Introduction
Last week, the IRS issued long-awaited proposed regulations under Section 2704 of the Internal Revenue Code. If adopted, they will severely curtail valuation discounts on transfers of interests in family-controlled entities,1 for purposes of estate, gift and generation skipping transfer taxes.
The proposed regulations newly define broad categories of disregarded restrictions on liquidation, which would no longer work to reduce valuation for transfer tax purposes. In so doing, they seek to shut down decades of customary estate planning techniques for family controlled entities. They also newly provide that certain transfers made within three years of death would be treated as made at death and includible in the transferor's gross estate.
The proposed regulations must await a 90-day notice and comment period, and a public hearing scheduled for December 1, 2016, before they may be made final.2 During this time, potentially affected taxpayers who hold interests in family-controlled entities should review their plans, and complete transfers in progress without delay.
Effect of the Proposed Regulations
To illustrate the effect of the proposed regulations, suppose that a parent is the sole shareholder of 1,000 shares of stock of a family controlled corporation, and that a majority vote of all shareholders is required for all transactions. The parent then makes a gift of 500 shares to a child, and holds the remaining 500 shares at death. Under existing law, the parent generally may apply a partial interest discount of 20% or 30% or more, to the value of the stock at the time of the gift, and later to the value of the remaining stock at the time of death.
The proposed regulations, if adopted, would alter this result. Neither the gift value nor the estate value of the stock of the family-controlled corporation would be eligible for a partial interest discount unless the shareholder's restrictions on liquidation meet stringent requirements, for instance, if they are tied to a put right and minimum value (in which case any discount may be negligible); or are mandated by applicable law; or are commercially reasonable nonfamily member restrictions.
For many family-controlled businesses, the loss of the partial interest discount may mean millions of dollars of additional value subject to 40% transfer tax.
Furthermore, under the proposed regulations, the lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor's death is treated as a lapse occurring on date of death, includible in the gross estate. In the example above, if the parent's gift of 500 of 1,000 shares is made within three years of death, the full value of all such 1,000 shares of stock would be includible in the parent's gross estate.3
Key Features of Proposed Regulations
Section 2704 of the Internal Revenue Code imposes special valuation rules on transfers of interests in family-controlled entities, for purposes of gift, estate, and generation-skipping transfer taxes. The proposed regulations make the following adjustments, among others, to the statutory scheme:
1. Covered Entities.
The proposed regulations clarify that Section 2704 applies not only to corporations and partnerships, but also to limited liability companies and all other entities that are business entities for tax purposes within the meaning of Treas Regs. 301.7701-2(a), regardless of how the entity is classified for other Federal tax purposes. Conforming clarifications are made to the definition of "control" of such entities.
2. Three-Year Rule for Lapse of Voting or Liquidation Rights.
As noted above, the proposed regulations provide that the lapse of a voting or liquidation right as the result of the transfer of an interest within three years of the transferor's death, is treated as a lapse occurring on the transferor's date of death, and includible in the transferor's gross estate under Section 2704(a).
3. Expansion of "Applicable Restrictions"
The proposed regulations expand the scope of "applicable restrictions" that are disregarded for transfer tax valuation purposes. Such a restriction will be disregarded unless (i) it cannot be removed or overridden by family members and is mandated by applicable law; or (ii) it is commercially reasonable and imposed by unrelated persons providing capital to the entity for the entity's trade or business operations, whether in the form of debt or equity. If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction does not exist.
4. Newly Defined "Disregarded Restrictions"
The proposed regulations provide that, in the case of a family controlled entity, any "disregarded restriction" on a holder's right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor or the transferor and family members, without regard to certain interests held by non-family members,4 may remove or override the restriction. The proposed regulations define a "disregarded restriction" as follows:
- limits the ability of the holder of the interest to liquidate the interest;
- limits the liquidation proceeds to an amount that is less than a "minimum value";5
- defers the payment of the liquidation proceeds for more than six months; or
- defers the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes of an active operating business.
Without limiting the foregoing, a disregarded restriction includes limitations on the time and manner of payment of the liquidation proceeds.
If a restriction is disregarded, the fair market value of the interest in the entity is determined under generally applicable valuation principles as it assumes that the disregarded restriction does not exist, either in the governing document or applicable law.
