New Proposed Regulations Under Code §2704
On August 4, the Treasury Department issued long-awaited Proposed Regulations on valuation discounts for family-owned businesses under §2704 of the Internal Revenue Code (“IRC”). The regulations are out for public comment until the public hearing on December 1, 2016. If adopted, the regulations will become effective on or after the date of publication of the Treasury decision.
The Proposed Regulations will introduce significant changes that eliminate almost all valuation discounts in the family context. These changes clarify the application of IRC §2704 and curb transfer tax valuation discounts used by family-owned businesses. The Proposed Regulations (1) apply to limited liability companies (LLCs) and address what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership, (2) restrict “deathbed transfers” that result in the lapse of liquidation right and clarify the treatment of transfer that creates an assignee interest, (3) refine the definition of the term Applicable Restriction by eliminating the comparison to state law liquidation limitations, and (4) add a new section to address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family.
Valuation discounts have been a staple of estate planning for decades. By creating restrictions on marketability and control, families can reduce the fair market value of interests in corporate entities, such as LLCs, limited partnerships, and corporations. The logic behind the discounts is that a reasonable buyer would pay less for an interest that he cannot control and will have a hard time liquidating. These restricted interests are then transferred to future generations at the reduced value, allowing the transferors to use less of their allotted gift and estate tax exemption.
Restriction of Deathbed Transfers of Liquidation Rights
In order to curtail these family discounts, the Proposed Regulations seek to redefine §2704. Section 2704(a) was enacted in response to a Tax Court ruling that liquidation rights that lapse at death were excluded from the decedent’s estate. IRC §2704(a) prevents this result by applying special rules to value lapsing rights in closely-held businesses. Under these rules, a lapse of rights is treated as a transfer for federal gift and estate tax purposes. If the rights lapse during a person’s lifetime, the lapse is treated as a taxable gift. If the lapse occurs at death, the gross estate of the deceased taxpayer includes the value of the lapsing rights.
Section 2704(a), however, only applies if the entity is controlled by the individual holding the lapsing right and members of that individual’s family. As a general rule, a liquidation right is considered to lapse when it is restricted or eliminated. But the regulations contain an important exception: A transfer of an interest that results in the lapse of a liquidation right is not treated as a lapse if the rights with respect to the transferred interest are not restricted or eliminated. This exception allows taxpayers to transfer liquidation rights during lifetime without having the liquidation rights treated as a taxable gift.
The Proposed Regulations would disallow this exception for all transfers within three years of death. The Treasury argues that by transferring liquidation rights just prior to death, the transferor can value the rights with a large discount, where in reality, there is very little reduction in fair market value because of the impending death. Therefore, any transfers of liquidation rights within three years of death will not be allowed a valuation discount.
Changes under §2704(b)
Section 2704(b) applies to discounts to reduce transfer tax value in family-owned business contexts. It applies when (1) the transferor and her family hold at least 50 percent, by vote or value, of equity in the entity, (2) there is a transfer of a business interest to (or for the benefit of) a member of the transferor’s family, and (3) immediately before the transfer, the transferor and members of the transferor’s family hold control of the entity. If §2704(b) applies than any Applicable Restriction will be disregarded for purposes of determining the value of the transferred interest for transfer tax purposes.
Currently, restrictions that are no more restrictive than those that would apply under state law are not considered Applicable Restrictions under §2704(b) and thus do not adversely affect valuation discounts. State law restrictions in many states are very expansive, meaning that most restrictions in the operating document of the entity are not more restrictive than state law, and are therefore not considered Applicable Restrictions and can be used to justify a valuation discount. The Proposed Regulations seek to redefine §2704(b) by removing the comparison to state law. The Proposed Regulations provide that an Applicable Restriction includes both a restriction imposed under the governing documents and a restriction imposed under local law, regardless of whether that restriction may be superseded by or pursuant to the governing documents or otherwise. This regulation is intended to ensure that a restriction that is not imposed or required to be imposed by federal or state law is disregarded without regard to its source.
New Disregarded Restrictions on Transfers
The Proposed Regulations go further in redefining §2704(b) by creating new categories of restrictions that will be disregarded for valuation purposes. The four new categories are:
- Provisions that limit or permit the limitation of the holder’s ability to compel liquidation or redemption of the interest
- Provisions that limit or permit the limitation of the amount that may be received by the holder of the interest on liquidation or redemption of the interest to an amount that is less than minimum value.
- Provisions that defer or permit the deferral of the payment of the full liquidation or redemption proceeds for more than six months after the date the holder gives notice to the entity of the holder’s intent to have the holder’s interest liquidated or redeemed.
- Provisions that authorized or permit the payment of any portion of the full liquidation or redemption proceeds in any manner other than in cash or property.
The practical effect of the new categories of Disregarded Restrictions is to create a fictional put right for all interests in the family-owned business context unless there is a mandatory state law the precludes the put right. In other words, the restriction on withdrawal of a limited partner is disregarded and all partners are treated as if each partner had the ability to liquidate his or her interest. Each partner is treated as though he or she has the right to be redeemed for full value. This would reduce, and perhaps eliminate, any minority or marketability discount.
Finally, the Proposed Regulations would impose new guidelines for treatment of transfers to non-family members. Any transfer non-family members would be disregarded if, at the time of the transfer, the interest (1) has been held less than three years before the date of the transfer, (2) constitutes less than 10 percent of the value of all of the equity interest, (3) when combined with the interest of other non-family members, constitutes less than 20 percent of the value of all of the equity interests, or (4) lacks a right to “put” the interest to the entity and receive a minimum value.
The new Proposed Regulations will severely impact planning strategies involving valuation discounts for family-owned entities. The Treasury will vote on these regulations on December 1, 2016 and if accepted will probably be implemented beginning January 2017. Clients that have a taxable estate or own a closely held family business will want to talk to an estate planner as soon as possible in order to take advantage of the current allowable valuation discounts.