In early August, the IRS issued a proposed rule that effectively ends the practice of “valuation discounting.” For example, say that ownership interests in a privately held business are estimated at a fair market value of $100 (typically as determined by a third-party valuation expert). While that may represent a fair market price, in the case of illiquid assets such as closely-held businesses, there is not a fair market available. As a result, the interests are typically discounted 30–40% to account for this lack of liquidity, along with the sometimes limited rights of a minority ownership stake. For estate planning purposes, that $100 interest is carried on a person’s balance sheet for $60. This lower valuation is then used as the basis to determine annual exclusion gifting levels and lifetime exemption planning.
The August proposed rule effectively boosts valuations for closely held entities by ~66%. This will push many estates outside the $10.9 million current lifetime exemption levels. Common-sense tells us that it is a good thing for valuations to increase. But for a select group, typically those families who own a business, this change can have significant ramifications. The news is littered with stories of family-owned companies that are forced to sell when the owner of a large stake in the family business passes away. The person’s estate owes a large estate tax bill, but lacks the liquidity to cut the check, because the largest asset in the estate is the ownership of the business. The company lacks the liquidity to purchase the deceased’s interest, and consequently the business must be sold to settle the bill.
While the proposed change is currently in a comment period, a final rule is anticipated by year-end. We would note that many of our contacts in the estate planning community expect that this change will be challenged in the court system. It is not unreasonable to foresee this heading to the US Supreme Court. What this means then, is there is a unique window of time from now to year-end to make additional gifts, establish new trusts, etc. that take advantage of lower valuation levels, ahead of the meaningful increase in value at the end of 2016.
No doubt if you find yourself in this situation, you have already or will be hearing from your estate and tax advisors with a number of strategies and techniques to take advantage of this window of time. If you do not have estate or tax counsel and would like a referral, please let us know. While we believe it is prudent to consider and perhaps implement many of these strategies, it also pays to pause, reflect, and consider the longer-term consequences before making large gifts. Too often we see clients and others who are victims of ‘drive-by’ gifting. They do an excellent job in avoiding the tax man, but have under appreciated the longer-term family implications.
Long-time family business advisor and author, Jay Hughes, in his seminal The Cycle of the Gift, refers to this occurrence as The Meteor. Hughes’ analogy is that a gift of any sort can be like a Meteor crashing into the world of the recipient who then has to figure out how to integrate and possibly adjust their life style. Gifts from one generation to another are in one sense the transfer of the wishes/hopes/dreams of a prior generation to the next. The task upon the recipient is to determine how best their own dreams align with those of the gifter.
“Where are the guideposts or road maps for someone for whom the question is not, “How do I make a living?” but rather, “Given that I have money, how do I live well?”
- Hartley Goldstone, Jay Hughes, Keith Whitaker
When evaluating gifting strategy, take time to reflect and plan for life after the gift. First, assess the recipient of your gift. Are they ready to make the shift of mindset from working to make a living, to determining what does a life well lived look like? Are you ready to serve as a guide along that path? Are you ready for the giving up of control that comes when an asset that was formerly yours now belongs to another?
While none of us want to pay taxes above and beyond what is owed, no one wants to hinder the potential of our children or grandchildren by failing to give well. So by all means consult your advisors to consider all the opportunities available this fall to take advantage of this unique window of opportunity, but at the same time, consider the impact of your choices on those who you want to benefit from your generosity.