Business owners can generally take advantage of discounting as part of their estate and family business succession planning strategy to transfer larger amounts to family members during their lifetime and avoid greater taxes on their assets at death. However, experts are eyeing a potential reissuance of Treasury Regulations related to discounting that could make it more expensive to transfer business ownership interests. With these potential changes on the horizon, now is the time for business owners to review their business succession plans and take action if necessary.
For tax purposes, gifted or inherited assets are valued at their fair market value. The fair market value of a business is generally determined by the pro rata portion of the overall entity’s value reduced by certain factors to reflect the actual price a buyer would be willing to pay for an interest in a family-controlled company. For example, it is commonly accepted that minority interests in family-controlled companies are less valuable than controlling interests or shares in a publicly traded company because of the lack of control and lack of marketability. These factors are called “discounts” for tax purposes and serve to reduce the fair market value of the business.
To illustrate how discounting impacts the cost of transferring business ownership, consider a minority owner of a family business who wants to transfer their interest worth $1 million to their children. Without a discount, the gift is valued at $1 million, and taxes would be assessed based on that value. With discounting, however, the value of the interest is reduced by a certain percentage because of the lack of control and lack of marketability. For example, a 30% discount to the fair market value means the value of the interest is now only $700,000. The amount subject to tax liability is reduced by $300,000, as is the value of the business owner’s lifetime gift tax exemption which reduces the amount of their estate subject to tax at death.
Section 2704 of the Internal Revenue Code makes it harder to transfer business interests at reduced estate and gift tax costs by means of discounts because it disregards certain restrictions on the ability to liquidate family-controlled companies when determining fair market value. In 2016, the Treasury Department proposed regulations expanding Section 2704 to reduce or eliminate discounting for family-controlled businesses, but the regulations were withdrawn in 2017.
There is now concern is that the proposed Treasury Regulations may be reissued. As a result, it may become much more expensive to transfer business ownership to the next generation. Business owners contemplating such transfers may want to take action now to implement these plans while it is still possible to use discounting to transfer ownership in a tax efficient manner. Your attorney and financial advisor can help you review your situation to determine how these changes may impact your plans and how to take advantage of discounting while it is still available.