Window Closing On Discounted Family Gifts
Making gifts of partial interests in family-controlled business entities in order to reduce transfer taxes is likely to become much more challenging in 2017. Using family-owned limited partnerships and limited liability companies to make children partners has been an effective way to transfer wealth out of a parent’s generation at a discounted value for transfer tax (estate, gift and generation-skipping taxes) purposes. When such gifts are made, gift tax returns for each gift must be filed demonstrating the value of property that has been gifted.
The logic of the technique is quite simple: say a couple owns development real estate with a value of $1,500,000 and wants their children to participate in the development of the land and to not have to pay estate taxes to inherit it. The owners would first deed the land into a newly-organized LLC of which one or both of them is the member (owner). If the owners had 3 children, they then could transfer, say, 30% membership interests in the LLC to each of the children, making each a 30% owner of the land development.
But ownership of a membership interest in an LLC is subject to the terms of the LLC’s partnership agreement also known as an operating agreement. Those terms include lack of marketability limitations (right of first refusal for other members) on selling the membership interest as well as lack of voting control over the investment for minority (say 30%) interests. So even though a 30% interest in the land should be worth an asset value of about $450,000, it is unlikely any unrelated buyer would pay that amount because of the partnership limitations.
When we counsel clients regarding making such discounted wealth-transfer gifts, we always have an appraisal prepared which indicates the appraiser’s evaluation of just how much the value of the LLC membership interest is diminished by these two factors and therefore what is the actual value of the gift. Over the years, while much more aggressive discounts are sometimes sought, we have typically seen discounts of 20-30%. Thus, a gift of $450,000 in value of real estate would only be assessed for gift and estate tax purposes for $337,500, which is 75% of its true asset value. Multiplied by three, the couple could transfer 90% of $1.5 Million real estate to their children for a value of just over $1 Million. In addition, the post-gift appreciation of the land would also be out of the parents’ estates, amplifying the estate tax avoidance benefits.
It should come as no surprise that the IRS has been very unhappy with this concept through the years, as the family is able to keep their property into the next generation with a nice estate tax discount. But while they have consistently fought court challenges to the amount of claimed discounts, the IRS has been unable to provide a legal objection to the discount concept. The IRS on August 2 finally issued long-anticipated proposed regulations which will be the subject of public hearings, after which final regulations will be issued which will be binding upon taxpayers. The proposed regulations, as expected, effectively eliminate discounts for transfers to family-controlled entities. The hearings will commence soon, and it is expected the regs will become enforceable sometime near the beginning of 2017.
If gifting makes sense for your plan, please call your DiMonte & Lizak estate planning attorney to evaluate whether it will be possible to make discounted gifts prior to the new law’s effective date. Until then, the technique will be legal. Even after the law takes effect, it may make sense to gift certain assets to children if the gifted assets are likely to appreciate over the years. Every family’s estate planning needs are unique, so allow us to be of assistance.