February 9, 2023
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Estate tax changes threaten small businesses


Jim Lisi

By Jim Lisi

In addition to the disproportionate effect of the estate tax on family farms highlighted by Business Times staff writer Marissa Nall, other estate tax issues are also lurking. In December, the Treasury and Internal Revenue Service held hearings on proposed regulation changes to Section 2704 of the tax code. The issues regard applying the fair market value standard to partial interests in companies for estate transfers and gifting. These changes threaten small businesses, too.

Fair market value is a simple concept. Treasury regulations have defined it in one sentence based on three ideas: a willing buyer and willing seller unrelated to each other, with reasonable knowledge of all facts, both free to walk away from the deal. When it comes to fractional interests in a private company, investors buy at discounted values.

The primary drivers of these discounts are the inability to resell the interest like a public stock, the risky nature of being in private businesses and a lack of company control.

A buyer of a minority interest is at the complete mercy of others with regard to the ability to recover the investment or alter its course toward profit or loss.

So what is the hubbub about? The IRS appears to be working to overturn 60 years of settled case law on the definition of fair market value and attribution of family interests. They propose broadening the definition of family interest to include nieces, nephews and all companies in which an owner holds an interest and combining them to impose a minimum value, replacing fair market value. As a myriad of attorneys will attest, having family members as shareholders does not produce accord and control.

Not only are economic interests different, rivalries also play out.

The proposed regulations also add hypothetical conditions to artificially increase values, eliminate contingent liabilities from the company balance sheet and add a bright line rule. This rule voids any discounts if the donor dies within three years of the gift. Why so long? What happens when a healthy 50-year-old business owner makes family gifts of stock and dies in a car accident two years later? Think about the accounting complexities of having to reverse these valuations. Business owners will need another set of books to account for estate tax.

There is hope that the new administration will void these changes, but this has not been verified. So, if they go through, we have multiple special definitions and rules that will create uproar in the estate planning industry, and potentially tax small businesses at a rate that will force company liquidations and ownership changes at the death of the founder. Without a doubt, estate planning and valuation costs will increase significantly, as will life insurance costs to cover higher estate taxes upon death of a company owner.

From the IRS standpoint, a narrow elimination of discounts for partnerships holding marketable securities and for death bed transfers is understandable, but this proposal is an extreme over-reach. Their shotgun approach will be an artificial tax increase that decimates family businesses and something that needs to be fought. And if these regulations are imposed, the divisiveness within the courts and the expense and burden of trying to figure out their acceptability will be a two-decade fight.

The proposed regulations are fatally flawed and cannot be salvaged. Even if the estate tax is repealed, they should not be allowed to linger as a threat to America’s family-owned businesses and all those that depend on them.

The only sensible conclusion is that the Treasury should withdraw them.

• Jim Lisi is a certified valuation analyst at American ValueMetrics Corp. in Santa Barbara.