August 2016 Alert Letter
Andrea Schanker | Aug 01 2016 13:45
Alert: Popular Estate Tax and Family Business Planning Technique to Be Curtailed by the IRS
The Internal Revenue Service recently proposed regulations that will adversely affect clients' ability to substantially mitigate Estate Taxes. These proposed regulations seek to curtail the use of "valuation discounts" for family-operated businesses and for Family Limited Partnerships/Limited Liability Companies holding investments. Although the proposed regulations were not expected to be finalized until the end of 2016, time was of the essence to utilize this planning technique before it was potentially foreclosed.
A "valuation discount" occurs when a limited partnership interest in a Family Limited Partnership, or a non-managing member interest in a Limited Liability Company, is gifted. The Family Limited Partnership or LLC can own income-producing property, an investment portfolio, or an actively family-operated business.
For example: Steve and Carol own two apartment buildings in Manhattan. Each building is owned by a Limited Liability Company (LLC). Steve and Carol are the Managing Members with all the control and equity. Because of that equity, their taxable estate far exceeds the Estate Tax thresholds ($5,450,000 per person Federal Exemption and $4,187,500 New York State Exclusion at the time).
Carol and Steve gift their daughters 99% of the non-managing member interests in each LLC. For purposes of their lifetime gift tax exemption, they can enjoy a valuation discount on the value of the gift. If 99% is worth $4,950,000, the actual value of the gift, after applying a 35% discount, is only $3,217,500. Why the discount? The gift is "worth less" because what is being gifted is really a minority interest, and non-managing members have no ability to sell, borrow against, or assign their interests in the LLC.
The effect of this planning is that it freezes the discounted value of the asset at the time of the gift, removing all future appreciation from the taxable estate, while maximizing the use of the lifetime gift tax exemption and the ultimate Estate Tax Exemption at death.
In this example, Carol and Steve go on to actively manage the LLCs and may collect a management fee, with potentially advantageous income tax consequences. There is also an asset protection element, since the daughters' interests are protected against creditors and "predators."
The IRS's proposed regulations would substantially restrict the use of such discounts. We would not know the final rules until they were finalized, but the recommendation at the time was to seriously consider this planning — transfers made prior to the final regulations would not be disregarded. Clients were encouraged to schedule an initial consultation to consider this widely used Estate Planning strategy before it might no longer be available.