The IRS has long voiced its concern over taxpayer’s use of valuation discounts to transfer assets at significantly reduced values for estate and gift tax purposes. While changes to the regulations expected most recently in the Fall of 2015 did not come to fruition, the IRS continues to keep these real estate and estate planning strategies on its radar. As a result, now may be an ideal time for families to reevaluate their estate plans and identify opportunities to maximize the tax saving benefits of valuation discounts with an eye to a possible change in the way they may be interpreted in the future.
How do Valuation Discounts Work?
A family may create a common ownership structure, such as a family limited partnership (FLP), a limited liability company (LLC), or a sub-S corporation to hold assets, such as real estate, investments and business holdings. The entity may then transfer minority or non-controlling interest in the assets to family members or trusts at significantly reduced estate and gift tax costs due to a lack of marketability and lack of control. In other words, because the recipients do not have the ability to exercise their minority interest to control the entity’s operations or its potential future sale, the value of the interest they hold should be worth less. As a result, the recipients may be entitled to a discount off of the asset’s underlying fair market value, which could be as high as 40 percent. In some instances, these valuation discounts have completely eliminated gift taxes on transfers of assets during life as well as estate tax liabilities after one’s death.
As an example, consider a $10 million property held in an appropriately structured ownership entity. When the entity distributes up to 49 percent of the property’s non-controlling interest or more than 50 percent of non-voting interest to family members, a discount of up to 40 percent off the property’s value may be claimed for lack of marketability and control. For gift and estate purposes, the property will be worth $6 million, and the valuation discount will remove from the estate $4 million in tax exposure and all of the property’s appreciation.
How May I Take Advantage of Valuation Discounts?
Restructuring the entities that own family assets can be a powerful estate-planning tool. The actual entity selected will depend on a family’s unique circumstances, and each entity will yield different results.
One option is to combine real estate holdings and estate-discounting strategies through the creation of single member LLCs, multi-member LLCs, limited partnerships with general partners and limited partners or sub-S Corporations. These common structures can separate control and liability from the majority of ownership while providing some liability protection and availability of valuation discounts to reduce estate taxes.
For example, consider a limited partnership with multiple LLCs and properties. A general partner with 1 percent interest in the entity may, in essence, isolate or remove that interest from the taxable estate through an irrevocable trust, thereby allowing discounts on 99 percent of the property. Similarly, a family may recapitalize corporate stock in an S Corporation into voting and non-voting shares and apply the valuation discounts to the non-voting shares due to lack of marketability and lack of control over those shares.
Once the proper entity is in place, several strategies can be implemented to maximize the benefits of valuation discounts, including:
Making annual or lifetime gifts outright or through a trust;
Employing estate freezing strategies, such as selling assets to an intentionally defective grantor trust with promissory notes, private annuities or self-cancelling installment sales;
Establishing a grantor retained annuity trust (GRAT), through which a grantor may transfer by gift appreciable assets to future generations with little to no gift tax implications while also allowing the grantor the right to receive annual income from the trust.
Establishing a Spousal Lifetime Access Trust (SLAT) through which one spouse makes a gift and then allows the other spouse to take distributions, if needed. When restructuring ownership entities and applying valuation discounts, however, taxpayers should take special care to execute the strategy with precision and keen attention to details.Why Now?
This, combined with the possibility of restrictions on the use and/or interpretation of valuation discounts in the future, makes the timing ideal for taxpayers to consider creating family ownership entities now. Doing so may allow families to transfer wealth from generation to generation with minimal, if not completely eliminated federal estate and gift taxes.
The current low interest rate environment is ripe for families to restructure their holding entities and take advantage of valuation discounts for long-term tax and estate-planning purposes. As real estate appreciates, low interest rates essentially enhance estate sales and allow the entity to pay down loans more quickly. This strategy may not be as effective as interest rates rise, which the Federal Reserve has made clear it plans to in 2016, but at a gradual pace. In its most recent announcement, the Fed said that it expects the federal funds rate is “likely to remain, for some time, below levels that are expected to prevail in the longer run.”
The professionals with Provenance Wealth Advisors have deep experience working with entrepreneurs and high-net-worth individuals to implement tax-efficient financial-planning strategies designed to help meet desired wealth-preservation goals.
About the Author: Eric P. Zeitlin is managing director of Provenance Wealth Advisors, an independent financial services firm affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call 800-737-8804 or email info@provwealth.com.
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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The above are hypothetical examples for illustration purposes only and do not represent an actual investment.
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