Act Soon…Discounted Gifts Will Become Harder…
Individuals and their attorneys are very creative when planning to reduce estate taxes. One technique is to transfer an interest in a family owned family limited partnership (“FPL”), at a discounted value, to a family member while keeping the entity in the family.
For example, Ed owns an interest in a FLP valued at $1,000,000, . His interest is subject to certain restrictions in the FLP agreement. Ed gives a 10% interest in the FLP to his son, Jerry. The value of the transferred FLP interest will not be the total value of the FLP interest times 10% or $100,000 but will be valued at a discount because of restrictions in the agreement or under state law. Further, the interest is subject to discounts because, not only does Jerry own only a minority interest, but, as the FLP is owned by family members, the interest is non marketable. Thus, an appraiser may appraise the interest with a 30% discount for a value of $70,000. Thus, if the 10% interest appreciates substantially, not only did Ed gift the 10% from his estate at a discounted amount, he also removed related appreciation from his estate.
Section 2704 of the Internal Revenue code was enacted in 1990 to curb abuses in this area but it has not been working and there are many cases supporting substantial discounts. Over the past years, officials at the Internal Revenue Service (“IRS”) have stated that the IRS would be reviewing the regulations to eliminate or reduce the ability to make such discounts. Proposed regulations were finally issued on August 2, 2016.
While these regulations are proposed and public hearing is being held on December 1, 2016, it is clear that the IRS has discounts in its sights and future discounted transactions between family members will be severely curtailed. With 50 pages of regulations and comments this blog only discusses a few highlights:
- The definition of control will be expanded and the family attribution rules will be broader so Section 2704 will apply to more transactions to restrict such discounts.
- The types of entities will include, not only corporations and partnerships, but also limited liability companies and any other business entity regardless of how the entity is classified for other federal tax purposes.
- Transfers within 3 years of death will be deemed to be a lapse of rights occurring at the time of the death which will result in inclusion in the transferor’s gross estate. This will avoid the “death bed” gifts to reduce the size of the estate.
- The courts have stated that, if the restrictions imposed on the interests are no less restrictive that those imposed by state law, then the restrictions are valid (and thus can be used to calculate a discount). Many states have changed their statutes to provide restrictions to allow for discounts. Under the proposed regulations, the state default rule will be disregarded unless the state law is mandatory
ADVICE: Advisors need to carefully review these regulations and advise their clients to complete the transfers necessary prior to the enactment of the final regulations. Further analyze whether gifts, even with NO discounts, will still be favorable. Discounts have been referred to as “icing on the cake”. If they are no longer available, then there are many techniques to reduce estate taxes.
WORD OF THE WEEK: Minority interest is an interest held in a company under 50%. While an individual with a minority interest has certain rights as defined in the statutes or in the business agreement, a minority shareholder does not have control and is subject to the decisions of the control ownership. If the minority is the swing vote, then the minority interest could have a lot of implicit control.
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