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IRS Issues Proposed Regulations Restricting The Use Of Valuation Discounts

On Behalf of | Aug 22, 2016 | Estate Planning, Firm News |

For many family owned businesses the creation of a Family Limited Partnership (“FLP”) is a great way to achieve succession planning. When it works well, a founding member of the business can enjoy peace of mind knowing that his hard-earned business can stay within the family, with a long term plan in place to better insure its success.

However, FLPs have also been favored for their potential to provide significant estate tax savings. When used to insure that the business stayed within the family, restrictions can be placed on an individual’s ownership share within the company. Two popular methods of accomplishing this was to restrict an individual’s ability to transfer their shares (by only being able to sell their shares to other family members and/or the FLP itself) or to restrict an individual’s ability to control the business (often by restricting an individual’s ability to liquidate the company). Control and of transferability restrictions can result in an asset receiving a significant valuation discount.

Valuation discounts allow the transferring member, usually the founder and sometimes the founder and his spouse, to leverage gift-giving, by gifting assets with significant valuation discounts. While estate and business planners have viewed these restrictions as legitimate planning techniques, the Internal Revenue Service has always viewed them with deep skepticism. In short, the Service often viewed the intra-family based restrictions, despite the terms of the governing document, as primarily aimed at avoiding estate taxes and not advancing legitimate business objections. Hence, the Service sought to void or rein in such discounts. To that end, in 1990, the service enacted Section 2704 of the Internal Revenue Code, “Treatment of Certain Lapsing Rights and Restrictions”, in an effort to limit the types of discounts FLPs could obtain.

On August 2, 2016, the Service published new regulations that seek to close certain “loopholes” they believe planners have been using to circumvent Section 2704. While these regulations are not due to become final until sometime next year, if they are enacted in their current form they would entail significant changes to how FLPs are planned and structured. One of the biggest proposed changes is the addition of a three-year look back provision. For example, if restrictions on a member’s ability to control or liquate the FLP were granted within three years of the business owner’s death, any potential estate tax discount will be ignore by the IRS. As many wait to do their estate planning until the last minute possible, this means that an individual who waited too long may end up needlessly incurring millions of dollars’ worth of estate tax liability.

Note that the proposed regulations are currently under a ninety day commentary period and a hearing is scheduled for December 1, 2016 to determine their final format. However, while the exact formatting of the rules is unclear, what is clear is that the IRS is coming close to finalizing long awaited revisions of Section 2704. If you are interested in learning how these proposed rules may affect your estate plan and how to best plan for them, please contact an experienced estate planning attorney to get further details.


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