What’s the news?
The IRS has issued proposed regulations that can have significant effects on the valuation of closely-held business interests for gift and estate tax purposes.
Before gifting an ownership interest in a business, you need to know how much that ownership interest is worth (this is important for tracking things like the gift tax annual exemption and life-time exclusion). To do so, you would hire a professional to value both the business as a whole and the specific ownership interest in the business that is being gifted. While it might seem strange that the whole business and a 10% ownership interest in the business would be valued separately (as opposed to just multiplying the total value by 10%), that very difference is where this IRS announcement becomes an important factor.
The difference between 10% of the value of the whole business and the value of 10% of the business comes down to discounts. Here are a few reasons that a 10% ownership interest in a business might be subject to a valuation discount that would make it worth less than 10% of the whole business:
- The 10% ownership interest might not have any voting rights in the business
- The 10% ownership interest might be subject to a limitation, such as being unable to sell or liquidate the ownership interest for a set period of time
- The 10% ownership constitutes a minority of the ownership of the company, preventing the owner from exercising some rights that a majority owner has
For example, if ABC Co is valued at $100 and the owner of ABC Co, John Smith, is planning to gift his daughter, Jane, a 10% ownership interest in ABC Co, it might be valued as follows:
|Value of ABC Co||$100|
|Multiplied by Ownership %||x 10%|
|Undiscounted Value of Gifted Ownership Interest||$10.00|
|15% Marketability Discount (because it can’t be sold)||($1.50)|
|15% Non-voting Discount (because Jane has no votes)||($1.50)|
|Discounted Value of Gifted Ownership Interest||$7.00|
What do the new IRS rules change?
In short, they take away some of these discounts in certain situations, specifically with relation to liquidation restrictions for closely-held businesses.
How does this affect John & Jane?
Without the discount, the value of John’s gift to Jane increases from $7 to $10, despite the fact that he’s gifting the exact same thing, a 10% ownership interest in ABC Co.
If John is a savvy taxpayer, he knows that he can only give Jane gifts up to the annual exclusion amount each year ($14,000 in 2016) before he is forced to begin using up his lifetime exemption (or paying gift tax). Therefore, if he wants to gift Jane part of his ownership interest in ABC Co, he wants to do it at a lower value in order to avoid going over his annual exemption, using up his lifetime exclusion or paying gift tax.
Why did this change?
The IRS thinks that some of these discounts were being abused by taxpayers to artificially lower the value of their gifts. For example, what if, at the time of the gift, Jane is 5 years old. Does it really matter that she doesn’t have voting rights? If not, is the 10% ownership interest really worth any less? Should it really be discounted? Or, what if the liquidation/sale restrictions that were in place at the time of the gift can be removed after the gift was made? Should the gift really be subject to a liquidation discount?
What does this mean for me?
It means that now might be the time to gift assets (especially assets you expect to appreciate down the road) that can take advantage of these discounts to your beneficiaries before the rules change in 2017, even if it means adjusting your gifting strategy, exceeding your annual exemption or using up some of your lifetime exclusion.