Scott Roberts, CPA, CLU
Director of Estate Planning

On August 2, 2016, the IRS issued the long-anticipated proposed regulations for section 2704 related to valuation discounts for closely-held entities.

The action comes as no surprise to the tax planning community familiar with the long battle our country’s tax collection agency has waged against these discounts which allow savvy taxpayers to leverage exemptions and transfer greater wealth to future generations without taxation. For decades, the IRS has challenged these discounts in court and, barring bad facts on the part of the taxpayer, has repeatedly lost, essentially creating a how-to roadmap along the way.  But, just as it has for multiple other issues, when the IRS can’t win with the rules, it just changes the rules by petitioning congress or, as in this case, simply reinterpreting the rules via new regulations.

First, a word on what this is all about, and then a comment on the Proposed Regulations themselves. In a very simplified nutshell, here is how valuation discounts work: If parents were to gift children 50% of a $10 million asset, logically, the value of the gift would be $5 million. However, if, prior to the gift, the asset is transferred into a Limited Partnership and 50% of the Limited Partnership interest is given to the children, what would be the value of the gift now?  Considering that the parents undoubtedly retained control of the entire partnership by keeping the small General Partner percentage and, further, since the Partnership Agreement likely limits the Limited Partners’ ability to sell, one could conclude that the Fair Market Value of the gift is less than $5 million. Exactly how much less has been the subject of many IRS disputes over the years but the discounts for lack of marketability and lack of control have been repeatedly upheld. Of course, each particular situation is different but, depending on the facts, including language in the agreement and the mix of assets contributed, discounts can range from 15% to 35% or more, resulting in millions of tax dollars saved (or lost, if you’re the IRS).

In a hearing on December 1, the IRS will hear comments on the proposed regulations which, essentially, prohibit the discounts described above on intra-family transfers.  Many feel the IRS has overstepped with a net thrown too widely since the proposed regulations would not only apply to passive entities but also to actual operating companies.  Still, conventional wisdom says that the regulations will become final with very few changes and will affect all transactions beginning 30 days after the date the final regulations are published.  The timing creates a window of opportunity during which many taxpayers will avail themselves of this technique for the last time.

A proven and much-used planning tool is being put out to pasture like an aging, reliable thoroughbred. But there’s still time for one last ride.

This information is not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or tax advisor for guidance on your specific situation.  LPL Financial does not provide legal advice or services.