Due to recently proposed regulations to Section 2704 by the U.S. Treasury Department, high net-worth taxpayers and their advisors need to act now to evaluate the best course forward. The proposed regulations threaten to significantly curtail the application of discounts to intra-family transfers of entity interests, which impact key gift and estate tax planning techniques used for high net-worth individuals.  For wealthy families and their advisors, these proposed regulations call to mind the flurry of wealth transfer planning activity that took place in late 2012.  Advisors are anticipating a very busy fourth quarter working with clients to address the impact of the proposed regulations.

Who Should Act Now

In consultation with their advisors, the following taxpayers should look carefully at their assets to determine whether there are any opportunities to shift substantial value out of the taxpayer’s taxable estate before discounts effectively disappear:

  • Taxpayers whose estates are subject to the imposition of estate tax
  • Taxpayers who have historically made annual gifts of discounted business interests to family members or trusts
  • Taxpayers who have been considering establishing a long term trust for family members to hold business interests
  • Taxpayers who have an existing trust in place for family members
  • Taxpayers who have a need for business succession planning

Next Steps – What to Do and When

The proposed regulations could become final and effective as early as late December 2016 (although a later effective date is more likely) and a hearing on these regulations is scheduled for December 1st. As a result, all family business owners and wealthy taxpayers should take this opportunity to meet with their team of advisors to review their wealth transfer plans and, if additional transfers are warranted, initiate that process as soon as possible. 

The affected taxpayers should consider gifts or sales of discounted business interests to family members or trusts by the end of this year. However, it is important to note that there will likely be a 3-year-look-back on transfers.  These taxpayers should also consider the transfer of discounted entity interests to a trust in exchange for a note or an annuity interest to preserve future planning opportunities.  While it is unclear whether the IRS will require some sort of consistency of valuation for payment of promissory notes and annuity interests, there is the potential that payments could be made with undiscounted interests later, further enhancing the tax savings. 

Background

Many gift and estate tax planners assist their wealthy clients with transferring interests in family-owned entities to other family members and/or trusts. The application of appropriate discounts reduces the value of these interests for gift and estate tax purposes, permitting the transfer of more value for the benefit of the taxpayer’s family at a lower tax cost. 

Internal Revenue Code Section 2704 provides special rules for valuing intra-family transfers of ownership interests in companies. These rules limit the types of restrictions that will be respected in determining applicable valuation discounts for transfer tax purposes.  In response to what it perceived as taxpayers’ abuse of discounts, the IRS has proposed new regulations under which restrictions that previously generated significant discounts would now be disregarded in intra-family transfers. 

It is well established that a savvy buyer of an interest in a business will demand a reduction in price (a “discount”) when the buyer has no control over the business’ operations, no ability to liquidate the interest, and no ready market to re-sell the interest. Nevertheless, the IRS does not believe that the same realities apply when a taxpayer transfers an interest in a family-owned business entity to or for the benefit of family members.  As a result, on August 2, the IRS issued proposed regulations to impose significant restrictions on the application of discounts in the context of family-owned entities. 

Application of the Proposed Regulations

The proposed regulations apply:

  • To any business entity, including a corporation, partnership, LLC or other arrangement. They apply to investment holding companies and operating businesses.
  • When the family of the transferor “controls” the entity. A family controls an LLC when it owns 50% or more of the company, or if the family members, in the aggregate, would have the power to cause the company to liquidate.
  • When an interest in the entity is transferred to or for the benefit of family members.
  • For the purposes of valuing the interest transferred for transfer tax purposes.

Importantly, the new regulations make no distinction between operating businesses and passive holding companies.

Effect of the Proposed Regulations

The proposed regulations provide that a restriction on the ability of an owner of the business to liquidate the entity, in whole or in part, would be disregarded for valuation purposes, if the family could collectively agree to remove that restriction.  

For purposes of determining whether family members can collectively agree to remove a restriction on liquidation, nominal interests held by non-family members are disregarded. The proposed regulations provide that interests held by non-family members are only recognized for this purpose if (a) the non-family member individually holds at least a 10% interest in the company (and has for at least 3 years prior to the transfer), (b) at least 20% of the company overall is owned by non-family members (and has been for at least 3 years prior to the transfer), and (c) each non-family member has a put right to receive at least “minimum value” (discussed below) for his or her interest.  This last requirement is a high hurdle, as it is unusual for investors in a small business to have a right to liquidate their interest at any time.

For valuation purposes, the proposed regulations treat the intra-family transferee of an interest as though he or she could force the company to redeem his or her individual interest within 6 months, even if the right doesn’t actually exist.  Moreover, the proposed regulations require the assumption, for valuation purposes, that the intra-family transferee could force a redemption at a price that is equal to at least the pro rata share of the value of the entity (“minimum value”), paid in cash or in kind (no promissory notes, except for an operating company), again, regardless of whether that is actually the case.

The proposed regulations will also disregard other provisions for valuation purposes. For example, if an interest owner dies and leaves his or her interest to multiple family heirs, the resulting fractionalization of control will not cause the new, smaller interests to be eligible for discounts under the proposed regulations.  The IRS seeks to create a legal fiction where family members always agree with each other, in particular when it comes to family assets.  As many professionals who make their living as fiduciary, probate and trust litigators, mediators and planners know, this is frequently untrue.