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OP-ED: Discount Landscape May Change Soon

Daily Journal of Commerce
December 14, 2015


By Jennifer Woodhouse

Discounts can be a powerful tool for transitioning the wealth inherent in a closely held business to the next generation at a reduced transfer tax (estate and gift tax) cost. As a result, discounts are often critical elements of many business transition plans, particularly for family-owned entities.

The IRS commented recently that forthcoming regulations could affect the discounts available to family-owned businesses. To the extent that an existing business transition plan relies on discounts, consult advisers about possible impact. In certain cases, advisers may recommend taking steps to complete transfers that rely on discounts before the regulations are released to increase the chance that current discounts will be available.

In a common family business transition plan, the owner slowly transfers ownership of the business to other interested family members. This is generally preferable to leaving the entire business to children at death because of the way the transfer would be taxed. At death, state and federal estate taxes are imposed on the fair market value of everything owned by the decedent. For tax purposes, the fair market value is the price that would be reached between a willing buyer and a willing seller.

If the decedent owned the entire business, its value is higher than if the decedent owned only a portion. This is because the fair market value of a partial interest may be less than its proportional value due to the application of discounts. Valuation principals (and common sense) indicate that a hypothetical willing buyer would pay more for a controlling interest in a business than a non-controlling interest, which gives rise to a "minority discount." Similarly, the value of a partial interest in a closely held business may be discounted because it can be difficult to sell as there is usually no established market for such interests. This gives rise to a "lack of marketability discount."

Discounts have two primary benefits in the estate planning and business transition context: reducing the value of the interest and freezing the value of the interest for transfer tax purposes.

Consider a family construction business owned entirely by A. If A intends to pass the entire business to family members at death, state and federal estate tax will be imposed on its entire value. Federal estate tax is imposed when a decedent's lifetime giving plus assets at death exceed $5.45 million (for deaths in 2016). This amount is indexed for inflation. Estate tax in Oregon is imposed if the decedent's estate exceeds $1 million. Washington imposes an estate tax if the decedent's estate exceeds $2.054 million (this amount is also indexed for inflation). Neither Oregon nor Washington includes lifetime giving in determining the estate tax imposed and neither state has a gift tax.

Given the current tax landscape, a more tax-efficient approach may be for A to transfer small interests in the business to children involved in the business over time. In addition to the tax benefits, this approach offers the benefit of involving the children in the business before A's death, which provides long-term continuity of operation in the event of A's death or incapacity. If the transfers are made by gift, federal gift tax laws apply. An annual exclusion is available for gifts, and allows an individual to give up to $14,000 (for gifts in 2015 and 2016) each year to any number of recipients without federal tax consequences. Such gifts cannot be included in a decedent's estate and are not taxable.

The value of a gift is determined by considering its fair market value. So if A passed a 2 percent interest in the business to A's two children, that interest would likely be worth less than 2 percent of the entire business' value due to the application of discounts. Combined discounts for a minority interest and lack of marketability in the range of 35 percent are not unusual. Discounts must be determined and substantiated by a professional appraisal.

If the construction business was worth $6 million, a 2 percent interest before discounts would be worth $120,000. If an appraiser determined a 35 percent discount on the interest applied, the value of the gift would be reduced to $78,000. If the gift qualified for the annual gift tax exclusion, only $50,000 of the transfer would be taxable, as A could apply a $14,000 annual exclusion for each of the gifts to A's two children. In this scenario, A has transferred 2 percent of the business (worth $120,000 in A's hands) to A's children, but for tax purposes, the taxable gift is only $50,000 because of the use of discounts and the annual gift exclusion. Furthermore, A has removed 2 percent of the business from A's estate and shifted all future appreciation and income from that portion of the business to A's children.

Discounting is often a feature in a well thought-out business transition plan because it offers such significant tax benefits. The IRS recently announced its intention to issue regulations that could change the availability of discounts from existing practice. Until regulations are issued, it is unclear what changes the regulations might make, though practitioners generally anticipate the changes will limit the availability of discounts in a manner that is unfavorable to taxpayers.

Given the changing discount landscape, owners with an existing transition plan in place should review their plan and consult with their advisers as soon as possible to determine whether the anticipated regulations might affect the plan and whether any part of the plan should be implemented immediately.

Originally published in the Daily Journal of Commerce of Oregon on December 14, 2015.


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