The federal government proposed sweeping new tax rules earlier this month that would dramatically affect family businesses, investment partnerships and other entities.  These rules, which have been widely reported, would artificially inflate the value of interests in family entities for gift and estate tax purposes, increasing the tax cost of transferring those interests.  The rules could become final and binding as early as the end of 2016, at which time individuals would incur significantly higher tax costs in transferring their family entity interests by gift or at death.  Families should now consider whether to accelerate their plans to transfer family business and investment assets ahead of these rules.

The proposed rules supplement tax law enacted by the U.S. Congress in 1990, which the U.S. Department of the Treasury and the IRS now believe to be outdated.  If they become final, the rules would constitute a sea change in valuation of family-controlled entities.

While the rules are issued by the federal government, states with their own estate taxes generally rely on federal law for determining the value of an estate.  These proposed rules, if made final, are expected to apply for state estate tax purposes as well.

Overview of Current Law and Proposed Rules

When a limited liability company (LLC), partnership, corporation or other entity has more than one owner, the governing documents of the entity typically impose restrictions on an owner's unilateral rights over the entity.  The restrictions often prevent an owner from selling interests to outsiders without first offering the interests to the other owners.  They also customarily prevent any single owner from dissolving the entity and forcing a sale of the entity’s assets without majority or even unanimous support of the other owners.

These restrictions are common to family-owned entities as well as to closely held entities owned by unrelated individuals, and they understandably cause the value of the interests to be less than the value of the owner's proportionate share of the entity's assets.  An appraiser, when called upon to value interests in an entity for gift and estate purposes or for any other purpose, will typically assess the value of the entity’s assets, and, under current law, the appraiser will then analyze the restrictions applicable to the entity and adjust the value to account for these restrictions.

Under the proposed rules, when family-owned entity interests are transferred to other family members, appraisers will generally be prohibited from taking these restrictions into account in valuing the interests for gift and estate tax purposes.  Instead, the value of each family member’s interest in the business will be determined as if the family member could immediately force the termination of the business and the liquidation of its assets.

The rules would apply to almost all family entities created after 1990 and to some entities created before that time that have since been substantially modified.

Impact of Rules on a Family Business

How could this new rule play out?  For example, suppose three siblings—Mary, Edith and Sybil—inherited a business from their parents, and each owns one-third of the shares.  Their parents, who intended the business to remain in the family indefinitely, imposed certain restrictions on the shares.  These restrictions prevent any owner from transferring shares outside the family and require unanimous approval to sell the business.

When Sybil dies, her shares in the business will be valued by an appraiser, and estate tax will be due on the value of her shares to the extent her estate exceeds the estate tax exclusion amount ($5.45 million for federal purposes; many states have lower exclusions).  The appraiser might first evaluate the total value of the business and determine that it could be sold for $9 million, which would yield $3 million for Sybil’s shares.

Under current law, the appraiser would then analyze the restrictions imposed on Sybil’s shares.  Because Sybil’s shares are not marketable—they cannot be sold on the open market as publicly traded shares can—their value would be diminished.  More importantly, the owner of Sybil’s shares could not single-handedly force Mary and Edith to sell the business and could not dictate any other management decisions.  The appraiser might also consider the difficulty a hypothetical buyer of Sybil’s shares would face in co-owing the business with Mary and Edith.  Taking these factors into account, the appraiser would likely reduce the value of Sybil’s shares, perhaps by 30%, from $3 million down to $2.1 million in value.  Assuming Sybil’s estate exceeds the estate tax exclusion amount, estate taxes would be owed on the $2.1 million value (the current federal estate tax rate is 40%; state estate tax rates vary).

Under the proposed rules, appraisers will no longer be able to consider restrictions on the sale of shares or the liquidation of an entity if at least 50% of the entity is owned by members of the same family.  For valuation purposes, families would be presumed to agree to release any restriction and to liquidate any entity, even if they would never actually agree to do so.  In Sybil’s case, this would significantly increase the estate tax burden on her shares and make it more difficult for her family to continue the business.  If the proposed rules are made final, the estate tax value of Sybil’s shares will remain at $3 million for estate tax purposes even though the true economic value of Sybil’s shares is only $2.1 million.

Application of New Rules to Common Transfer Planning Strategy

A common strategy for transferring assets to family members has developed from the recognition under current law of the economic realities of restrictions on family entities.  Under this strategy (about which we have previously written), individuals transfer investment assets, such as commercial real estate, stocks and bonds, for example, into an LLC and then give or sell interests in the LLC to family members or to trusts for family members with the intent that the LLC would serve as a pooled investment vehicle for the family.  Because these LLCs incorporate common restrictions on resale and liquidation of the entity, when the interests are valued at the time of the gift or sale, appraisers generally determine that the interests are worth less than a proportionate value of the assets owned in the LLC.

For many years, the IRS has objected to reductions in the value of family entities, especially investment entities, for gift and estate tax purposes.  It has been successful in doing so in cases where it could show that the primary purpose of an investment entity was to reduce the tax cost of transferring assets to beneficiaries.  Under current law, for transfer and liquidation restrictions to be recognized for tax purposes, the family investment entity must be formed with a primary non-tax purpose, such as unified management of family investment assets.  The IRS also commonly attacks the level of reduction in value to account for these restrictions even when they are recognized, asserting that the value should be much higher than appraisers suggest.  If the proposed rules are finalized, the IRS would instead simply assert that the new rules prevent any reduction in value at all, regardless of the purpose of the entity, whether or not the entity is an operating business or the actual economic effect of the restrictions imposed on the ownership interests.

Status of Proposed Rules and Planning Considerations

These proposed rules are scheduled for a public hearing on December 1, 2016, and they could be made final sometime after that date.  Proposed regulations are often revised before they are made final, sometimes substantially.  Even so, these proposed rules in particular, because of their sweeping nature and the apparent resolve within the government for these rules to be implemented, warrant prompt action in advance of their possible finalization.

Until then, individuals concerned with the impact of the estate and gift tax should complete any planning that would be affected by these proposed rules.

First, individuals who currently hold interests in family business or investment entities might analyze how these rules would increase their gift or estate tax burdens and consider whether to do additional planning to lessen the impact of the rules if they do become final.

Second, individuals who have considered initiating succession planning with family entities may be motivated to do so before the proposed rules disregard the economic realities of that planning and dramatically increase the tax burden.

Finally, even those individuals who currently own family entity interests but do not wish to complete any additional planning may still want to review the restrictions on their interests and consider whether such restrictions should be revised to mitigate the impact of the proposed rules.  As noted above, while the rules would disregard the restrictions for valuation purposes, the restrictions would continue to have an actual negative impact on the value of the underlying interests.

© 2016 Perkins Coie LLP