Recently proposed Treasury Regulations (“Proposed Regulations”), if enacted as proposed, would curtail valuation discounts that currently reduce the value of certain business interests transferred during life or at death for gift, estate, and generation-skipping transfer tax purposes. The limitation or elimination of these discounts will increase the value of a transfer of certain business interests made during lifetime, or such assets included in a decedent’s estate, in turn using more of a transferor’s lifetime gift exemption or a decedent’s estate tax exemption, or resulting in the imposition of more gift or estate tax if no exemption remains at the time of the gift or at death, as the case may be.
Currently, if a business owner transferred a portion of his or her business, to children or a trust for children, the tax value of such gift would most likely be reduced by certain discounts, such as for the recipient’s inability to participate in management, lack of a ready market for future sale of such interests, and restrictions on the sale or other transfer of such interests; such discounts would often be impacted by restrictions contained in shareholder buy sell agreements, partnership agreements, or in LLC operating agreements on rights to liquidate the interests or rights to vote the interests. These combined discounts, can be as much as 35% to 40%, or more. The transfer tax cost of lifetime transfers or estate inclusion would be higher under the Proposed Regulations if such discounts are limited.
The Proposed Regulations increase the complexity of an already extremely complicated and highly technical area of the tax law. Changes made by the Proposed Regulations would increase the number of transfers during life and at death subject to the Code Section 2704 valuation or estate inclusion rules, by:
- Subjecting LLCs and other business arrangements to Code Section 2704;
- Imposing a new 3-year lookback rule to capture certain “deathbed” transfers;
- Treating assignees (nonpartners) in the same manner as partners for purposes of Code Section 2704;
- Eliminating an exception to the application of Code Section 2704 to governing documents that contain less restrictive liquidation provisions than mandatory federal or state law required liquidation provisions;
- Applying Code Section 2704 to a transferor’s right to liquidate his or her interest in the entity (as opposed to a liquidation right as to the entity as a whole); and
- Disregarding interests owned by nonfamily members in most instances.
The Proposed Regulations modify an existing example to illustrate the new 3-year lookback rule (modifications in italics): D owns 84 percent of the single outstanding class of stock of Corporation Y. The bylaws require at least 70 percent of the vote to liquidate Y. More than three years before D's death, D gives one-half of D's stock in equal shares to D's three children (14 percent to each). Section 2704(a) does not apply to the loss of D's ability to liquidate Y because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D's death. However, had the transfers occurred within three years of D's death, the transfers would have been treated as the lapse of D's liquidation right occurring at D's death. The result of the Proposed Regulation is to include a “phantom asset” (an asset already physically transferred from the transferor’s estate) in the estate of the transferor that will not qualify for the estate tax deferring marital deduction, or the estate tax-eliminating charitable deduction.
As drafted, the Proposed Regulations apply only to applicable restrictions created after October 8, 1990, and, therefore restrictions contained in the governing documents created prior to such date will generally be exempt from the Proposed Regulations. However, any amendment made to a governing document after October 8, 1990 would be subject to the proposed rules.
A public hearing is currently scheduled for December 1, 2016; the Proposed Regulations will not become effective until final regulations are published, which will be at least 30 days from the hearing date. Due to the unexpectedly broad scope of the Proposed Regulations, we expect they will be challenged in court if adopted in their current form. If the Proposed Regulations are adopted without revision, and upheld upon review, certain transfers made within 3 years of death (even those made prior to the issuance of the Proposed Regulations) may be subject to the final regulations.
Whether or not a transfer during life or at death may fall within the scope of Code Section 2704 is factual, and largely depends upon the terms of a business’s governing documents, the type and nature of the business interests being transferred, and the ownership composition prior to and after the transfer.
Accordingly, we encourage family business owners, including family owners of business entities which hold real estate and/or marketable securities, to consider having their governing documents reviewed and completing gifts of certain business interests (including corporations, LLCs, partnerships, and other business arrangements that hold real estate and/or marketable securities) prior to December 31, 2016 to take advantage of current valuation rules.