Assessing the value of an ownership interest in a family business can be a tricky matter. If a person owns a minority interest in a family business, for example, the value of that interest is not necessarily the same as the pro rata share of the business’ value. This is due to disadvantages inherent in these types of ownership interests, which often make their real-world value less than what might appear on a balance sheet. The Internal Revenue Code (IRC) allows “valuation discounts” for certain types of ownership interests, under certain circumstances, for the purposes of gift and estate taxation. See 26 U.S.C. § 2704. A proposed regulation recently issued by the Internal Revenue Service (IRS), however, would make major changes to the valuation discount system. 81 Fed. Reg. 51413 (Aug. 4, 2016), 81 Fed. Reg. 68378 (Oct. 4, 2016). The agency is currently accepting public comments on the proposed rule change, which could take effect as early as January 1, 2017.
Minority interests in family businesses, particularly family limited partnerships (FLPs) and limited liability companies (LLCs), present multiple drawbacks. Owners of these types of interests are limited in their control and influence over the business, which affects the value of the interest. Additionally, when the rights associated with an ownership interest lapse, this creates valuation problems. In either case, the owner will have difficulty selling or otherwise transferring the interest for an amount equal or close to its value on paper—a 10 percent interest in an FLP with $1 million in assets is not really worth $100,000 because of these drawbacks. This is where valuation discounts come in.
Current rules regarding valuation discounts apply to controlling interests in family businesses—meaning 50 percent ownership or more—when voting or liquidation rights lapse. See 26 C.F.R. § 25.2704-1. The lapse is treated as a transfer of the ownership interest to the owner’s family. If the lapse is the result of the owner’s death, the transfer is subject to estate tax. Otherwise, it is considered a taxable gift. In general, the transfer is deemed to have occurred just before the lapse. The valuation discount uses the value after the lapse, i.e., when the value is diminished, as the value at the time of the transfer. This has the effect of reducing the taxable value and reducing the overall tax burden.