Last Fall, my newsletter focused on Family Limited Partnerships (FLP) and how they can be used to reduce both estate taxes for your family and your income taxes during your lifetime. A description of FLP’s and how they work can be found at:
http://www.legacyfamilyofficellc.com/legacy-blog/2016/9/1/fall-2015-newsletter.
This quarter’s newsletter discusses the need for families that have an active family business to do their estate planning NOW. Later, in this case, may be too late. The reason: final changes to the IRS regulations governing FLP’s that are likely to become effective on January 1, 2017.
Here is the background: In the August 4, 2016 issue of the Federal Register, the Department of the Treasury proposed and then made final amendments to Section 2704 of the Internal Revenue Code. The department is eliminating a taxpayer’s ability to apply valuation discounts, also described as “minority interest” discounts, to all intra-family transfers of interests in certain entities (such as corporations, FLP’s, other partnerships, or Limited Liability Companies (LLC)).
“These proposed regulations affect certain transfers of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests,” the Treasury stated.
In short, the IRS believes that the tax advantages of an FLP and other transfers of business entity interests to family members and the ability to transfer minority interests at a discount to current market value should be ELIMINATED.
A “minority discount” is an interest in a business entity that represents less than the majority interest necessary under state law to exercise control over the business. Most of the time, this means that a gift or bequest to one child or family member (“family member” hereinafter) of an interest that represents less that 51% of the operating entity is a “minority interest.”
Under current law, a parent can create an FLP, transfer all or most of the ownership of his or her family company to the FLP. The parent can then begin gifting limited partnership interests to family members. These gifts of limited partnership interests do not transfer enough of an interest in the business for the receiving family member to exercise control over the business, nor would a third party pay full market value for the interest, if instead of gifting the interest, the FLP were to market the interest on the open market.
Say for instance, that a business owner decides to sell the business and the business has a market value of $5,000,000. After discussions with the family, he decides instead to create an FLP. The FLP is made of 1000 shares, or as they are named in FLP’s, “units”. If the company is worth $5,000,000 on the open market, each unit would have a market value of $5000. Instead of selling the FLP the owner starts to gift units annually to his children. The first gift is of 50 units having a market value of $250,000 and representing 5% of the FLP. The units are not worth full market value however, because a third party would not pay full value for a minority interest in a company and the 50 units do not give the third party buyer control of the business. Under current regulations the FLP is permitted to take a minority discount when valuing the gift for estate and gift tax purposes. In some cases, a discount of up to 40% can be applied to the valuation of the gift, thus the gift instead of being valued at $250,000 is valued at $150,000. The discount rules currently apply both to lifetime and testamentary gifts of minority interests in an FLP.
Under the final regulations, parents cannot transfer their company interests to children with a “minority interest” discount valuation for purposes of making either a lifetime or a testamentary gift to family members. By eliminating the minority discount, the IRS is eliminating a core component of the FLP vehicle, which has been a tax-favored entity, intended to encourage families who have valid non-tax reasons to keep the business in the family.
Since at least 1990, when the original FLP regulations were adopted the IRS has recognized the “minority discount” to encourage families to continue to run the business with the knowledge that when the business owner passed away, the business would stay “in the family.” Further, once the business owner has the gifted the limited partnership interest to another family member, the proportionate share of the income earned by the family business is distributed to the family member who presumably is paying income tax in a lower income tax bracket.
As often happens with favorable estate planning vehicles, some abuse of the strategy occur, leading the IRS to characterize the regulation as a “loophole” that should be eliminated. Since the adoption of the, FLP regulations some taxpayers, their attorneys and planners have utilized the discount provisions to transfer FLP interest at a discount when no discount could reasonably be defended.
In some cases, an FLP was established in a “deathbed” situation, where the family asset owner created the FLP, assets were transferred to the FLP, and “minority interests” were distributed to family members at a discounted value. Within a matter of a few hours, in one case and in others a few days or months, the family asset owner passed away. The beneficiaries of the estate then attempted to apply the “minority discount” to the value of the assets received when valuing the FLP for estate and gift tax purposes. The IRS has rightly believed that these cases have been an abuse of the current provisions, because an FLP cannot take a minority discount if the FLP serves no legitimate business purpose and is solely being used as a tax avoidance mechanism. The agency has argued these points successfully in federal court in a number of these deathbed cases.
In other cases, taxpayers have used the FLP vehicle to transfer marketable securities to an FLP and then transfer a minority interest in the FLP to family members, taking a minority discount in the process. IRS argued that marketable securities were not entitled to a discounted value because the FLP has no legitimate business purpose, and the securities could have easily been sold at market value on a public exchange. Again, the federal courts have supported the IRS position in most cases.
Since the IRS has not always been successful in these cases and has been unsuccessful in getting congress to change the underlying law on which the regulations are based, the IRS proposed and adopted the new rules eliminating the minority discount provisions.
The IRS is scheduled to hold a public hearing on the proposed regulation on December 1, 2016. However, under the regulation adoption process federal agencies are permitted to use, the IRS has made the regulations “final” and they have no obligation to change the regulations before implementation. President Obama has indicated he will permit the IRS to move forward with the change before he leaves office on January 20, 2017.
As a result, as of January 1, 2017, parts of the regulations will go into effect including a new “3 year rule.”
Under the new regulations, a business owner who forms an FLP and transfers assets to the FLP PRIOR to January 1, 2017 may still use the minority discount valuation for the transfers thereafter. However, if the business owner does not survive for 3 years after the creation of the FLP, the discount will be disallowed on the deceased owners estate tax return. Thus for any business owner who creates an FLP now and does not survive until after January 1, 2020 the discount is ineffective. Providing the FLP meets all the other tests of the regulations such as a business purpose, an FLP created before January 1, 2017 by a business owner will continue to be able to take minority discount valuations on minority interest gifts.
One Commentator on the regulations states:
“There is no mulligan. If a family is considering doing some tax planning and they’re putting it off to next year, they can’t go back in time and take advantage of the discounts,” Mark Parthemer, senior fiduciary counsel at The Bessemer Trust, told Joseph Sullivan in the August 25, 2016 New York Times column titled “Treasury Wants to End Tax Deal For Some Family-Owned Businesses.”
The takeaway: do your planning now and get your minority FLP or LLC interests transferred before December 31, 2016 to the family members you wish to take over the business before you retire or pass away.
Contact me to learn more about FLP’s, minority discounts, and how they can be of use to you and your family.