New Discounted Entity Regulations Leave Small Window for Tax Planning

By Lorin G. Page, Esq.

In early August, the Internal Revenue Service issued long-awaited proposed regulations in an attempt to limit the use of a key tax planning technique. In light of the proposed regulations, individuals and families with estate tax exposure should consider implementing these strategies before the regulations go into effect and the window for using them closes; those who have already employed these techniques are well advised to review them for compliance with the new regulations.

To date, one of the most effective tax planning tools available to estate planning attorneys has been the creation of Family Limited Partnerships (FLPs), Family Limited Liability Companies (FLLCs) and similar entities to hold a family business, marketable securities, or, indeed, a wide variety of assets.

By dividing up ownership of the controlling family entity into more than one ownership groups, the owners can take advantage of well-established business valuation rules that value partial ownership interests in the entity substantially lower than the liquidation value of the underlying assets. Because arm’s length purchasers view a fractional interest in a family business as an undesirable asset, the value of a business divided into separate interests is often considered to be less than the sum of its parts.

As an example, imagine a small family manufacturing business owned entirely by Dad. In his hands, a purchaser might pay $5,000,000 for the liquidation value of the business at sale. But if Dad owns 80% and his children own only 20%, a normal purchaser would be unlikely to pay Dad $4,000,000 because the remaining 20% own by the children significantly diminishes the value of the company, especially if Dad’s voting rights in those 80% lapse at his death. As a result of giving or selling his children 20%, Dad’s interest may now be valued by third party appraisers at only $2,000,000, rather than $4,000,000. In this example, the value of the assets in Dad’s estate at his death is diminished by $2,000,000, and if Dad has a taxable estate (over $5,450,000 in total), this means that his estate avoids paying taxes on $2,000,000, which at a rate of 40% amounts to a savings of $800,000.

For reasons that are obvious in light of the above example, creating such “discounted entities” has long been one of the primary techniques used by estate planning attorneys to minimize estate and generation skipping transfer tax. Just as understandably, it has been the object of IRS disapproval, and the new regulations are designed to drastically curb or even eliminate its usefulness. The following are some of the key changes made by the proposed regulations:

• Treat a lapse of voting or liquidation rights as an additional transfer of interests in a family entity if made within three years of death.
• Eliminate discounts for limited assignee rights.
• Extend entities covered by the regulations to include LLCs, corporations and partnerships.
• Disregard liquidation restrictions not required by law.

The good news is that these regulations are not expected to go into effect until the end of the year and are not slated to be retroactive, so there is an opportunity for forward looking individuals. Bottom line: individuals who may have estate tax exposure need to consult with their tax professional or estate planning attorney to see if employing these techniques while the window remains open can save their loved ones millions in taxes. Call us today to schedule a consultation.