Based largely on comments made by an IRS representative at a tax conference earlier this year, the IRS has signaled the likelihood of new rules designed to curtail the use of valuation discounts to leverage a taxpayer’s gift tax exemption in situations where assets are transferred to or for the benefit of family members. The comments indicated these rules would likely be issued this fall.

The impact of leveraging through discounts can be dramatic. Gifts are valued based on the “fair market value” of the property transferred. A common scenario is the transfer of property by a parent to a limited liability company followed by gifts of interests to children. The value of the ownership interest transferred is discounted, typically because the recipient does not control the LLC (minority interest discount) and cannot freely transfer the interest received (illiquidity/marketability discount). Discounts can range from 30% to 60% in the value of the gifted interest.

The IRS has litigated discount cases for years. Generally the courts have been receptive to reasonable discounts when the other requisites for transfer of the gifted interests (such as credible valuation and bona fide transfer) have been met. In addition to legislative proposals to change the statute, the IRS continues to focus on the issue. The current suggestion is that the IRS would use the rules of Section 2704 of the Internal Revenue Code to reduce or eliminate discounts for purpose of determining the value of certain gifted interests in family-controlled entities. The scope and application of any rules – including effective dates and any limit on the type of assets to which the rules would apply – will not be known until the IRS formally acts but the public mention indicates that the issue remains on the IRS radar. At a minimum, any rules are likely to be subject to a prolonged period before finalization and possible litigation and have a chilling effect on techniques that have become a standard tool in estate planning.