and offsetting any discounting effect for so termed “death bed” transfers.

As noted above, the IRS scheduled a public hearing on the proposed regulations for Dec. 1. If the IRS doesn’t make changes to the proposed regulations and finalizes them on Dec. 2, many of the changes would be effective on the date they are finalized. However, changes related to restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family would not apply until 30 days after that date. The same 30-day delay will apply regardless of when the proposed regulations
are finalized.

There’s little doubt the IRS will push for finalization as early as possible. But the controversial position in the regulations and the complexity of what happens to the 20-something years of court case law that has been created for intra-family transfers may slow the finalization process into mid to late 2017, if not longer. However, the longer finalization period is not something to
count on.

Planning considerations should not wait, even if a taxpayer is not a “high wealth” taxpayer, particularly where future basis considerations come into play. And, there is also a new three-year look-back rule that could affect transfers of a transferor who happens to have an untimely death.

Any intra-family transfer made after finalization will deal with all or a great many of the provisions currently held in the proposed regulation. It is unlikely the IRS will be swayed from their proposed intent to prevent the undervaluation of intra-family transfers of interests.

As the finalization process slowly moves forward, there are many unknowns. But there is one known item for you to consider: Act now, not later. 

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