In August 2016, the Internal Revenue Service (IRS) issued proposed regulations under Code Section 2704 that caused immediate concern that discounts used in the valuation of family-owned businesses could be significantly reduced or even eliminated.
The discounts in question – the lack of marketability and lack of control discounts – are typically used when valuing privately-held businesses. These discounts have generally been an effective way to reduce the overall value of an entity, to help minimize taxes when used in connection with ownership transfers between family members.
These discounts allowed privately held and family-owned companies to account for some of the very real and unique challenges they face that their public company counterparts do not. The lack of marketability discount exists for privately-held companies because it generally takes significant time and cost to transact a private business sale, unlike public companies whose shares can more easily and quickly be sold on an open market. And the lack of control discount exists for family-owned companies because family members do not always vote in accord.
The proposed regulations quickly became a topic of significant debate and have been contested by many professionals in the valuation community, including the National Association of Certified Valuators and Analysts (NACVA). In its response to the proposed regulations, the NACVA stated that “these proposals ignore the economic realities and would, if finalized in their present form, work to artificially inflate values for a specific targeted group of taxpayers and not others (and therefore lead to taxation of citizens without uniformity).”
On Dec. 1, 2016, a public hearing was held on the proposed IRS regulations during which many business owners, estate attorneys, valuation analysts, and CPAs expressed their concerns about and highlighted problems with the proposed regulations. During the hearing, a Treasury Department representative confirmed that it did not intend to include a “deemed put right” provision in the proposed regulations, which would eliminate the use of discounts when valuing transfers of business interests. The representative also stated that the Treasury Department is planning to clarify this when the regulations are finalized.
In the meantime, the IRS needs to sort through and consider the more than 9,000 comments it received. This high volume of comments makes it unlikely any changes will take effect in the near future. The timing may also be impacted by the new Trump administration, which has been hinting about plans to repeal the estate tax altogether.
If the proposed Code Section 2704 regulations ever do become finalized, they could still impact how family business interests are valued for gift and estate tax purposes, although the impact on such valuations is not expected to be as significant as originally feared. Nevertheless, it is wise to stay abreast of the situation. More importantly, it serves as a reminder that it’s never too early to start planning for a family business ownership transfer.
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