On August 4, 2016, the IRS issued proposed regulations that would eliminate most valuation discounts for family-owned entities. The proposed regulations will be effective 30 days after they become final, which could be as soon as December 31, 2016.
What is at stake? For business owners who want to transfer business interests using traditional valuation discounts, time is running out. More importantly, every shareholder agreement, LLC operating agreement, and limited partnership agreement needs to be reviewed to ensure that buyout valuations will not be lower than federal estate tax values.
Although the new regulations are complex in their operation, their effect is fairly straightforward. In basic terms, any entity — whether it is a corporation, LLC, or limited partnership — will be valued as if the owners had an absolute right to require the entity to redeem their interests. It will no longer matter what the entity’s governing document, or even state law default provisions, say regarding buy-back rights.
This is a marked change from the past. Prior to these proposed regulations, valuations of closely held entities generally reduced the entity’s value based on lack of marketability and lack of control.
The traditional lack of marketability discount reflected the impairment to value caused by ownership and transfer restrictions built into governing documents and default state law — restrictions such as ability to transfer only among family members. These restrictions were historically recognized as a real limitation on an owner’s ability to sell his or her interest. Under the new regulations, regardless of what the governing document says, an owner is presumed — for valuation purposes — to have an absolute right to demand that the entity buy their interest back at fair market value.
The new regulations also redefine the meaning of control in two ways. First, all transfers within 3 years of death are aggregated. This eliminates so-called “deathbed” transfers of minority (non-controlling) interests intended to reduce value. Second, control of an LLC is defined as ownership of 50% or more of the equity in the LLC. In a limited partnership, any ownership interest in the general partner will amount to control. In most cases, entity interests owned by all family members will be aggregated for purposes of determining control.