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The Sun is Setting on Valuation Discounts

December 2016

Harry Sturgis, Senior Financial Analyst at Weyrich,
Cronin & Sorra, Chartered, joined the firm in 2012 as
an intern. He was hired full-time shortly thereafter,
upon completion of the educational requirements to
sit for the CPA exam. Harry attended the University
of Baltimore and graduated Summa Cum Laude
in 2008 with a Bachelor of Science in Business
Administration with a concentration in Finance.
Harry is working on obtaining the Accredited Senior
Appraiser designation.

The U.S. Department of Treasury recently proposed regulations that could end up giving family owned businesses a significantly higher tax bill as early as January of 2017. The proposed regulations, which were released on Aug. 1, aim to eliminate or reduce valuation discounts used for transfers of interests in family businesses. Valuation discounts are reductions in value based on a limited ability to control the entity (discount for lack of control) and a limited ability to sell or transfer an interest to a third party (discount for lack of marketability).

Transferring ownership in a business to a family member is subject to tax (to the extent its value is greater than $14,000), which is calculated using the fair market value of the business interest transferred. Excluding valuation discounts creates a higher value, which results in higher taxes. The additional amount of taxes for those taxpayers who exceed the estate tax exemption of $5.45 million for individuals and $10.9 million for couples could be significant.

Valuation discounts often reflect economic reality when appraising a business. If a family member owns a minority interest in a family-owned entity, that family member will not have the ability to force a liquidation of the entity to realize his or her value. A potential purchaser would pay less for this type of interest and therefore a discount for lack of control should be applied. Also, many family-owned businesses severely restrict the transfer to third parties. Without the ability to sell an interest in the open market, there should be a reduction in value for this lack of marketability. The proposed regulations assume that these limitations do not apply to an entity that is controlled by a family. The assumption that a minority ownership interest in a family-owned entity enjoys the same rights as a majority interest is seldom true.

There are also limitations on value that are outside the control of owners. This is evident with franchises. Franchise agreements often limit the size of the market when selling a business by putting requirements in place for potential franchisees. This coupled with strict requirements for reinvestment and royalty fees can significantly reduce the value of the business and would need to be captured in some form of a discount. These factors are outside the control of the family, which owns the business since franchisors impose these terms in their agreements as they see fit.

The proposed regulations target any business held within a family-controlled entity when the family retains control before and after the transfer takes place, regardless of the individual ownership of each family member. Some assume the original intent of the regulations were to reduce the aggressive discounts taken on family owned entities that hold investments such as publicly traded stocks and bonds which are easily sold in an open market, but as the regulations are currently written, they include family-owned entities which also hold operating businesses. If you own real estate or a valuable family business and have given thought to transferring your business to the next generation, you should probably consider estate planning before year-end. I95