One of the more favorable estate-planning techniques is the transfer of minority shares in either the farm operation entity or the land-holding entity. A direct transfer of land to a son, a daughter or anyone else in the family usually results in having to value the transfer at full fair-market value.
Yet the transfer of units in an LLC or family limited partnership (FLP) allows a producer to discount these units at various rates listed below.
Courts often look favorably on these discounts. Because the IRS continues to lose most of these cases, the agency issued new proposed regulations in August 2016 attacking these discounts with three prongs.
Prong No. 1: Bring any minority discount back into the estate within three years of death. The IRS continues to lose cases where the taxpayer set up a family LLC or FLP within a few months of death, contributed a large amount of marketable securities (not illiquid land or businesses), gifted most of the value to kids, grandkids or a trust, and took a large discount for minority interest. To counter this trend, the proposed regulations would require most family transfers within three years of death to be brought back in the estate. This results in a phantom asset.
Suppose Farmer Jones controls a farm partnership worth $10 million. His wife owns 20% and he owns 80%. He transfers 20% each to his son and daughter. After the gifts, he now owns 40% of the partnership. The valuation took a 25% discount for minority interest and claimed a gift value of $1.5 million for each gift. This reduced his lifetime exemption from $5.45 million to $2.45 million. If he dies within three years of the gift, the proposed regulations go into effect, his estate will have to include the $1 million discount and pay an extra $400,000 of estate tax.
Prong No. 2: New restrictions on family transfers will be disregarded. The IRS asserts certain restrictions on family transfers should be disregarded, such as those that:
- Limit the interest-holder’s ability to liquidate
- Limit the liquidation proceeds to an amount that is less than a “minimum value”
- Defer payment of the liquidation proceeds for more than six months
- Permit payment of liquidation proceeds in any manner other than cash or property
Prong No. 3: The changes would affect how state law treats restrictions. Most family farm documents have restrictions that increase discounts allowed by state law, and almost all of them have provisions to eliminate these restrictions to take advantage of discounts. The proposed regulations essentially eliminate the discounts on using these restrictions if the family can change the restrictions.
Take Action Now. For farm families with taxable estates, consider making substantial gifts to your heirs while the old rules are in effect. Care must be taken to ensure you only transfer what makes sense. Talk to your estate tax adviser now.
Transfer Discounts at Risk
Built-In Gains Tax Discount: This discount can range from 25% to 35% of the value of the net corporation assets. If the family farm is operated as a C corporation and there is land in the corporation, there can be a large amount of built-in gains tax on the underlying assets.
Lack Of Marketability: This discount usually ranges from 15% to 25%. A willing buyer is likely to pay less for shares in a family LLC or family limited partnership (FLP) because there is no ready market for these shares.
Minority Discount: This discount usually ranges from 5% to 15%. When shares that account for less than 50% of a business are transferred, this results in a discount because the shares
do not represent a controlling percentage of the operation.
Non-Voting Discount: This discount is usually less than 5%. Many family farm businesses have voting and non-voting stock or units. If non-voting interests are transferred, there is
an additional discount.