Valuing a publicly traded company is a fairly easy proposition. Every day, shares trade hands between willing buyers and willing sellers. The price of that trade, times the number of shares outstanding, provides the capitalized value of the company. For any shareholder’s stake, the value of that interest is the number of shares held multiplied by the price.
Valuing privately held companies is far more difficult. The standard is, fundamentally, the same: What would a willing buyer pay, and what would a willing seller accept, if neither were under any requirement to buy or sell? Putting that standard into practice is very different, because there is no public market for the shares. In particular, with closely held firms the issue of control becomes paramount. If one stakeholder controls the enterprise, his or her share may command a premium, while the minority shareholders’ interest will be discounted. The minority interest may get an additional discount if there are restrictions on selling it, as is usually the case.
These principles of tax law are nothing new. The new twist came in utilizing them in the context of a family limited partnership or, alternatively, a family-run limited liability company. These are legal entities used to manage family wealth, and also to move wealth to younger generations in a planned, controlled fashion. By employing discounts for illiquidity and lack of control, the transfer tax costs (gift taxes or estate taxes) could be significantly reduced. The IRS gets particularly unhappy when the new legal entity is essentially a repository for a portfolio of marketable securities. There are many sound non-tax reasons for employing a family limited partnership to manage any kind of wealth, but the IRS believes that no one would go to the trouble for a portfolio of securities except to secure additional tax benefits.
Accordingly, the IRS has effectively declared war on family limited partnerships, by proposing a new set of regulations under Internal Revenue Code 2704 last year, which deals with intra-family transfers. The proposal is detailed and abstruse, and it is not limited to securities portfolios. There has been much resistance to the proposal from business owners.
Speaking to estate planners at the Heckerling Institute on Estate Planning, Catherine Hughes from the Treasury Office of Tax Legislative Counsel reported that the IRS will be moving ahead on finalizing the controversial proposed Regs. She reported that more than 10,000 comments were received, and no doubt the vast majority were in opposition. The December hearing on the proposal lasted more than six hours, which Ms. Hughes thought to be a record for recent times.
Contrary to the reactions of many commentators, the proposed Regs. were not intended to eliminate all minority discounts, Ms. Hughes asserted. The final Regs. will make that point very clear, as well as addressing other misunderstandings identified during the comments period.
Elimination of the federal estate tax might not render the §2704 Regs. moot. They could come into play if the federal gift tax is retained, or if there will be a capital gains tax imposed at death.