Business owners considering transferring part of their interests in their companies to the next generation may want to accelerate their plans to get ahead of newly proposed IRS regulations on estate and gift taxes.
The proposed regulations would result in artificially higher valuations for many minority ownership interests in family-held businesses — resulting in higher estate and gift taxes.
When family business owners transfer minority holdings to their heirs during their lifetimes, proper valuations performed for tax purposes consider the negative impact on value that results from the minority owner’s inability to control decisions impacting business operations. Further, a good valuation will consider the negative impact on value that results from the minority owner’s inability to sell the ownership interest quickly on a public exchange, a problem that is enhanced if the company does not pay regular, if any, dividends. Upon transfer to heirs, the valuation of those holdings is discounted to reflect the economic reality that they are often worth less because minority owners cannot control how the company operates and may have difficulty in selling a minority stake.
The lower valuation is important for purposes of estate and gift taxes, which kick in after a $10.9 million lifetime exclusion for married couples or $5.45 million for single taxpayers.
For example, a business owner with a company valued at $39 million might give each of two children 33 percent of the equity in the business. At first glance, each child’s equity would be worth $13 million. But because of its status as a minority holding, the difficulty of selling it, and a plethora of other factors, the stake might be fairly discounted to a value of $10 million, resulting in lower gift and estate taxes for the business owner.
Under proposed regulations announced recently, if the business owner(s) dies within three years of making the gift, any discount applied to the valuation could be disallowed. That means that in the example above, the estate taxes may increase by recapturing the discounts previously taken for purposes of determining the gift tax payable upon making the gift — in this scenario up to $6 million.
There is still some uncertainty about exactly how these regulations would apply, particularly in cases where the original owners still retain a 50 percent or greater interest in the company. That uncertainty is unlikely to be cleared up before the proposed regulations take effect, which would be 30 days after the final regulations are published. That publication will not take place until a 90-day public comment period occurs and a public hearing is held, now scheduled for December.
That time window offers business owners an opportunity to get their transfers in place under the current regulations. If business owners wish to do that, the first step is to get a valuation of the company from a qualified outside valuation specialist, who can determine an appropriate value for the company and minority interests in the company, which would include appropriate valuation discounts for lack of control and marketability of the interest. A fair and accurate valuation is necessary to hold up to IRS scrutiny, and it is recommended that business owners begin planning now to make transfers to the next generation under the current regulations.
Business owners wishing to explore this path should also consult a qualified tax advisor to guide them through the process.