Have a Family-Owned Business? Proposed Treasury Regulations Aim to Eliminate Valuation Discounts for Interests Transferred to Family Members


Families that own businesses (corporations, partnerships, LLCs, and other business entities) and plan to transfer interests in that business to other family members for less than fair market value (via gift or a below-market sale).

Why Should Business Owners be Concerned?

When a family member (the “Transferor”) transfers interests in a family-owned business via gift or below-market sale, the value of the interest transferred (or the difference between the value of the interest transferred and the amounts paid by the receiving family member for the interest), is treated as a taxable gift by the Transferor.  Any gift in excess of $14,000 if the Transferor is single ($28,000 if married), to any one recipient will reduce the amount the Transferor can own at their death free of federal estate tax. 

Currently, when these family business interests are valued, discounts are applied if the interest transferred lacks control over the whole business (a.k.a. a minority interest discount) and/or a lack of marketability discount is applied where there is not an available, established market to buy and sell partial interests in the closely-held family business.  These valuation discounts can reduce the value of assets owned by the business by as much as 65%, drastically reducing the value of gifts to relatives.

On August 4, 2016, the Treasury Department and the IRS released proposed regulations under IRC Section 2704 which, if finalized, will severely limit, if not eliminate valuation discounts for interests transferred in a family controlled entity.

Valuation discounts are due in large part to restrictions on voting, redemption and liquidation. The current Section 2704 does little to limit restrictions placed on voting, redemption and liquidation, but the proposed regulations would cripple the ability of family-owned businesses to place effective restrictions on voting, redemption and liquidation, therefore decreasing allowable discounts on transfers of interests in family-controlled entities, and increasing gift and estate taxes to the Transferor and their families.

When Would the Proposed Regulations Take Effect?

We expect there will be opposition to the regulations during the hearing scheduled for December 1, 2016, but taxpayers should be prepared for the scenario that the proposed regulations are finalized as drafted. The earliest effective date would be the beginning of January, 2017.

What Planning Can I Do? 

If you are planning to transfer interests in your family’s business to other family members, consider making those transfers before the end of 2016. We at JDSA would be happy to work with you to identify the interests affected by these proposed regulations and help you effectively transfer such interests, before the end of the year, ensuring a more favorable gift and estate tax outcome.


Want a More Detailed Explanation of the Proposed Regulations?

Keep Reading. There are five key changes the regulations would make:


Transfers Within 3 Years of Transferor’s Death that Result in a Lapse of Voting or Liquidation Right

Example: An individual owns 80% of the stock in a corporation that requires 70% of the vote to liquidate gives one-half of their shares to their 3 children. Two years later the individual dies.

Current Regulations: Section 2704(a) treats the lapse of a voting or liquidation right in a family-owned entity as a transfer by the individual holding the right before its lapse, but such a transfer is exempt if the rights are not restricted or eliminated. Under the current regulations, the gift would not be subject to transfer taxes because the children still have the right to vote those shares.

Proposed Regulations: The exemption would be denied if the transfer occurred within three (3) years of the transferor’s death if the entity is controlled by the transferor and the transferor’s family before and after the lapse of the right.  Under the example, the transfer would have been treated as if the lapse of the liquidation right occurred at the individual’s death. An additional “phantom asset” would be included in the individual’s estate that would not qualify for the marital or charitable deduction.


Restrictions Imposed or Required by Law

Current Regulations: Restrictions are disregarded only if they are more restrictive than the limitations on transfers that would apply under state law in the absence of a restriction. However, most state laws allow governing documents to override their restrictions on transfer, allowing for more strict restrictions.

Proposed Regulations: Default state law restrictions that can be superseded by governing documents are no longer considered “restrictions.” Therefore, because state law restrictions are minimal and will now be the ceiling for restrictions, few restrictions will reduce the value of an interest in a family-controlled entity. Restrictions in governing documents will be disregarded if they are more restrictive than specific state restrictions.


Restrictions on Redemption or Liquidation

Current Regulations: For the purposes of valuing interests, restrictions on redemption or liquidation are disregarded if after the transfer, the restriction will lapse or can be removed by the transferor or any member or members of the transferor’s family.

Proposed Regulations: A restriction will be disregarded if it limits the ability of the holder of that interest to compel liquidation or redemption of that interest on no more than six months’ notice for cash or property equal at least to what the proposed regulations call “minimum value,” then the restriction is disregarded. “Minimum value” is defined as the pro rata share of the net fair market value of the assets of the entity, reduced by the debts of the entity. In other words, the proposed rule assumes for valuation purposes that each holder of an interest in a family controlled entity has the right to liquidate or redeem the interest for its proportionate share of the entity’s net asset value in cash or other property payable within six months of exercise.

Also, if a family member interest holder wants to redeem an interest, they cannot receive an obligation of the entity, except for a promissory note issued by an entity engaged in an active trade or business that, as the proposed regulations state, “is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.


Nonfamily Member Owners’ Ability to Block the Removal of Covered Restrictions

Current Regulations: Ability of nonfamily members to prevent the removal of a restriction is not a disregarded restriction for valuation purposes.

Proposed Regulations: Interests held by nonfamily members, which give those nonfamily members the power to prevent the removal of a restriction, are disregarded unless those interests have been held for at least 3 years, represent at least 10 percent of the entity (and 20 percent in the aggregate with other nonfamily members), and can be redeemed by the nonfamily holder on no more than six months’ notice.



Proposed Regulations: Eliminate any discount based on a transferee’s status as a mere assignee and not a full owner and participant in the entity.


Caitlyn Evans is an attorney with JDSA Law

[Content provided in this article should be used for informational purposes only and is not intended to be a substitute for professional advice. Always seek the advice of a relevant professional with any questions about any legal decision you are seeking to make.]