What the Proposed IRS Regulations Mean for Your Family
New IRS proposed regulations would effectively end the common practice of discounting the value of interests in so‐called “family limited partnerships” and other family controlled entities, or FLPs. The regulations would apply not only to entities formed to hold passive assets for estate planning purposes but also to family entities with active business operations. Fortunately, taxpayers can benefit from the existing rules by engaging in FLP discounting transactions before the regulations become effective in 2017.
What they’re targeting
FLP transactions that generate valuation discounts are among the most commonly utilized estate reduction techniques. These transactions are not favored by the IRS, which views them as purely tax motivated. But when related cases have gone to court, the IRS has often lost—which is what created the impetus for the new regulations.
Here’s one way these transactions are structured. First, a taxpayer transfers assets to the FLP in exchange for both general and limited partner interests. Then the taxpayer transfers an amount of the limited partner interests to his or her children or grandchildren (or trusts for their benefit), such that the taxpayer does not have a sufficient number of limited partner “votes” to be able to liquidate the partnership by him or herself. Upon the death of the taxpayer, the estate will claim a reduction in the value of the remaining partnership interests from the value of the taxpayer’s actual pro rata share of the underlying assets.
Where does the reduction in value come from? It’s based on fundamental valuation principles that assets are worth less when they are held in an entity which the owner does not control—that’s known as a “minority” or “lack of control” discount—and for which there is no ready market (“lack of marketability” discount). The size of the discount depends on the nature of the underlying assets, with marketable securities generating the smallest discounts and real estate and other illiquid assets generating the larger discounts.
Suppose a taxpayer transferred $50 million of assets to a FLP and then formed an irrevocable trust for the benefit of his or her children and funded it with $5 million. That trust could purchase partnership interests from the taxpayer using the $5 million in cash and a note. Assuming a 20 percent valuation discount, the partnership interests are worth a total of $40 million even though the underlying assets are worth $50 million. The trust could buy half of the partnership interests for the $5 million of cash and a $15 million note paying the lowest interest rate permitted by the IRS. Upon death, and assuming no change in values, the taxpayer would have a total of $40 million in his or her estate ($5 million cash, the $15 million note and the $20 million remaining value of the partnership interests owned), because of the valuation discount, rather than $50 million. $10 million is thus removed from the taxable estate. Assuming that the partnership assets appreciate, one‐half of the post‐transaction increase in value of the partnership assets would also be outside of the estate, because one‐half of the partnership interests are now held by the trust.
In addition, if the taxpayer has not used up his or her unified credit amount—the amount you can give away during your lifetime without having to pay gift tax (currently $5.45 million)—there would be no gift tax on the transfer of the $5 million to the trust.
It’s complicated—this is why you have tax attorneys—but the bottom line is that valuation discounts have been a highly effective way to diminish the tax hit of significant assets in an estate. And now they’re going away.
The new rules, and what you should do
The IRS’ new rules would disregard all transfers or lapses of liquidation rights that occur within three years of the death of the party who gave up the liquidation right. The result: no valuation discount on the estate tax return, because the taxpayer would be able to liquidate the FLP by him or herself. Also, while current law provides that restrictions on liquidation are disregarded in the FLP valuation context, the law contains an exception for restrictions that are no more restrictive than state law. The new regulations would change that result unless the state law rule is mandatory. (Currently, the state law rules are mere defaults that can be modified by the partnership or other entity governing agreement.)
In the past, in addition to relying on the state law exception, taxpayers have given a nominal amount of their partnership interests to a charity. That, in turn, gave the charity the right to veto a liquidation of the partnership. This strategy permitted the taxpayer to argue that he or she was entitled to an estate discount because the family did not control the liquidation of the partnership. The proposed regulations would put an end to this planning unless the partnership interest held by the charity is at least 10 percent and meets certain other requirements.
Taxpayers likely have until the end of the year to engage in these FLP estate discount transactions. But again, the IRS has always frowned upon these transactions and consistently challenges them, so it is important to retain experienced tax planning professionals and appraisers who can accomplish these complicated transactions before year’s end.