Long-awaited proposed regulations under section 2704 of the Internal Revenue Code, released on August 2, 2016, would make sweeping and very significant changes to the valuation of interests in many family-controlled entities for estate, gift, and generation-skipping transfer tax purposes. The primary focuses of the proposed regulations are treating the lapse of voting or liquidation rights as an additional transfer and disregarding certain restrictions on liquidation in determining the fair market value of a transferred interest.
In 1990, Congress enacted section 2704 of the Internal Revenue Code, titled “Treatment of Certain Lapsing Rights and Restrictions,” in an effort to limit the valuation discounts for gift and estate tax purposes applicable in the case of intra-family transfers of interests in family-owned, or “closely held,” corporations and partnerships. If an individual and the individual’s family hold voting or liquidation control over a corporation or partnership, section 2704(a) provides, in general, that the lapse of a voting or liquidation right shall be taxed as a transfer subject to gift or estate tax. Section 2704(b) provides, in general, that when an interest in a family-owned corporation or partnership is transferred within the family, if a restriction limits the ability of the corporation or partnership to liquidate and that restriction can be removed by the family, that restriction is disregarded in valuing the transferred interest for gift or estate tax purposes.
Finally, in section 2704(b)(4), Congress authorized Treasury to issue regulations providing “that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor's family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”
Tax professionals have been expecting these regulations for many years. Treasury and the Internal Revenue Service (IRS) have included these regulations as a project in their Priority Guidance Plan every year since 2003. From 2009 until 2012, the regulatory project was supplemented in the Administration’s annual budget proposals by a recommendation that Congress clarify or enlarge Treasury’s regulatory authority to disregard other restrictions, referred to as “disregarded restrictions,” to be measured by standards provided in regulations. This request for legislative action was dropped in 2013 after it failed to gather support. Meanwhile, the section 2704(b) regulatory project continued to appear in every annual Treasury-IRS Priority Guidance Plan.
The Proposed Regulations
The IRS released the section 2704 proposed regulations on August 2, 2016, and they were published in the Federal Register on August 4. 81 Fed. Reg. 51413-51425 (Aug. 4, 2016). If and when finalized, the proposed regulations would:
- Treat as an additional transfer the lapse of voting and liquidation rights for transfers made within three years of death of interests in a family-controlled entity, thereby eliminating or substantially limiting the lack of control and minority discounts for these transfers;
- Eliminate any discount based on the transferee’s status as a mere assignee and not a full owner and participant in the entity;
- Disregard the ability of most nonfamily member owners to block the removal of covered restrictions unless the nonfamily member has held the interest for more than three years, owns a substantial interest in the entity, and has the right, upon six months’ notice, to be redeemed or bought out for cash or property, not including a promissory note issued by the entity, its owners, or anyone related to the entity or its owners;
- Disregard restrictions on liquidation that are not mandated by federal or state law in determining the fair market value of the transferred interest; and
- Clarify the description of entities covered to include limited liability companies and other entities and business arrangements, as well as corporations and partnerships.
If the final regulations are similar to the proposed regulations, taxpayers will have lost a significant estate planning technique, and the tax cost of transferring interests in family-owned entities will increase.
Lapse of Voting or Liquidation Rights
Treasury and the IRS have been concerned that taxpayers are able to structure transfers of interests in a family-owned entity so that the transferees would not individually have the power to liquidate or control the entity but the transferees together would be able to control or liquidate the entity. Thus, the transferor’s right to control or liquidate the entity would not pass to any of the transferees individually and would not be subject to transfer taxes. Because the transferees do not have voting control or the right to liquidate the entity, the values of the transfers for transfer tax purposes are reduced by lack of control or minority interest discounts that could range from 30 to 50 percent or even higher.
Section 2704(a) treats the lapse of a voting or liquidation right in a family-owned entity as a transfer by the individual holding the right immediately before its lapse. The current regulations exempt such a transfer if the rights with respect to the transferred interest are not restricted or eliminated. The proposed regulations would deny that exemption for transfers occurring within three years before the transferor’s death if the entity is controlled by the transferor and members of the transferor’s family immediately before and after the lapse. Although the informal legislative history of section 2704 states that the enactment of section 2704 in 1990 was not intended to eliminate minority or lack of control discounts, the proposed regulations apparently would now have that effect in some cases.
The proposed regulations modify an example in the regulations to illustrate the impact of this provision. An individual owning 84 percent of the stock in a corporation whose bylaws require at least 70 percent of the vote to liquidate gives one-half of the individual’s stock in equal shares to the individual’s three children. The individual in this example gave up the individual’s right to liquidate or control the corporation by making the gift. The example provides that if these transfers had occurred within three years of the individual’s death, the transfers would have been treated as if the lapse of the liquidation right occurred at the individual’s death. The result is tantamount to including in the transferor’s gross estate an additional “phantom asset” that will not qualify for the estate tax marital or charitable deduction.
