Potential Changes to Family Entity Valuation Rules and Implications for Your Estate Planning

Background

On August 2, 2016, the Internal Revenue Service proposed changes that will potentially substantially limit applicability of discounting rules for valuation of family-owned entities, reducing the transfer tax savings available from commonly used estate-planning techniques. If implemented, the rule changes could dramatically increase the value of assets remaining inside your estate and exposed to the 40% federal wealth transfer tax. The changes could be effective as soon as December 31, 2016, so prompt action may be necessary.

If you and your family own a business, are in a family-limited partnership, or otherwise own assets through a family-controlled legal entity, you should act quickly to become familiar with the current rules, how they may apply to your estate planning, and the implications of the proposed changes. If you decide to make changes in your estate plan under current discounting rules, you will need to work with your advisors to do so well before December 31, 2016, to ensure you do not lose the benefits should the changes become effective.

General Estate Planning Assumptions

Typically, individuals and couples want to minimize their transfer taxes (gift, generation-skipping, and estate) through careful estate planning. In doing so, you will want to use your lifetime exemption judiciously with the goal of maximizing the potential wealth transfer tax savings. Achieving that goal often entails transferring assets with significant potential to appreciate in value into an irrevocable trust outside of your estate for estate tax purposes. The lifetime exemption is the total amount you can transfer during your life and in your estate free of transfer tax, currently $5.45 million for an individual and $10.9 million for a married couple. Importantly, you will likely want to transfer appreciating assets out of your estate as soon as possible so those assets grow in value outside of your estate.

Valuation discounts for family-owned entities (Internal Revenue Code Section 2704)

The proposed rule changes are relevant to you if your assets include a family business or other family-controlled entity with good long-term growth prospects; and, you intend to own your family entity for the long-term. For purposes of this rule, family ownership includes parents, siblings, children and grandchildren, and the spouses of parents, siblings, children, and grandchildren. Family ownership does not include cousins or other family members outside of the direct family line.

Under current rules, the fair market value (“FMV”) of a minority interest in a family-owned entity with restrictive transfer rights reflects valuation discounts, which often can be in the range of 30% to 40%.

The proposed rule change will substantially limit applicability of valuation discounts for intra-family transfers of interests in family-owned entities. Limiting or eliminating discounting will reduce the share of the family entity (and, as described below, the share of future appreciation of an interest in the entity) that can be transferred free of transfer tax – increasing the owner’s potential estate tax liability.

A public hearing concerning the rule changes is scheduled for December 1, 2016. Final regulations could be effective as early as 30 days after the hearing. We believe the probability of these changes being implemented is greater than 50%. To ensure that a transfer of an interest in a family-owned business qualifies for the current valuation methodology (which reflects applicable discounts), the transfer should be complete well before December 31, 2016. This may entail implementation of new trusts and changes to legal entity documents. You will also need an independent valuation of the business interest, but it is not necessary to be completed prior to transfer.

Examples

The following examples illustrate how current discounting rules apply in estate planning using common techniques.

In the following examples, we assume you own a 25% interest in a family business (a cash-flowing operation) with enterprise value (“EV”) of $400 million. An independent valuation would potentially reflect a 30% discount on your interest due to your minority position and the lack of marketability of your interest. As a result, we assume the FMV of your interest is $70 million.

Example #1 – Transfer Using Discounting

In our first example, you execute a transfer from your revocable trust (inside your estate) to your irrevocable trust (outside your estate) of a portion of your interest in the family entity equivalent to your lifetime exemption of $5.45 million.

potential-changes-example-1

* Subject to estate tax
** Proportionate share of the enterprise value when disregarding applicable discounts

The transfer of your $5.45 million interest effectively transfers $7.79 million of the EV (i.e., 7.8%, the proportionate share of the EV disregarding applicable discounts), shifting the future appreciation of that interest outside your estate. Thus, your beneficiaries will receive the future gains on the 7.8% share free of transfer tax.

Example #2 – Transfer Using Discounting and Leverage

In our second example, you use leverage in your trust to increase the proportion of the family entity transferred, while still staying within the limit of your lifetime exemption. You decide to transfer 50% of your interest to your irrevocable trust. You use a promissory note between your revocable trust and your irrevocable trust to increase the proportionate share of the family business, compared to the previous example, shifting a much greater portion of the appreciation free of transfer tax.

potential-changes-example-2

As a result, the FMV of your transferred interest is $35 million, while the net value of the transfer remains $5.45 million. The application of the discount to your interest effectively transfers $50 million of the EV of your interest (i.e., the proportionate share of the EV disregarding applicable discounts). This will shift future appreciation of your business interest into the irrevocable trust (and outside of your estate) to the extent the appreciation exceeds the interest rate of the note, which can be as low as the IRS applicable federal rate (“AFR”) (in September, the mid-term rate is 1.22%).

Example #3 – Maximize Transferred Value and Minimize Use of Lifetime Exemption

In our third example, you decide to transfer 90% of your interest to your irrevocable trust, $63 million of the FMV of your interest, and you want to minimize, to the extent possible, the amount of lifetime exemption you use. You determine your business has sufficient cash flow to support a 20-to-1 leverage ratio, so your promissory note is $60 million. [Note: a more commonly used leverage ratio is 9:1, which may be more appropriate under a number of circumstances.]

potential-changes-example-3-copy

As a result, your net transfer is $3 million, leaving $2.45 million of your lifetime exemption remaining to be used for other transfers. In addition, this effectively transfers $90 million of the EV (i.e., the proportionate share of the EV disregarding applicable discounts). As in the previous example, this will shift future appreciation of the business interest into the irrevocable trust (and outside of your estate) to the extent the appreciation exceeds the interest rate of the note.

Conclusion

The proper valuation of interests in privately owned entities is an important facet of estate planning. In our examples, we illustrate only one of numerous common techniques for transferring assets outside of an estate.

If the IRS proposed rule changes are implemented, the value of your interests in family-owned businesses effectively will increase, because the value of those interests will reflect little or no discounts when you transfer those interests to family members. The value of business interests transferred out of your estate, and therefore the future appreciation transferred free of transfer tax, would be significantly smaller and your transfer taxes significantly higher.

Advantages of New Hampshire Trust Law

For implementing estate plans like those described above, New Hampshire trust law offers a menu of options not available in other states. The options include the ability to:

  • Establish a directed or divided trust;
  • Use self-settled spendthrift trusts;
  • Use an exception to the duty to diversify; and,
  • Waive the duty to inform.

How Perspecta Trust Can Help

Perspecta helps clients set up new trusts in and move existing trusts to New Hampshire for a myriad of reasons. Contact us to see how we can help structure a trust that takes advantage of New Hampshire’s most favorable trust laws.

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