On August 4, 2016, the Treasury Department released Proposed Regulations that seek to eliminate valuation discounts for interests in family-controlled entities. The impact of these new rules is significant and far reaching, and if adopted in their current form, will drastically alter the landscape of wealth transfer planning for family business owners.
The foundation of many estate planning techniques involves the transfer of fractional, non-controlling interests in family-owned business entities from parents to children and grandchildren, or to trusts for their benefit. By transferring only a non-controlling interest, and placing certain restrictions on the rights and abilities to transfer or liquidate the interest, the fair market value for federal gift and estate tax purposes is often discounted to reflect the non-controlling owner’s lack of control (e.g., inability to influence major business decisions, such as whether to compel distributions or liquidate the entity) and lack of marketability (i.e., the degree of difficulty the interest owner would encounter when trying to sell the interest). Generally, the greater the restrictions, the greater the valuation discount for transfer tax purposes.
Current Section 2704
Congress enacted Internal Revenue Code Section 2704 to prevent families from using valuation discounts to artificially reduce the value of interests in family-controlled entities. Under Section 2704, certain restrictions, known as “applicable restrictions,” are disregarded for valuation purposes if the restriction limits the ability of the entity to liquidate under certain circumstances. Existing regulations, however, provide an important exception whereby restrictions on liquidation that are no more restrictive than those allowable under applicable federal or state law may be used to discount the value of the interest. For example, if a state statute provides that liquidation of an entity requires unanimous consent of all owners unless otherwise agreed upon in the operating agreement, a governing instrument of a family-controlled entity that requires unanimous consent for liquidations would not be subject to the Section 2704 rules because the restriction is allowable under state law. An interest in such entity, therefore, could be subject to an appropriate discount reflecting this restriction. Such restrictions tend to generate significant valuation discounts, allowing interests in family-controlled entities to be gifted among family members with reduced gift and estate tax liability.
The Proposed Regulations
According to the IRS and Treasury, Section 2704 has been rendered “substantially ineffective” by the recent trend of states providing restrictive default liquidation provisions. In response, one of the many changes contained in the Proposed Regulations narrows the exception to only those restrictions that are required to be imposed by federal or state law, and not merely those allowable as default provisions. Because state partnership and corporate laws are largely default rules, and not mandatory, this change effectively removes the existing exception, breathing new life into Section 2704 and rendering valuation discounts more difficult to apply. Of the many changes to Section 2704, the most significant change in the Proposed Regulations is the creation of a new class of restrictions, referred to as “disregarded restrictions,” that must be ignored in determining fair market value of an interest in a family-controlled entity. In particular, this new class includes restrictions that: (i) limit the ability of the owner to liquidate the interest; (ii) limit the liquidation proceeds to any amount less than a “minimum value”; (iii) defer payment of liquidation proceeds for more than six months; or (iv) permit payment of the liquidation proceeds in any manner other than cash or property. In this context, minimum value is essentially the enterprise value multiplied by the ownership percentage. Read as a whole, the Proposed Regulations suggest that an entity’s failure to confer each owner with a “put right” to sell his or her interest within six months for minimum value is a disregarded restriction that must be ignored for valuation purposes. As a result, the right of the owner to liquidate the interest in six months’ time for minimum value will be imputed in valuing the interest even if that right does not actually exist in the governing document. Imputing this right to non-controlling interests would effectively eliminate the minority interest discount.
Suppose an individual owns 100% of a family-controlled LLC with a gross value of US$25 million, and transfers 40% of the company to a trust for the benefit of her children. The undiscounted value of the transfer would be US$10 million. However, since a 40% owner lacks certain valuable rights, such as the ability to force the company to redeem the interest, valuation principles provide that the non-controlling interest transferred to the trust is worth less than the pro-rata value of the underlying business. Under current law, an aggregate discount for minority interest and lack of marketability could equal 40%, producing a gift tax value of US$6 million. After using her federal gift tax exemption of US$5.45 million, she would pay only US$220,000 of gift tax on the transfer. However, if this same transfer takes place after the regulations become final, the interest must be valued as though the owner can redeem the interest for minimum value--or in this case US$10 million--within six months’ notice. Under this assumption, it is likely that any discounts that may still be available could be limited to around 10%, which would produce a gift tax value of US$9 million. In that case, after applying her gift tax exemption, the transfer results in a gift tax bill of US$1.42 million--a staggering difference of US$1.2 million.
Planning for Change
Fortunately, there is still time to act. The new rules do not become effective until the Proposed Regulations are issued in final form, which is expected to occur in late 2016 or early 2017. Note also that the tax and estate planning environment could be further impacted by the result of this November’s election. For family business owners, this presents a closing window of opportunity to make transfers utilizing the full extent of valuation discounts currently available. Please contact a member of the Trusts and Estates group at Arnold & Porter immediately to discuss the impact these changes may have on your current estate plan, and to review the options available to accomplish your wealth transfer objectives in light of the Proposed Regulations.