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If you have ever bought a pie, you know buying the whole pie is the only way to decide if it makes it Thanksgiving dinner or if you eat it alone in the dark. Consider this, you buy a pie for $10.00. Then If someone gave you 1/4th of a second, exactly the same pie but told you that the pie can’t be eaten until the other owner says so and they get to store the pie, that second pie’s ¼ interest should be worth less than the $2.50 that simple math would suggest. Not if you work for the government.

The IRS released proposed regulations in August that would enhance code sections regarding valuation of privately-held, minority interests that are controlled by the same family. This means LLCs, corporations and partnerships that many farm and small business operators use. It wasn’t out of the blue that the IRS decided to adjust the code, they lost in court and see a potential loss in revenue, so they are changing the rules.

This will impact  intra-family interest transfers like when an elder generation gifts a portion of the farm via LLC membership interest to the next generation. The prevailing theory is giving Junior 1/8 of the farm isn’t really worth 1/8 of the total value of the operation because Junior probably still takes orders from Ma and Pa and can’t control the company in any meaningful way and the company is not something that Junior could turn around and sell for 1/8th of the total value to a disinterested party. Think about that pie again.

Valuation principles have long been established showing that Junior interests in privately-held businesses like that are worth less than controlling (Ma and Pa) interests or similar interests in publicly-held companies like Target, IBM and the like . It makes sense that certain adjustments are made when valuing Junior interests in family contexts.

The two most common adjustments are discount for lack of control and the discount for lack of marketability. A discount for lack of control discounts the value of a business interest because Junior does not have the ability to manage the operations of the business and also does not have the ability to control the business. The discount for lack of marketability discounts value of a business interest because the interest cannot be sold and converted to cash as quickly as a publicly traded stock. Many take a 10-20% discount for these impairments.

The IRS has had some leeway in calling out sham discounts however, the latest set of amendments look pretty grim.

They include special valuation rules for such as:

Disregarding Restrictions – No discount for a buy sell restriction on who you can sell your interest to.

Elimination of Assignee Interest – No discount for the situations where the stock doesn’t have full rights, like when a spouse ends up with the family stock but doesn’t get voting rights.

Three Year Lookback – Makes transfers made within three years of death not eligible for a discount.

Assumed Put Option –Assumes that the junior holder in a family-owned business can sell back at full price within six months. Family owned business do not grant put provisions as they cause liquidity problems which would cripple the operations of the company, when owners can withdraw and demand cash at any time.

Family-owned businesses will lose lose an estate planning tool for families that a valid business purpose for junior interest, like running a farm and separating off farm heirs from on farm decisions.

This is a big change from the ways accepted by the IRS and tax court in years past. It invites a court challenge, which could create uncertainty for an extended period of time.

The regulations are subject to a 90-day public comment through November 2, 2016. Those interested in posting public comments should look at  at: https://www.federalregister.gov/articles/2016/08/04/2016-18370/estate-gift-and-generation-skipping-transfer-taxes-restrictions-on-liquidation-of-an-interest

If placed into effect gifts made before the actual implementation will not be subject to the new restrictions (unles the IRS forgets about the Consitutional provision on ex post facto laws). If entities are formed now but gifted after the change  they will be subject to the new view. The new rules could be in effect before the end of the year, as early as  Dec 2016.

 

Thursday, April 02, 2020
  • Patrick B. Dillon
  • Jill Dillon
Dillon Law PC
Patrick B. Dillon enjoys finding solutions to legal issues and catching problems for clients. Pat practices in the Sumner office regularly represents clients in district, associate district and magistrate courts for agricultural, real estate, criminal and collection issues. He drafts wills and trusts, creates estate plans and helps clients through the probate process.
Dillon Law PC
Jill Dillon focuses on family law, estate planning and IRS matters. Jill is a University of Northern Iowa undergraduate (Political Science Cum Laude) and a Drake University Law School graduate. Jill spent extensive time advocating for low income tax payers in front of the IRS and the State of Iowa Department of Revenue while at Drake.

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