Disregarding Certain Restrictions on Redemption or Liquidation
The proposed regulations would also make significant changes to the valuation for transfer tax purposes of interests in a family-controlled entity that are subject to restrictions on redemption or liquidation – that is, subject to limitations on the ability of the owner of the interest to require the entity or other owners to redeem or buy out that owner. The overall effect of section 2704(b) is that specified restrictions are disregarded in valuing such an interest for gift or estate tax purposes when that interest is transferred to a family member. Under the proposed regulations, the threshold element of the new type of disregarded restriction is still the fact that after the transfer the restriction will lapse or can be removed by the transferor or any member or members of the transferor’s family. For this purpose, interests held by nonfamily members, which otherwise might give those nonfamily members the power to prevent the removal of a restriction, are disregarded unless those interests have been held for at least three years, represent at least 10 percent of the entity (and 20 percent in the aggregate with other nonfamily members), and can be redeemed by the nonfamily holder on no more than six months’ notice.
But rather than describing the kinds of such lapsing or removable restrictions that will be disregarded in making such valuations, the proposed regulations define those restrictions with reference to the effect they would have on gift or estate tax value. If the effect of a restriction on an interest in an entity is to limit the ability of the holder of that interest to compel liquidation or redemption of that interest on no more than six months’ notice for cash or property equal at least to what the proposed regulations call “minimum value,” then the restriction is disregarded. “Minimum value” is defined as the pro rata share of the net fair market value of the assets of the entity – that is, the fair market value of those assets reduced by the debts of the entity, multiplied by the share of the entity represented by that interest. Because the valuation of interests when those restrictions are disregarded is still a complex matter, these rules do not mean that all interests in entities will necessarily be valued on a “look-through” basis at their pro rata share of the net value of the assets of the entity, but the proposed regulations would certainly move much closer to such a model.
The property for which the interest may be redeemed at the holder’s election cannot include a promissory note or other obligation of the entity, its owners, or persons related to the entity or its owners, except for a note issued by an entity engaged in an active trade or business that, as the proposed regulations state, “is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value on the date of liquidation or redemption equal to the liquidation proceeds.” It is very significant that the proposed regulations specify “market interest rates” and “fair market value,” rather than an “applicable federal rate” or other objective rate determined from published sources and a value inferred from the use of such a rate. This small difference in wording is likely to produce a huge difference in the ease of administration of these new rules.
Restrictions Imposed or Required by Law
Section 2704 exempts restrictions on the owners’ ability to liquidate the entity “imposed or required to be imposed, by any Federal or State law.” The current regulations state that “[a]n applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction” (often referred to as the “default” state law). When section 2704 was enacted and the current regulations were issued, the state law applicable to partnerships granted owners certain rights to liquidate the entity. Since then, state legislatures have tightened their default laws, appearing to support provisions in partnership agreements that more significantly restrict the liquidation rights of the owners. Tax advisors have taken advantage of those state laws to increase the restrictions in partnership agreements so as to decrease the transfer tax value of partnership interests. Because those restrictions were consistent with the default state law, the restrictions were not applicable restrictions and were respected for transfer tax purposes.
The proposed regulations would provide, in effect, that a default state law restriction that may be superseded by the governing documents is not a restriction imposed or required to be imposed by Federal or state law. Because most states allow the governing documents of an entity to override any restrictions on transfer, there will be few if any applicable restrictions that will reduce the value of an interest in a family-controlled entity for transfer tax purposes if the proposed regulations become final.
Although section 2704, when it was enacted, referred only to corporations and partnerships, the proposed regulations would clarify that they also apply to limited liability companies and other entities and business arrangements, as well as corporations and partnerships.
The provisions of the proposed regulations applicable to voting and liquidation rights are proposed to apply to rights and restrictions created after October 8, 1990, but only to transfers occurring after the date the regulations are published as final regulations. The new rules described above under the heading “Disregarding Certain Restrictions on Redemption or Liquidation” will not take effect until 30 days after the date the regulations are published as final regulations.
We expect that there will be significant comments to the proposed regulations and lively discussion at the public hearing scheduled for December 1, 2016. We expect that the earliest the regulations will become final will be sometime in 2017.
Clients who are considering transferring interests in family-controlled entities that are not controlling interests and do not have liquidation rights should consider making the transfers as soon as possible. It is possible, however, that if the client dies within three years of the transfer and after the date that the proposed regulations become final, the client may be caught by the final regulations. The proposed regulations would also apply to determine and measure any gift component of transfers otherwise structured as sales. Likewise, clients who have recently made transfers and die after the regulations are finalized but within three years of the transfer may be caught by the final regulations.
Because of the broad sweep of the proposed regulations, we expect that there will be challenges to Treasury’s authority to adopt them in their present form. Meanwhile, attention should be given to the provisions in existing and future operating agreements and other governing documents and also to the source for payment of the tax on any potential “phantom asset.”