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12-07-2016 Proposed Regulations Take Aim at Valuation of Family Entities

Traditionally, family entities have been a popular estate planning tool. The arrangement-creating an entity, funding it, and then transferring ownership interests in the entity to family members-offers a number of benefits for individuals wanting to transfer wealth to the next generation. It can be very helpful for assets that might otherwise be difficult to own jointly, such as real estate. It also allows donors to make periodic transfers over time (taking advantage of annual federal gift tax exemptions), while still retaining overall control of the asset.

One of the other historic benefits of the family entity was the reduction in value created by the arrangement: an interest in the entity generally has a lower value than that of outright ownership of the assets held by the entity. From a transfer tax perspective, this reduction creates a great opportunity for donors to transfer wealth to the next generation. Through the transfer of interests in the family entity, an individual could still effectively transfer ownership of an asset, but that transfer would cost less for federal gift or estate tax purposes than if he or she had transferred the asset itself.The Internal Revenue Service has proposed regulations, though, that could greatly reduce the benefits of the family entity. The regulations were first proposed in August, with a period for public comment that ran through November. Following that comment period, a public hearing was held last week (on December 1st) to allow interested parties further opportunity to offer their suggestions and voice concerns regarding the regulations, before the Internal Revenue Service finalizes them.

The regulations address a number of issues regarding family entities and gifting, but those that seem to have some of the broadest potential impact relate to the valuation of interests in family entities. Ownership interests in family entities often come with restrictions (e.g., the requirement to obtain majority approval before transferring the interest). It is these restrictions that often serve as the basis for asserting that the ownership interest has a value lower than that of the underlying assets owned through that interest. So, an individual might assert that, for federal gift and estate tax purposes, her transfer of a 25% ownership interest in a family entity that owns $1 million in real estate is actually only worth $200,000 because the entity prevents owners from liquidating their interests without approval of a majority of all the owners. The argument is that such an ownership interest (with its associated restrictions) is not as valuable as directly owning 25% of $1 million in real estate.

If the proposed regulations are adopted, however, the Internal Revenue Service will begin ignoring a number of restrictions that previously served as the basis for asserting a reduction in value for family entity ownership interests. The list of disregarded restrictions would include, among others, (1) limits on an owner's ability to liquidate; (2) restrictions providing less than a "minimum value" (defined in the regulations) for the liquidation price of an interest; (3) provisions postponing payment of the liquidation price beyond six months; and (4) provisions requiring that the liquidation price be paid other than in cash or certain property. Also included in the list of disregarded restrictions are those liquidation restrictions imposed by federal or state law as default rules. If the owners of the family entity could opt out of following those default rules, then they will not be recognized for valuation purposes by the Internal Revenue Service.


Also significant from the proposed regulations is that operating businesses are not treated differently. Often, family entities are created simply to facilitate joint ownership and transfer of substantial assets, but there are many instances in which the family entity owns an active business. For such entities, there can be additional compelling business purposes for imposing restrictions on ownership interests in the entity. Regardless, the proposed regulations do not treat active family entities any differently. Their restrictions are disregarded the same way as passive family entities.

Another important topic addressed by the proposed regulations is the altered treatment of certain lapsed liquidation or other voting rights. Under the previous regulations, an individual with liquidation or other voting rights in a family entity had until death to transfer a portion of her ownership interest or otherwise let those rights lapse, in order to avoid inclusion in her estate. So, if a family entity required a 75% vote to force liquidation of the entity, an owner could transfer half of her 80% ownership interest to her family members on her death bed, and she would not have to include the value of the liquidation right in her estate (assuming other conditions were met).

The proposed regulations would eliminate this practice, by creating a three-year look-back period for these kinds of transfers. In the above example, the proposed regulations would require the owner to live three years after her transfer to her family members in order for the transfer to be recognized. If not, she would be treated as owning as of the date of her death the right to liquidate the family entity, and the value of that right would be included in her estate.

The proposed regulations could come into effect as soon as the end of this year, but that seems unlikely given the high number of critical responses provided during the public comment and hearing phases. That being said, these regulations present a number of significant changes for family entities. Family entities will remain a valuable estate planning tool for many clients, but the planning considerations could change significantly after the proposed regulations are implemented. Those already owning an interest in a family entity, as well as those considering creating a family entity, should contact an attorney right away to discuss their options and consider the potential impact of these proposed regulations.

Contact Fraser Stryker's Estate Planning & Probate Group

Fraser Stryker's Estate Planning & Probate attorneys are leaders in providing assistance with estate and trust administration. For information about the proposed new regulations, estate planning, or administration, please contact Daniel Guinan, Robert Freeman, Mark Brasee, or Adam Grieser.

This article is provided by Fraser Stryker for general informational purposes and is not intended to be, and should not be construed as, legal advice on any specific facts or circumstances.

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.