In May of this year a representative of the United State Treasury Department’s (“Treasury”) Office of Tax Policy addressed the American Bar Association’s tax section meeting. At the meeting the representative indicated that Treasury would issue proposed regulations under Internal Revenue Code § 2704 to address and to curtail valuation discounts related to family owned businesses, most notably family limited partnerships or “FLPs”. As of the date of this article, no such regulations have been issued but estate tax professionals are concerned of what impact new regulations could have on legitimate business and tax planning involving family business succession planning.
In regard to FLPs, a FLP, or a similar family limited liability company, is a partnership typically established by an older generation family member to run and manage a business and/or investment portfolio. Usually the organizing member contributes valuable and/or appreciating-in-value assets to the FLP. The organizing member of the FLP may have many different and legitimate non-tax reasons for creating it, including a desire for liability protection for partnership assets and for the member personally, and/or a need for an entity and its owners to oversee the management and administration of diverse assets on a centralized basis.
Once the partnership is created, the organizing family member may, and often does, sell or gift limited partner interests in the FLP over time to younger family members thereby divesting the older family member of ownership of the partnership and its underlying assets. There is nothing unusual or suspect about passing a family business to family members and the same pattern often occurs with family corporations. The older family member may be a general or managing partner of the FLP. Because non-managing, non-controlling limited partner interests in a closely-held family partnership (or in a corporation as well) are not highly marketable to the general public, the value of the limited partner interests being sold or gifted, or which may remain as a part of the older family member’s taxable estate at death, are subject to discounts to value based mainly upon their lack of marketability and lack of partnership control.
Due to the potential for significant discounts to the value of FLP interests, or other non-partnership business interests, especially in the gift and estate tax arena, the IRS has criticized FLPs as nothing more than tax scams that have no legitimate business purpose and that are designed solely to generate valuation discounts. Where audits of FLPs have revealed a weak business purpose for creating a FLP, unsupportable discount values of FLP interests, or where the founding family member retained too much control over the management and enjoyment of partnership assets, the IRS has had some success in setting aside or reducing FLP valuation discounts and in including the value of previously transferred FLP interests in the transferor partner’s taxable estate. Despite its wins, the IRS has lost many more FLP audit cases where FLPs have legitimate business purposes, discounts taken to the value of FLP interests were supportable, and where the taxpayer partner did not retain taxable control over the FLP or its assets. The biggest roadblock to the IRS is that no one, setting the issue of related parties aside, can dispute that a member of the general public will usually not pay top dollar to become a limited, non-controlling owner in a closely held, private business entity and discounts supporting such accepted reality are valid.
Code § 2704 provides that an “applicable restriction” that may affect, or discount, the value of a family business ownership interest is to be ignored in valuing such ownership interest. Section 2704 applies to all family business entities and not just to FLPs. The statute defines an “applicable restriction” as any restriction that limits the ability of the business entity to liquidate and which restriction either (a) lapses after the ownership interest is transferred (by gift or at death); or (b) can be removed by the transferor or a family member after the ownership interest is transferred (by gift or at death). Id. at (b)(2). A restriction that is imposed by any state or federal law is not an applicable restriction. Id. at (b)(3). Section 2704 has been interpreted to mean that an applicable restriction is a limitation on the ability to liquidate the entity that is more restrictive than what would apply to the entity under state law if the restriction did not exist. Treas. Reg. § 25.2702-2(b). Because an entity will not, by design and/or by applicable state law, have liquidation limitations more restrictive than state law, §2704 will rarely if ever apply. The current presidential Administration, in past budget proposals, has conceded that as is, the statute has limited value as a discount deterrent. The Administration, until recently, has advocated for a legislative amendment to § 2704 to expand the definition of applicable restrictions to include restrictions unrelated to liquidation of an entity.
Section 2704(b)(4) provides Treasury with the authority to issue regulations that identify other restrictions to be ignored when determining the value of transferred interests in family entities but no such regulations have been issued. It is now apparent that the Administration, through Treasury, will issue regulations without further Congressional revision to § 2704.
We do not know what the proposed § 2704 regulations will look like. The regulations will presumably add to the list of discount generating restrictions on family ownership interests that are to be disregarded. The list of disregarded restrictions could include restrictions related to the transferability of acquired ownership interests by family members (i.e., buy-sell provisions) or the ability of an assignee of an ownership interest becoming a full owner of an entity. The regulations could also provide some guidance to as to restrictions to value that may be acceptable to support valuation discounts. It truly is anyone’s best guess at this point.
If the proposed regulations are issued and finalized after public comment, when will they be effective? Typically proposed regulations are not effective until finalized which could be years after they are first issued; however, Treasury has in the past made the effective date of proposed regulations retroactive to the date they were first issued. Given the expansive and controversial impact new § 2704 regulations would have upon the multitude of family owned businesses in America, it is likely that the regulations will not be effective until they are later finalized.
Estate planning professionals should keep an eye on the horizon and be prepared to deal with the regulations if they are issued. The pending regulations present an opportunity to contact family business clients and discuss valuation discounting and non-discounting issues related to the management and succession of their business.
For those clients considering a transfer of business interests, it may be prudent to complete the transfer in the near future to avoid a possible retroactive application of more restrictive Treasury regulations.