New IRS Regulations Might Raise Taxes on Your Family’s Inheritance

The IRS recently released proposed regulations that would effectively end valuation discounts relied upon by estate planners for over 20 years. The end of these strategies could have dramatic consequences for individuals with taxable estates. If the IRS’s current timetable holds, these regulations may become final as early as January 1, 2017. Although that date isn’t set in stone, we expect that the regulations will be final around that time or shortly thereafter, which gives us a limited amount of time to do some planning under the current, more favorable law.

The new regulations would severely limit the ability to employ valuation discount strategies when transferring assets to family members.  These strategies have been used to transfer assets out of any individual’s estate so as to decrease or eliminate any estate taxes at their death.  Currently only individuals with an estate of $5.45 million have to worry about estate taxes, but Hillary Clinton has proposed lowering this exemption amount to $3.5 million if she is elected. 

Valuation discount strategies are commonly used to transfer interests in a family owned business, often a partnership or LLC, at a discounted rate.  Such transfers are ordinarily subject to estate and gift taxes based on the fair market value of the interest transferred.  For instance, if a 40% interest in a one-million dollar business were transferred to a family member, the transfer would be valued at $400,000 for gift and estate tax purposes.  However, if the recipient of the business interest is restricted in his ability to vote or transfer his interest, it is currently possible to discount that $400,000 transfer to something considerably lower, thus lowering or eliminating any estate or gift tax owed on the transfer. 

The IRS has fought, often unsuccessfully, to eliminate such valuation discounting strategies.  In 1990, Internal Revenue Code §2704 was enacted to curtail discounted transfers between family members.  Notwithstanding, experienced estate planners have been able to employ nuanced strategies that have allowed the use of valuation discounts to continue.  This is all set to end in 2017, however, as the IRS has proposed rules that would effectively close these loopholes. For instance, under Proposed Regulation §25.2704-2(b), putting voting restrictions in an LLC operating agreement would no longer be sufficient to discount the interest transferred to a family member.

There is a rapidly shrinking window during which individuals can transfer value discounted assets under the current rules.  Since these plans often take 2-3 months to fully implement, individuals who have or may have taxable estates should act immediately if they wish to take advantage of valuation discounting in their estate plans. 

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