It is hard to keep up with all the conversations around potential tax changes. Family business owners contemplating a transition to the next generation should pay careful attention to the potential reissuance of the proposed Treasury Department regulations related to Section 2704 of the Internal Revenue Code and how they might affect the “cost.”

Generally, assets that are gifted or bequeathed are valued at fair market value for tax purposes. Determination of fair market value starts with the pro rata portion of the entire entity’s value. Oftentimes this is adjusted to reflect characteristics of the business and the terms under which an owner holds interest to better reflect the actual price a willing buyer would pay. These factors, referred to as “discounts,” generally reduce the pro rata value.

Discounting is a powerful tool for transferring closely held business interests to the next generation at a reduced estate and gift tax cost. Section 2704 hampers this by disregarding certain restrictions on the ability to liquidate family-controlled entities when determining the fair market value, but business owners have been able to work around Section 2704 to ensure discounts with careful planning.

In 2016, the Treasury Department proposed expanding Section 2704 regulations to reduce or eliminate the use of discounting for family-owned businesses. The proposed regulations were withdrawn due to the 2017 executive order limiting the number of new federal regulations. With a new administration, there is speculation that the Treasury Department may reissue the proposed regulations. 

Using discounts

The reduction or elimination of discounting could dramatically increase the cost of transferring business ownership. Let’s say Jane owns a construction company worth $10 million today, and she has one adult child, Bob. Jane has two options for giving the company to Bob. She could transfer it at her death and the then-current value of the company would be included in her estate. Or she could transfer some or all of the company during her lifetime to take advantage of discounting. 

Two important discounts for the closely held business owner are lack of marketability and lack of control. Lack of marketability reflects the difficulty of finding a market for a minority interest in a family-owned business. While the whole company may be worth $10 million, a fair market value of a 10 percent portion will be discounted below $1 million to reflect this. Few are willing to purchase a 10 percent interest in a family-owned company due to the limited ability to influence how the company is run. The fair market value of a minority interest in a family-owned company takes this into account by also including a discount for lack of control. Together, these discounts can significantly reduce the value.

Now imagine that Jane decides to gift 30 percent of the company to Bob this year and 30 percent next year. When making these gifts, Jane would need to report the value of each interest on a federal gift tax return. In determining the value, the appraiser would likely  apply a lack of control discount and a lack of marketability discount because each transfer to Bob is a minority interest. 

So what is the value of these gifts for gift tax purposes? If the 30 percent interest is worth $3 million and the valuation expert determines that a 35 percent discount is appropriate to reflect the lack of control and lack of marketability, the value of each gift is reduced to $1.95 million, for a total of $3.9 million. (Note that all discounts for estate and gift tax purposes must be determined based on the specific company by a qualified valuation expert.)

After all of one’s estate and gift tax exemption has been used, future transfers (by gift or at death) are subject to tax. Through the power of discounting, Jane has saved $2.1 million of her federal exemption on this transfer. If she is subject to federal estate tax at a rate of 40 percent, the discount just saved $840,000 in federal estate tax. If Jane lives in Oregon, a state with no gift tax, she has removed 60 percent of her company from her estate and saved all the Oregon estate tax (10-16 percent depending on estate size) she would pay on that interest if she held it until death.

Jane also shifted 60 percent of the company’s future growth to Bob and set up her own estate for a discount on her remaining interest since the portion she retains is a minority interest in a closely held company. If the company increases in value to $15 million by Jane’s death, she still owns 40 percent of it, and the appraiser determines 35 percent is the appropriate combined discount, the portion left in her estate is discounted to $3.9 million instead of $6 million. In this example, Jane only had to use $7.8 million of federal estate and gift tax exemption to transfer the company. Without discounting, these same transfers would have used $12 million of her federal exemption. If she transferred the entire company to Bob at her death, it would have used $15 million of her federal exemption and increased her Oregon estate tax significantly.

Concerns for the future

Many speculate that discounts could again be on the chopping block. Unlike most of the other tax changes under discussion, this change would be fairly easy to implement because the regulations are already drafted and could simply be reissued. The normal administrative process requiring notice and comment periods, etc. would apply to the rulemaking, but no legislative action is necessary since these are regulations, not laws. 

As a result, business owners contemplating transferring businesses to their kids would be able to do so in a more tax efficient manner now than would be possible if the discount regulations take effect – even if the current high federal estate and gift exemption ($11.7 million per person) remains in place. There is cause for concern that the federal exemption may drop in the near future. An exemption as low as $3.5 million has been considered, which, if implemented, would subject a much larger number of business owners to the federal estate tax.

The bottom line is that closely held business owners thinking about a transition need to keep a watchful eye on these developments. It would be worth consulting with advisors about whether any potential changes would be impactful and whether plans should be accelerated in order to take advantage of discounts available currently.

This article summarizes aspects of the law, it does not constitute legal advice. For legal advice for your situation, you should contact an attorney.

Column first appeared in the Oregon Daily Journal of Commerce on April 16, 2021.