Many of our clients have ownership interests in a closely held business. They might own such a business entirely, or co-own the business with other family members. These can be operating businesses, or entities that hold investments, such as real estate, for example. Among other tax planning reasons, these “family businesses” are often established as a way to create a platform for the future division and transfer of ownership of the business, or to spread income among the family. In most of these instances, one could argue about what the business is really worth, or what it should be worth, for estate transfer tax purposes. The following is an example and explanation of what this means.
What is an interest in a family business entity worth? That’s a very interesting question, and it’s debated constantly – mostly between the IRS and the business owner. Since family business stock is generally not sold on a public exchange, this valuation debate is warranted. Here is an example: Mom and Dad Jones have a family company that owns several pieces of rental property collectively worth $6 million – this could be in an LLC or several separate LLC’s owned by a parent LLC. Mom and Dad each own one-quarter of the parent LLC and their two children own one-quarter each. So it would appear that each owner has a $1.5 million ownership interest in the business. But because each of the family members owns less than a controlling interest (less than 51% of the business does not let you rule) and no one likely wants to buy a one quarter interest (as the owner of a one quarter interest, that new owner would have no effective say as to company decisions) each owner could argue that their interest is only worth, say, two-thirds or $1,000,000 each. That way, if they were to transfer their interest to another, especially through their estate at death, the resulting estate tax liability would be lower.
This tax planning strategy has been used for years, and there is a long list of court decisions and private IRS rulings determining what value the IRS would/could use to address the utilization of that strategy. If you’re too greedy and calculate a very large discount on the value for purposes of estate transfer taxes, you may lose the argument. There is an industry of professional valuation experts that help determine the values of these companies.
Recently, the IRS proposed new regulations that would disallow the use of some of these discounting methods and reasoning. It is anticipated, however, that until the end of the year, these discounts can be used (within limits).
Accordingly, there is an urgency to at least look into the advisability of this strategy before year end.
If you own a family business and you think you are in a position of potentially being subject to estate taxes, you may want to speak with your estate planning attorney soon, or you may want to reach out to your Washington Trust Bank relationship manager to inquire about more details and information as to what to do next. If you don’t currently have an estate planning attorney, Washington Trust can recommend several that may suit your needs.
As Vice President and Senior Wealth Advisor, Greg provides financial analysis to high net worth individuals. He is the author of several articles for various publications and nonprofit organizations on estate and financial planning subjects.