In early August, the IRS released draft regulations that, when effective, will impose major restrictions on valuation discounts of family-controlled entities. This represents a major change in our tax system, and the clock is ticking before the new rules become final.
MINORITY DISCOUNT THEORY
An example can best illustrate the old vs. new rules. Assume that Dad and Mom place $10 million of farmland in a family partnership and give a 1% partnership interest to each of their four children, with Dad and Mom each retaining 48% ownership. When either Dad or Mom's estate occurs, that person's 48% ownership is technically a minority, unable to control a liquidation or sale of the interest. That ownership receives a significant discount, often in the 30% to 40% range, due to minority and lack of marketability status. But under the proposed regulations, if the entity is controlled by family members, the 48% interest must be valued at its pro-rata share of the net fair market value of the assets of the entity; no discounting is permitted.
WHEN WILL IT BE EFFECTIVE?
The regulations are in draft form, with a hearing scheduled in Washington on Dec. 1. The rule regarding minority discounts is only effective 30 days after the regulations are published as final. Realistically, final regulations are not expected until early 2017. Prior to that date, it's still possible to make gifts of minority interests in a family-controlled entity and claim discounting (estate transfers are also available in this window, but our clients rarely volunteer to die early to save taxes). In the prior example, Mom and Dad could give an additional 10% interest in the entity to each child and claim a discounted valuation. However, recognize that each child, now an 11% owner, would be entitled to 11% of the annual net income and cash distributions. The obvious point is that while gifts reduce Mom and Dad's taxable estate, they also diminish retirement income.
For those with taxable estates (i.e., a federal net worth exceeding $5.45 million per spouse), gifts are still advantageous. Transferring an asset out of the estate during lifetime is valued at the date of the transfer, which may be many years in advance of the estate. Thus, future appreciation is removed from the estate tax.
For those with a net worth below the estate tax exemption, the regulations are potentially beneficial. If Dad dies with a 40% interest in the family land-holding partnership, we no longer are required to discount the value in his estate. This means that the heirs receive a higher tax basis for future capital gain purposes.
And finally, recognize that these family land-holding entities are still important for meeting Mom and Dad's objectives of holding the land together when it passes to the next generation. Even though there may not be a taxable estate at the senior generation, these entities are beneficial from the business aspect of assuring that children don't dispose of the land nor lease it outside of the family.
Editor's note: For up-to-date farm estate tax and transfer strategies, especially in light of the IRS regulations, attend DTN University's four-hour workshop Dec. 4 in Chicago with CliftonLarsonAllen CPAs. For details see http://www.cvent.com/…
Andy Biebl is a CPA and tax principal with the firm of CliftonLarsonAllen LLP in Minneapolis with more than 40 years' experience in ag taxation, including 30 years as a trainer for the American Institute of CPAs and other technical seminars. He writes a monthly column for our sister magazine, The Progressive Farmer. To pose questions for future tax columns, e-mail AskAndy@dtn.com.
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