When an owner of a closely held business makes a gift of his/her interest in the company or when the interest passes to the estate of a deceased owner, a business valuation is required to determine the value of the gift of the value of the business in the estate. A common estate planning practice is for the business owner to gift small interests in the company to his/her children or other heirs. When valuing a minority interest in a company, the value will normally be reduced by discounts for lack of control and lack of marketability. This is because the owner of a minority interest in a closely-held company has limited control of the company and there is no active market for trading interests in such types of businesses. Therefore, a hypothetical willing buyer of a minority interest in a closely-held company would not be willing to pay “full price” for that investment due to his/her inability to control the company and due to the lack of an active market for selling his/her interest in the company. These discounts have the ability to reduce the value of a gift or a decedent’s estate significantly, thus enabling the business owner to reduce estate and gift taxes.
The new regulations that the IRS has proposed aim to limit or eliminate these discounts. The estate planning and business valuation communities have been waiting for the release of these regulations for some time now. We expected the regulations to only cover investment partnerships that were non-operating in nature. However, the proposed regulations went further than anticipated and, if made final, would be applicable for operating companies as well.
Among other provisions, the key components of the proposed regulations are:
- “Control” for a family owned company will be evaluated at the family level instead of at the individual level.
- Regardless of what any shareholder agreements state, interests in family owned companies will be valued for estate and gift tax purposes as if each shareholder had a put right to sell the interest within six months for the net value (newly termed “minimum value”) in payment of cash.
- Transfers of company interests that occur within 3 years of death that result in an owner losing a liquidation right may be included in the value of the decedent’s estate.
These regulations are only proposed regulations at this time. The IRS is holding a public hearing for discussion on the regulations on December 1, 2016. If finalized in their current form, the earliest that they would be effective is December 31, 2016. However, it is possible that the proposed regulations will not be made final in their current form and additional time will be needed to draft the final regulations.
If you are considering gifting any business interests in the coming years, please keep in mind that these regulations could be finalized by the end of the year, and if they are, they could limit the control and marketability discounts that can be taken on those gifts.