Earlier this summer, the Treasury Department released proposed regulations that will, if finalized in their current form, substantially limit the usefulness of currently existing valuation discounts for transfers of interests in family-owned businesses. Clients who had planned to incorporate these valuation discounts into their business succession and estate planning strategies may find that their plans are no longer viable in light of the new regulations.
However, because the regulations are not likely to become effective until sometime in mid-2017, clients have a short window of time in which to take advantage of the valuation discounts available under today’s rules. For many small business clients, a grantor retained annuity trust (GRAT) can form part of an effective planning strategy—allowing the client to capitalize both on the value of the GRAT strategy and today’s family-business valuation discounts.
The Proposed Regulations
The Section 2704 proposed regulations are designed to eliminate valuation discounts for interests in family-owned businesses when those interests are transferred and the family controls the entity both before and after the transfer (meaning that it is likely that the interests were simply transferred within the family).
Under today’s rules, certain restrictions on liquidation rights in the family-owned business context can result in significant valuation discounts. These restrictions are currently ignored if they are more restrictive than the default state law that would apply to the entity (and it is perceived that this has caused many states to draft default laws that are favorable to family businesses).
The proposed regulations would essentially eliminate the reference to state laws, providing that state law will only be taken into account in determining whether a discount is appropriate if the state law provision is mandatory (i.e., cannot be circumvented in the entity’s governing documents). Further, restrictions that limit a transferor’s ability to require liquidation or redemption of his or her own business interests will be disregarded in valuing the interests. Instead, it will be assumed that the transferor has a six-month “put” option to liquidate or redeem the business interests.
Essentially, these new proposed regulations would substantially limit the ability of family-owned businesses to take advantage of discounts for lack of control over the business or lack of marketability.
A GRAT Strategy
In order to take advantage of the valuation discounts that currently apply with respect to small business interests, a GRAT strategy may be used to “freeze” the current value of these interests and transfer the appreciation to the client’s beneficiaries. A GRAT combines a trust that is established for a certain predetermined period of time with an annuity that pays the trust creator (the client) a set value each year of the trust's existence. At the end of the GRAT term, the remaining value passes to the client’s beneficiaries, and, thus, out of his or her estate.
The value of the taxable gift to the GRAT beneficiaries is equal to the fair market value of the property transferred into the GRAT minus the client's retained interest.The client's retained interest is the actuarially calculated value of the annuity stream he or she will retain over the GRAT's life based on the Section 7520 rate in effect for the month in which the GRAT is created.
Appreciation of the GRAT assets above the Section 7520 interest rate allows the client to transfer the appreciated value to his or her beneficiaries gift-tax-free. If the appreciation of the GRAT assets does not exceed the Section 7520 interest rate, the strategy will have effectively failed, because no interests will pass to the beneficiaries at the end of the GRAT term.
Contributing interests in the family business to a GRAT today essentially allows the client to freeze the value of the stock for transfer tax purposes at today’s discounted rate, taking advantage of discounts for lack of marketability and control. Assuming that the interests outperform the currently very low Section 7520 interest rate, the appreciation on the interests would be transferred to the client’s beneficiaries gift-tax free.
In order to protect any substantial appreciation that occurs during the GRAT term, the GRAT should contain a power-of-substitution provision that allows the client to replace the GRAT assets with a different set of equally valued assets. If the value of the transferred business interests appreciates substantially during the GRAT term, the client can choose to replace those assets in order to ensure that a decline in value later in the term does not erase that appreciation.
Depending upon the client’s life expectancy, it may also be advisable to create a GRAT with a relatively short term in order to ensure that the strategy does not fail because the client fails to outlive the term of the GRAT.
Although the proposed regulations have yet to be finalized (comments have been requested), it is likely that some limitations on the currently available valuation discounts will result—for many clients with family-owned businesses, transferring the interests through a GRAT to their beneficiaries at today’s discounted rates might prove to be beneficial.