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Proposed U.S. Rules to Deny Valuation Discounts


Canadian Tax Highlights

In determining the Fair Market Value (“FMV”) for income tax purposes, “valuation discounts” are usually the most contested items when it comes to family-held minority shares. These typically include, as applicable, (1) minority (lack of control) discounts, (2) marketability (illiquidity) discounts, (3) fragmentation (fractional or partial interest) discounts, (4) holding company (portfolio) discounts and (5) key-person discounts. The Tax Court of Canada has addressed some of these in Zeller Estate, 2008 TCC 426.  These types of discounts are discussed in my September, 2004 presentation at the Canadian Tax Foundation’s Annual Conference.

The Canada Revenue Agency’s stated policy since 1989 (Information Circular 89-3, paragraphs 32 ff.) has been that where there is family or group control, no minority discounts would be permitted — unless the facts would suggest otherwise.

In the United States, the Internal Revenue Service (“IRS”) had adopted the same policy, except that in 1993, after losing a number of cases in the U.S. Tax Court regarding minority discounts on family-owned shares, it changed its policy and issued Revenue Ruling 93-12, stating that it will not deny such discounts. Currently, the U.S. Internal Revenue Code (Section 2704) provides that if an interest in a family-controlled entity is transferred to a family member, any “applicable restriction” must be disregarded in valuing the transferred interest. While the IRS in some cases has relied on Section 2704 to challenge valuation discounts, it has had limited success (as it had prior to issuing Revenue Ruling 93-12 (above).  It is of interest to note that Section 2704 permits the Secretary of the Treasury to prescribe in regulations that other restrictions must be disregarded in determining the FMV of a transferred interest to a family member, if such restriction would effectively reduce the value of the transferred interest but not ultimately reducing the value thereof to the transferee.

In certain cases, U.S. taxpayers can reduce the taxable value of minority shares of their family-owned company to less than the U.S. $5.43 million gift-tax exemption by applying such discounts as permissible.

For example, a portfolio of investments might be “eligible” for a portfolio (holding company) discount of 5% to 10% in the holding company. If a 20% minority shareholding in the company were to be passed on to the taxpayer’s son or daughter, the pro-rata value of the shares might be discounted by, say, 30% (assuming both a minority discount and marketability discount).The transferred shares would have a reduced FMV (reduced from its pro-rata FMV), in which case, if the resulting value were to fall below the $5.43 million U.S. gift-tax exemption, the transfer could be tax-free.

Incidentally, if the taxpayer is a U.S. citizen, resident in Canada, there can be two FMVs — recognizing the difference between the CRA’s (non-discounted) and IRS’ (discounted) respective tax-valuation treatments.

In May 2015, at a meeting of the American Bar Association’s (“ABA”) Tax Section, Catherine Hughes, an Estate and Gift Tax Attorney in the U.S. Treasury Department’s Office of Tax Policy, said that the IRS will be issuing new rules by this coming fall to restrict or eliminate valuation discounts on the transfer of family-owned interests in LLCs and family partnerships. This is expected to occur prior to the ABA’s taxation meeting scheduled for mid-September.

The IRS maintains that it already has regulatory authority under Code Section 2704 to make changes (not statutory). Thus, there appears to be a consensus among U.S. tax practitioners that there may well be new regulations released by mid-September that would deny discounts on transferred family-owned minority shares. That being so, many practitioners are suggesting to their clients that they implement their estate plans, including family-owned share transfers, by the end of this summer.

Richard M. Wise