In light of the above, a restriction may be respected if:
- each holder of an interest in the entity has an enforceable "put" right to receive, on liquidation or redemption of the holder's interest, cash and/or other property with a value that is at least equal to the minimum value (described above);
- the full amount of such cash and other property must be paid within six months after the holder gives notice to the entity of the holder's intent to liquidate any part of the holder's interest or withdraw from the entity, and
- except in certain cases involving an active operating business,6 such other property does not include a note or other obligation issued directly or indirectly by the entity.
5. Coordination with Marital Deduction
Section 2704(b) applies to intra-family transfers for all purposes relating to estate, gift and generation-skipping transfer taxes. Therefore, to the extent that an interest qualifies for the marital deduction, the same value generally will apply in computing the marital deduction attributable to that interest. The Treasury explanation, but not the text of the proposed regulations, provide that the value of the estate tax marital deduction may be further affected by other factors justifying a different value, such as the application of a control premium.7
6. Coordination with Charitable Deduction
Section 2704(b) does not apply to transfers to non-family members and thus has no application in valuing an interest passing to a charity or to a person other than a family member. It is possible that the same family-controlled interest may have a high value, without a discount, for transfer tax purposes; yet a low value, with a discount, for purposes of the charitable deduction.
Conclusion
As noted above, the proposed regulations require a 90-day notice and comment period, and a hearing scheduled for December 1, 2016, before they may be made final. It cannot be predicted when, or if, they will be made final, or how they may change in response to comments. In the meantime, potentially affected taxpayers should review their plans, and complete transfers in progress without delay.
If adopted in their current form, the proposed regulations will affect all taxpayers who hold interests in family controlled entities, particularly those whose taxable estates exceed the lifetime applicable exclusion amount, which, in the year 2016, is $5,450,000 (to be adjusted for inflation each year, under current law). Such taxpayers will no longer be able to rely on significant valuation discounts to reduce the value of their taxable estates.
If adopted in their current form, the proposed regulations will mark a sea change in estate planning for holders of interests in family-controlled businesses. They will do away with decades of customary techniques, and will require new approaches and new strategies.
[1] For purposes of Internal Revenue Code Section 2704, (i) the term "member of the family" of an individual means a spouse, an ancestor or lineal descendant of such individual or his or her spouse, a brother or sister, or any spouse of any of the foregoing; (ii) attribution applies to interests held indirectly through another entity; and (iii) the term "control" means the holding of at least 50% of vote or value of a corporation; the holding of at least 50% of the profits or capital of a partnership; or the holding of any general partnership interest (the proposed regulations extend these definitions of control to cover any business entity).
[2] If adopted, certain provisions of the proposed regulations will apply to transfers occurring on or after the date they are published as final; and others will apply to transfers occurring 30 or more days thereafter; in each case provided that the transferred property is subject to restrictions created after October 8, 1990.
[3] See Prop. Regs. §25.2704-1(c)(1) and §25.2704-1(f), Example 4.
[4] In determining whether the transferor and/or the transferor's family has the ability to remove a restriction included in this new class of disregarded restrictions, any interest held by a non-family member is disregarded if such interest:
- has been held less than 3 years before the date of the transfer;
- constitutes less than 10% of the value of all of the equity interests;
- when combined with the interests of other non-family members constitutes less than 20% of the value of all the equity interests; or
- lacks a right to put the interests to the entity and receive a minimum value.
[5] For this purpose, "minimum value" is defined as the interest's share of the "net value" of the entity on the date of liquidation or redemption; and the "net value" is further defined as the "fair market value," as determined under section 2031 or 2512 and the applicable regulations, of the property held by the entity, reduced by the outstanding obligations of the entity determined under section 2053 as if they were claims against an estate. The term "fair market value" assumes a cash sale (willing/ able buyer). It may be quite difficult to impose a uniform methodology of determining "minimum value" of family-controlled investment entities, versus family-controlled operating business entities.
[6] In the case of an entity engaged in an active trade or business, at least 60% of whose value consists of the non-passive assets of that trade/ business, and to the extent that the liquidation proceeds are not attributable to passive assets as defined in section 6166(b)(9)(B), such proceeds may include a note or other obligation if such note is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.
[7] Neither the Treasury explanation nor the proposed regulations make any reference to a control discount, although if allowed, the lapsing rules of Section 2704(a) would need to be taken into account.