The IRS has proposed sweeping changes to the valuations of interests in family-controlled businesses for estate, gift and generation-skipping transfer tax purposes. If these changes go into effect in 2017, as planned, they will significantly impact the estate and business succession planning of family businesses.

Anyone considering transferring his or her business interest to a family member may want to act soon to take advantage of valuation discounts currently available for intra-family transfers.

The reasoning behind these valuation discounts is fairly straightforward.

If you own a minority interest in a small, privately-owned company with no liquidation rights (explained below), the value of your ownership interest reflects what a willing, arm’s length buyer would pay for it.

For example, let’s assume the fair market value of a business is $12 million – that is, a willing buyer in an arm’s length transaction would pay $12 million for the entire business. Let’s also assume that mom and dad who own the business have decided to transfer to each of their four children a 12 percent interest in the business, which translates to about $1.4 million in fair market value.

Let’s further assume that each child’s interest is subject to liquidation or redemption restrictions – meaning, the child is restricted from requiring the other family members in the business to redeem or buy out his or her interest.

If one of those children decided to sell his or her minority, restricted interest in the company, would a third-party buyer pay $1.4 million for it?

As a minority owner with limited redemption or liquidation rights, that buyer would have no control over the management and operation of the business, and would be limited in his or her ability to leave the company in the future by forcing the other owners to buy out or redeem his or her ownership interest.

As a result, the buyer would find it difficult to sell his interest to a third-party buyer. So the marketplace value of that interest would be well below $1.4 million – perhaps only $1 million, or even less.

This difference, reflecting the restriction on liquidity, lack of control and limited marketability of the interest, is commonly referred to as a “valuation discount.”

Why is this important? The valuation discount can help keep all or part of the value of the taxpayer’s estate under the unified exemption for gift and estate taxes, and the exemption for generation-skipping transfer tax.

Currently, the unified exemption for gift and estate taxes is $5.45 million for individuals, and $10.9 million for married couples who file jointly.

An additional generation-skipping transfer tax exemption of $5.45 million is also available for individuals transferring their interest to unrelated persons who are more than 37.5 years younger or to related persons who are more than one generation younger (e.g., grandchildren).

Under the proposed changes to Internal Revenue Code Section 2704, lapses of liquidation and voting rights for transfers of interest in a family-controlled business within three years of the transferor’s death would be subject to transfer tax.

More significantly, the Treasury Department’s proposed changes would disregard, for purposes of valuation discounts, restrictions on redemption or liquidation of ownership interests in a family-controlled entity when these interests are transferred between family members and when the restriction on these interests will lapse after the transfer, or may be removed by a family member.

The definition of “family members” includes the transferor’s spouse, ancestors or lineal descendants and their spouses, siblings and their spouses.

Furthermore, a family-controlled entity under the proposed changes would broadly include corporations, partnerships, limited liability companies and other business arrangements.   

The proposed changes to Section 2704, if finalized after their scheduled public hearing on December 1, 2016, would substantially eliminate the valuation discounts that are widely used to minimize the tax consequences of intra-family transfers within family-owned businesses.

This means a taxpayer who intends to transfer to a family member a minority interest in their family business can take advantage of the valuation discount by acting now. Waiting until after the New Year is likely to cause more of your estate to go to Uncle Sam, and less to your loved ones.

Jacqueline D. Yu