On August 2, 2016, the IRS released Proposed Regulations under section 2704 of the Internal Revenue Code of 1986 (“Code”). Those Proposed Regulations, which were published in the Federal Register August 4, 2016, make significant changes to the valuation of interests in most family-controlled businesses or other entities for estate, gift and generation-skipping tax purposes.
If the Proposed Regulations become final in their current form, they would impact private wealth and estate planning in five significant ways:
- Current planning allows discounts to value where the transferee of an ownership interest in a family-controlled entity was a pure assignee of an economic interest (as opposed to a substituted member, shareholder or partner with voting rights). The Proposed Regulations eliminate this planning opportunity.
- Under current law, discounts to value are allowed where the applicable federal or state law provided for restrictions on an owner’s ability to liquidate its ownership interest in an entity as a default rule (that may be superseded by the governing document of such entity). Under the Proposed Regulations, only restrictions on liquidations that are mandated by federal or state law can be taken into account in determining the fair market value of a transferred interest. Because most applicable provisions in state law are default rules, virtually all liquidation restrictions in a partnership or operating agreement would be disregarded in valuing an interest for transfer tax purposes.
- Under current law, the lapse of a voting or liquidation right in a family-owned entity is treated as a transfer by the individual holding that right immediately before it lapses. Under current law, a transfer is exempt from the above rule if the rights with respect to the interests that are transferred are not restricted or eliminated. Under the Proposed Regulations, that exemption will only apply if the lapse of the liquidation or voting right occurs more than three years before the transferor’s death. Under the Proposed Regulations, if there is a transfer, for example, of a minority interest in an entity that causes the transferor to lose the right to liquidate or vote and that transfer occurs within three years of the transferor’s death, then the value of that lapsed right will now be included in the transferor’s estate. So, if an individual holds 90 percent of a family-controlled entity, and makes a gift of a 30 percent interest to each of his three children and dies within three years of that transfer, then that transfer will be treated under the Proposed Regulations as if the lapse of that individual’s liquidation or voting right occurred at the individual’s death. This will result in a “phantom asset” being included in the transferor’s estate for federal estate tax purposes.
- Under the Proposed Regulations, certain restrictions will be disregarded in valuing the interest in a family-controlled entity. These disregarded restrictions are those that limit the ability of the holder of an interest in an entity to:
- Liquidate that interest
- Limit the liquidation proceeds to an amount that is less than a “minimum value” (defined to be fair market value less only outstanding obligations that would be allowable as estate tax deductions under section 2053 of the Code)
- Defer the payment of the liquidation proceeds more than six months, or
- Permit the payment of the liquidation proceeds in any manner other than cash or other property (other than certain notes)
- Under the Proposed Regulations, interests held by non-family members (a technique that is used under current planning to avoid the application of the rules ignoring restrictions on liquidation) will now be disregarded where:
- Such non-family member has held an interest for less than three years before the transfer
- The non-family member’s interest constitutes less than 10 percent of the value of all equity interest, and when combined with the interest of all other persons who are not members of the transferor’s family, constitutes less than 20 percent of the value of all equity interest, or
- The non-family member lacks the right to put the interest to the entity and be paid in cash within six months
Under current planning, non-family members could hold a minimal interest (for example, 1 percent), and under the operative documents be required to consent to any liquidation or redemption of an owner’s interest. Now, under Proposed Regulations, that interest not only has to be held for more than three years, but it also has to be substantial and coupled with a put right for that individual to effectively be paid minimum value (as indicated above) within six months in cash or other property.
Effective Date Public hearing is scheduled for December 1, 2016, for these Proposed Regulations. Proposed Regulations applicable to voting and liquidation rights will only be effective for transfers occurring after the date the regulations are published as final regulations. However, the new rules for disregarding certain restrictions on redemption or liquidation will not take effect until 30 days after the date the regulations are published as final regulations.
Planning Clients who are contemplating transferring interests in entities to family members should consider the timing of those transactions relative to the effective date of the Proposed Regulations. In addition, certain transfers as indicated above could be caught within the three-year net described above. It is not clear, however, under the Proposed Regulations, what happens if the transfer occurs prior to the effective date of the Proposed Regulations and death occurs within three years of the transfer. The Proposed Regulations are “legislative regulations” and are usually given deference by courts as to their effectiveness. Whether or not these Proposed Regulations will retain their current form when finalized – or be challenged after finalization – is unclear at this time. Nevertheless, they are perhaps the most important development in private wealth planning in years.