Treasury Hits Family Businesses!

The verdict is in, and Treasury’s proposed rules on estate tax valuations of family-owned businesses are broad – very broad indeed. They are, simply put, a direct assault on America’s family-owned businesses.

Here’s the take of WealthManagement.Com:

Although the details are significant, the bottom line is that the proposed regulations would appear to eliminate almost all minority (lack of control) discounts for closely held entity interests, including active businesses owned by a family. To accomplish that, restrictions under the governing documents and even those under state law would be disregarded for valuation purposes.

And Steve Leimberg’s Estate Planning Email Newsletter:

In short, it may appear that, outside of the new three year rule, that not much is being proposed with respect to the valuation of minority discounts.  One might, therefore, conclude… that minority discounts remain largely intact with a narrow exception for transfers made within three years of death.  That reading would not, however, be accurate.  As will be discussed, the proposed regulations under Section 2704(b), in particular based upon a new concept referred to as “Disregarded Restrictions,” are a frontal attack on the concept of discounts in the context of family entities.  Given the failure the IRS has sustained in the courts in terms of its argument favoring a family-attribution principle and given its resulting frustration, it must be conceded that the new Disregarded Restrictions approach seems masterfully drafted.  

So so-called “minority interest” discounts are at risk under the proposed rules. What does that mean?  It means that family owned businesses will be valued, and taxed, at significantly higher rates than businesses owned by non-related parties.  How much more depends on the facts and circumstances of each case, but minority discounts of 20, 30, 40 percent and higher are common and have been approved by the courts.

But aren’t these discounts just a loophole? No, not at all.  Minority interest or “lack of control” discounts reflect the underlying economic reality that ownership without control – control to sell, control to make management decisions, control to distribute profits — is worth significantly less than ownership with control.  If you own 30 percent of a company, but have no say in how the business is run or when it is sold, then your share of the company is worth significantly less than 30 percent of the total value of the company.

For examples of minority discounts, look no further than the stock exchanges. Every stock on the New York Stock Exchange is traded with a minority discount imbedded in the price.  That is why investors seeking to buy a controlling interest in a publicly traded company are willing to offer a premium over the traded price.  Unlike retail investors, they expect to have a controlling interest at the end of the day, so they are willing to pay more.

So when Treasury calls this a “loophole”, what they are really upset about is the underlying economic reality of control. One might as well complain that the sky is blue.

This is not a new fight. The IRS has been waging, and losing, the battle over these discounts for decades.  But the newly proposed rule represents a whole new tact on the part of Treasury that needs to be taken seriously by the business community.  This is the first time in the long battle over discounts that Treasury has hung its efforts on an existing, albeit 26-year old, statute.

So does section 2704 give Treasury the authority to eliminate minority interest discounts for family-owned enterprises? Probably not.  But we won’t have the ultimate answer to that question until these rules are fully litigated in the press, the comments to Treasury, the elections, the Congress, and finally the courts.

For next steps, there’s the 90-day comment period ending in early November, a public hearing in early December, and then the bums rush by Treasury to get these regulations out the door before the end of the Obama Administration.

In the meantime, the business community, including your S Corporation Association, will be up in arms once again. This proposed rule combines the two signature trademarks of this Administration – a jaded view of private enterprise coupled with a willingness to push the envelope on legal authority. We expect to ultimately win this battle, but it will take a long time and waste innumerable resources that could otherwise be used to invest and create jobs.  What’s the point in that?

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