Saving the Family Farm: The Sum of the Parts Always Equal the Whole?

The U.S. Department of the Treasury this summer fired “a warning shot across the bow” of family farmers who want to keep their farm in the family. Here’s how.

Transitioning the Family Farm

Farmer Dan owns a very profitable walnut farm outside Merced, California. Dan wants to pass ownership of the farm at his death to his two daughters, April and June, and his son, August. But, he would also like the kids to begin learning the business, and caring about it, while he is alive. So, Dan goes to see his lawyer, who advises Dan to set up an LLC to hold the farm, and transfer by gift a 15% membership interest in the LLC to each of his three children. After the 3 gifts, Dan will still own a controlling interest (55%), and his children’s interests will total 45%.

But, Dan is worried about his son, August, because August is not really interested in the business. Plus, August has been dating the daughter of the owner of a competing farm. So in the operating agreement for the LLC, Dan puts a restriction on any LLC member’s ability to transfer their share of the business without permission from a majority of the other members in the LLC.

Dan’s CPA has some bad news and some good news for Dan. The bad news is that the transfer of the LLC membership interests to his kids is subject to federal gift tax. The good news is that even though the farm as a whole is worth $15 million, the value of each child’s gift (for gift tax purposes) is not $2.25 million (15% x $15 million); instead, for gift tax purposes, the value is what a “hypothetical willing buyer” would pay for the interest if it were freely offered to the public. So, an independent appraisal of each 15% interest in the LLC is obtained, and the appraiser determines that, due to the lack of voting power a 15% member would have, and the lack of marketability due to the restrictions on transfer, the value on the open market of each child’s interest in the family business (and, thus, the basis upon which the gift tax will be applied) is only $1.8 million each. Therefore, the total of Dan’s taxable gifts for the year is $5.4 million (3 x $1.8 million), which happens to be under Dan’s lifetime exemption of 5.45 million. So, no tax will be due!

The Gift and Estate Tax Risk

For many years, closely held family businesses have utilized the sorts of valuation math described above to reduce the tax effects of transitioning the family business to the next generation. The tax effect of this “fractionalizing” often has the effect of reducing the value of the gift, and therefore, also the gift or estate tax on the transfer. These reductions in fair market value in the tax law parlance are sometimes referred to as “valuation discounts.” This term is of course a misnomer, because no one is getting any discount — the true value of each of child’s membership interests on the open market is in fact less than that member’s ownership percentage of the value of the whole business.

The IRS has never been too thrilled with taxpayers’ use of this valuation “discounting,” but has nevertheless been rather unsuccessful in Tax Court in challenging the valuations of well-advised taxpayers. So, after years of unsuccessful court challenges, the IRS took a major new step — representing a major change in tactics, to limit these “valuation discounts” by issuing new regulations governing how family business interests may be appraised. Under newly proposed regulations (REG-163113-02), released August 2, each of the gifts Farmer Dan made as described above would be valued at $2.25 million. The result would be that Dan would have a $520,000 gift tax liability, due and payable on April 15th of the year after the gifts are made! (This calculation is ($15 million x 15% of the business per gift x 3 gifts minus $5,450,000 lifetime gift tax exemption) x 40% gift tax rate.)

Good Tax Policy?

According to the Treasury Department, they are attempting to close a “loophole” in the valuation of assets for transfer tax purposes.   These new, proposed regulations have not yet been finalized. The Treasury Department is scheduled to hold a public hearing, to discuss the policies and efficacy of these new, proposed regulations on December 1, 2016; and they have invited public comment on the new regulations in the meantime.

So far, most of the public commentary has been highly critical of the proposed regulations, as being, at best, an overreach, not reflecting the realities of family businesses, and at worst, an unconstitutionally inaccurate interpretation of the tax statutes. So, we are hoping the regulations will not be made final without significant changes. Nevertheless, one can never predict what the Treasury Department will do.

Our advice is that if you are in the process of transitioning a family business to the next generation, you should consider making serious efforts to complete these types of transactions before the regulations are due to be finalized.

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C. David Spence and Michael Zosky