Following are two articles I posted on LinkedIn. They describe an attempt by the IRS to implement a “stealth tax” on business owners. Because business valuation techniques and processes can be somewhat obscure for most people, the impact of such a change could easily have passed unnoticed.
Business valuation is both art and science and this is an example of how these two factors interact.
We need to always be diligent about changes in public policy that are hidden in this way. There are real implications for real people.
Posted on LinkedIn November 7, 2017:
This is a follow-up to my post of December 2016. The Treasury Department and the Internal Revenue Service have in October 2017 proposed to withdraw Internal Revenue Code (IRC) §2704.
The August 2016 proposed changes to IRC §2704 could have effectively eliminated discounts for lack-of-control and lack-of-marketability in family-owned businesses. These are commonly used discounts and is a standard practice in IRC 59-60 tax-oriented valuations. If implemented and finalized this regulation could have inflated values for a specific targeted group of taxpayers and not others. Small and family-owned businesses would have been negatively impacted.
In effect, this was a stealth tax increase. The discounts being threatened are not commonly known or understood among business owners or even many legal and financial professionals. The impact may not be initially appreciated by many advising or having an interest in a small or family business. This was a way of raising taxes without appearing to raise taxes.
As related in my prior post, there was a public hearing where people from different disciplines and backgrounds testified against the change.
Posted on LinkedIn December 6, 2016:
Here is the text of an email I recently sent to my clients regarding proposed IRS rule changes affecting the valuations of family-owned businesses. I rarely (really never) post anything to LinkedIn but the number of inquiries and interest in the proposed IRC 2704 is intense.
This proposal would limit the use of the two most commonly used discounts in valuation – Discounts for Lack of Marketability (DLOM) and Discounts for Lack of Control (DLOC or minority interest discounts).
Depending on what is finally adopted by the IRS, these discounts would be curtailed or eliminated entirely on equity transfers between family members. This includes holding companies such as Family Limited Partnerships and also operating companies. If implemented in its current form, the result would be higher tax bills when a transfer occurs – including for both gifting and estates.
Back in the early 90s, the IRS allowed the use of these discounts (see Rev. Ruling 9312) and as a result, the use of Family Limited Partnerships expanded. The IRS believed that the use of these discounts was too aggressive and they tried to impair their use, but with limited success. Thus, the current proposal.
There has been a huge amount of interest in this possible change to the tax law by business valuators, CPAs, attorneys, and tax planners. The IRS has been hinting they were looking at changing the rulings in this area since at least 2009 and announced the proposed change in August 2016.
On Thursday, Dec. 1 the IRS held a hearing in Washington D.C. about the proposed IRC Section 2704 and invited comments and speakers. Reportedly, there has never been as well attended IRS comments meeting such as this, with over 150 people in the audience and 37 outside speakers. The IRS also has received over 9,800 written comments. I think it is fair to say that the comments and speakers attending the meeting were almost universally opposed to the new proposed regulations.
Of the speakers, several issues were raised. First, the proposed IRS provisions go against the standard definition of Fair Market Value and create a new standard for these types of valuations called “Minimum Value”. “Minimum Value” appears to be a version of Asset Value. Second, the provisions disregard the reality of family-owned interests. Especially considering that many, many families are not harmonious and do not act in concert with the primary consideration being each other’s well-being. Finally, there is a question as to whether the proposed IRC 2704 has exceeded the IRS authority, at least in part.
Every speaker and organization (except one) attending the December 1st meeting requested the proposed IRC 2704 not be implemented and that the IRS draft new regulations. The attendees were a very diverse group including everything from valuation organizations (NACVA), trade groups (National Cattlemen’s Beef Association, Car Dealers, etc.), other professional organizations (AICPA), and individual business owners. The latter included representatives of the family that owns the White Castle hamburger chain and a lodging business in Wyoming. These owners testified their fear of being forced to sell their businesses under duress due to estate taxes.
It cannot be determined what is going to happen with this proposal. The outcry against it is more substantial than anything the IRS has experienced in living memory. However, there are some indications that the IRS may relent. Trump has repeatedly stated that he would like to eliminate the estate tax or at least make it less of a burden. No one can forecast if this will actually happen. One of the IRS attorneys attending the meeting (the IRS stacked the meeting panel with attorneys) made a few comments – sort of – in support of the presenters and commentary positions.
But it is impossible to tell what will happen. Some observers think the IRS will delay making a decision on this until February at least, due to the negative public response. NACVA has stated they think the IRS will rethink their position. No one knows.
The best option at this time is to recommend to clients that anyone considering making an intra-family transfer do so before the end of the year. Before the rules are finalized. This will protect the client’s ability to take these important and sometimes substantial discounts. It is possible they will be able to continue to take the discounts next year, but maybe not. So the most defensive posture is to transfer the equity now.
