In The Field: IRS Faces Stiff Opposition to Proposed Valuation Rules for Family-Owned Entities
Proposed regulations issued by the Internal Revenue Service (“IRS”) artificially increase the value of ownership interests in family-owned businesses when valued for estate and gift tax purposes. These regulations are the death knell of the time-honored rule that assets in the estate of a decedent are valued based on the amount a reasonable third party would pay for the assets. The current valuation standard applies the common-sense understanding that a person would not pay as much for an interest in a business that the buyer cannot control and cannot easily sell. The proposed regulations generally do away with this pragmatic and realistic approach. Instead, they generally value the deceased’s interest in the family-owned business as equal to the value of the entire business multiplied by the deceased’s percentage ownership in the business. The estate pays taxes on this higher valuation of the ownership interest at rates of 40% to 56%, after including state estate taxes.
Opposition to these rules is fierce. In a November 3, 2016, letter to the Treasury Secretary, the House Ways and Means Committee stated that the proposed rules “represent a dramatic change from past practice and history and are not consistent with congressional intent.” That letter was sent after the IRS received almost 10,000 comments from taxpayers and association groups, including the U.S. Chamber of Commerce, the American Farm Bureau Federation, the National Association of Manufacturers, the American Bar Association, the American College of Trust and Estate Counsel, the Family Business Coalition, the American Institute of CPAs, and many others concerned that the new rules would be unfair to family-owned businesses and cause family-owned businesses to fail. Current studies show that only 30% of family-owned businesses survive into the second generation and only 10% survive to the third generation. The proposed rule is expected to worsen these survival rates.
No one knows for certain when, or if, the regulations will become final. Final regulations do not take effect until 30 days after publication in the Federal Register and there is no set timeline for publication of the finalized rules. The earliest possible (but not practical) date for the regulations to take effect is January 3, 2017. This assumes that the IRS publishes the final regulations, with no changes, the day after the IRS hearing scheduled for December 2, 2016. Based on their track record, it is more likely that final regulations will not be published for a few months and maybe even years. By way of comparison, on another noncontroversial estate tax matter, we have waited for more than six months for publication of the final regulations. The preamble of the final rules must include a response to significant and relevant issues raised by public comments, include the basis and purpose of the new rules, and show good reasons for the new policy.
Given the results of the election, it seems unlikely that the IRS will finalize the current version of the proposed regulations. However, the IRS remains likely to issue final rules that will impair the use of valuation discounts, especially given the IRS’s decades-long attack and the momentum gained by issuing the currently proposed regulations. Though implementation of these or revised rules will likely be delayed by months or years, once the IRS publishes final regulations there may be little time to address the effects of these rules on your estate plan. Plans that rely on valuation discounts often use multiple tax years to obtain the best result. If your current estate plan relies on valuation discounts, we recommend you discuss the potential impact of these regulations with your estate planning advisors soon. If you own a family business and do not have an estate plan, we recommend that you meet with an advisor to develop a plan.