A proposed IRS regulation could make it much more difficult for family-owned businesses to avoid federal estate taxes when assets exceed the current per-person limit of $5.45 million. That could prove especially painful to farm estates where a modest 600 acres of Midwest farmland owned free and clear can easily hit that ceiling, not counting mineral rights, equipment, livestock, grain bins or inventory accumulated over a lifetime.
“It would not be unusual for an 80-year-old farmer from around New Ulm, Minnesota, to hit that limit,” said Andy Biebl, a Minnesota-based CPA with CliftonLarsonAllen LLP. “And that doesn’t count some state thresholds that trigger on estates as small as $675,000 to $2 million.”
The IRS proposal published Aug. 4 in the Federal Register takes aim at the common practice of discounting stock of minority shareholders in family-owned operations, whether they be organized as partnerships, corporations or limited liability companies. The agency has long said it would try to block the practice of discounting minority shares when transferred, such as at an owner’s death or when a parent gifts or sells their stock to children as part of their estate or business plan. Since 1990, farm estate planners have typically discounted minority shares 30% to 40% or sometimes 50%, a practice that courts have largely blessed when handled properly.
“The thrust is if these rules become effective as written, IRS will pretty much kill discounts for transferring ownership in family business,” said Biebl. “If dad owned 25% of an LLC with $20 million in farmland, it will be valued at $5 million at his death, without the 40% haircut from discounting it could have received in the past.”
Many tax practitioners had expected IRS to ban the technique of wrapping marketable securities like stocks and bonds inside a family business entity, allowing wealthy nonbusiness owners to claim a large discount on their investment portfolios. Most ag CPAs and tax attorneys agreed that was a practice that needed to end, but said the abuses were among city slickers, not in country estate planning offices.
However, if these broad regulations are finalized in their current form, “the writing is on the wall” for an end to family business discounting as well, said Doug Mitchell, a Denver-based estate tax attorney for KCOE-Isom. He considers it one of the biggest shifts in small business estate tax planning since Congress ended the widow’s tax and enacted other landmark tax rules in 1981.
CPAs and tax attorneys have long justified 30% to 50% discounts for business owners because minority shareholders lack company control and marketability. Often owners of private businesses can only sell to other family members, and buy-sell agreements allow payments only over 10-year terms when exiting. Sometimes only one partner can be bought out at a time, so as not to create a cash crisis for the business. Contrast that long-term waiting period with something like Apple stock, which can be sold instantly on a public stock exchange with the click of a mouse.
“For decades, legal documents for nearly all family businesses and farming entities incorporated restrictions on withdrawing capital or forcing liquidation of the entity, so that one family member cannot force the rest of the family into a fire-sale situation,” said Mitchell. “It is these restrictions that make minority interests in a corporation, partnership, or LLC worth only 50% to 70% of their prorated share of the value of the assets owned by the entity.”
On the other hand, IRS believes these arrangements are abusive when used to minimize gift and estate taxes on gifts and other transfers to family members. It has waged battles since the 1990s to block what the agency considers an end run around estate tax thresholds. Courts have largely ruled in favor of the practices, however, and against IRS’ position.
Under current law, married couples are allowed $10.9 million in a lifetime exclusion for federal estate and gift taxes. Assets above $10.9 million per couple are taxed at a 40% federal rate. “But for many small business owners and farmers, the new IRS proposal would mean paying much higher gift and estate taxes when they transfer ownership of their business or farm to their heirs,” Mitchell said.
In effect, IRS believes that while families may have fractional business ownership, they likely act as one in business decisions, Biebl said. In reality, many parents establish limited liability companies because they want to keep their business intact after their deaths. They may need to protect the on-farm heirs in the event off-farm heirs would rather own cash than own shares in a cyclical business.
IRS has scheduled a hearing on the proposed rules on Dec. 1 and could technically finalize their decision as quickly as 30 days afterward. However, both Biebl and Mitchell expect nothing to take effect until early 2017.
If your estate or succession plan relies on sale or gifting of discounted stock, owners may have a small window to transfer shares before year-end, the tax advisers said.
“The proposed rules are very complex, and we don’t know how the final regulations will sort out,” said Biebl. “But if you have a taxable estate and want to make larger gifts or discounted sales to your heirs, it might make sense to do it before year-end.”
To read or comment on the IRS proposed regulation go to https://goo.gl/…