IRS and the Treasury Department have finally released proposed regulations (REG-163113-02) seeking to restrict valuation discounts long employed by sophisticated closely-held family businesses to reduce or eliminate gift, estate, and generation skipping transfer taxes. A Treasury official has stated that the proposed regulations “close a tax loophole that certain taxpayers have long used to understate the fair market value of their assets for estate and gift tax purposes.” Some of those taxpayers are family entities owning farmland.
Update: On October 4, 2017, Treasury announced that it would be withdrawing these proposed regulations.
The proposed regulations are far reaching and would significantly impact the ability of family businesses to employ strategies to reduce transfer taxes in passing these operations to the next generation.For example, a taxpayer forms a limited family partnership, transfers his assets into that partnership, and then, after some time, begins gifting limited partnership interests in that partnership to family members. As long as each recipient receives only a minority interest in the partnership and as long as numerous regulatory hurdles are crossed, a “lack of marketability” and/or “minority interest” discount has applied to reduce the value of the transfer anywhere from 15 to 35 percent or higher. In many cases, this discount can eliminate any estate or gift tax liability.
IRS has been fighting these transactions for years, arguing that they are abusive. And Congress did curb many of these transactions when it passed IRC § 2704 in 1990 (Part of Chapter 14's Special Valuation Rules). Section 2704 imposes limitations on valuation discounts in the context of family businesses. But current regulations implementing these restrictions are not a model of clarity. And, courts have interpreted the law so as to allow a number of exceptions. New regulations to curtail these concerns have been rumored for years. After several false alarms in the past year, proposed regulations, titled Estate, Gift, and Generation-skipping Transfer Taxes; Restrictions on Liquidation of an Interest, were issued August 2, 2016..
Specifically, the proposed regulations would amend current regulations to (among other changes):
- Address what constitutes control of an LLC
- Address deathbed transfers that result in the lapse of a liquidation right
- Refine the definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations of state law
- Clarify the treatment of a transfer that results in the creation of an assigned interest
- Address restrictions on the liquidation of an individual interest in an entity and the effect of insubstantial interests held by persons who are not members of the family
Following is a high-level summary of these provisions. It does not detail every provision of the proposed regulations.
Control of an LLC
The proposed regulations clarify that IRC § 2704 applies to LLCs and other entities, regardless of how the arrangements are classified for federal tax purposes and regardless of whether the entity or arrangement is disregarded as an entity separate from its owner for federal tax purposes.
IRC § 2704 speaks only of corporations and partnerships. The proposed regulations eliminate ambiguity by setting forth specific rules for LLCs (and "similar" entities, whatever those may be).The proposed regulations provide that in two situations involving LLCs (1. the test to determine control of entity and 2. the test to determine whether a restriction is imposed under state law), the form of the arrangement will be determined under local law, regardless of how the entity is treated for federal tax purposes. The proposed regulations will thus consider three types of entities: corporations, partnerships (including limited partnerships), and other business entities (including LLCs that are not S Corporations) as determined under local law.
The proposed regulations also “clarify” that control of an LLC would constitute the holding of at least 50 percent of either the capital or profits interests of the LLC or the holding of any equity interest with the ability to cause the full or partial liquidation of the LLC. An individual, that individual’s estate, and members of the individual’s family are treated as holding interests held directly through a corporation, partnership, trust, or other entity (including an LLC).
The proposed regulations also impose a bright-line test to eliminate deathbed transfers designed to reduce estate tax. Generally, under IRC § 2704(a)(1), a transfer that results in a loss or restriction of any voting or liquidation right (in a partnership or corporation) is a lapse and is treated as a transfer by the individual by gift (or included in the gross estate if transferred at death). The amount of the transfer is generally the fair market value of all interests held by the individual immediately before the lapse over the fair market value of such interests after the lapse. In other words, if the individual holding the voting or liquidation right immediately before the lapse and members of that individual’s family hold control of the entity both before and after the lapse, the lapse will be treated as a transfer by gift or, in the case of a transfer at death, a transfer includible in the individual’s gross estate. The current regulations provide, however, that a transfer is not subject to this “lapse” rule if the rights with respect to the transferred interest are not restricted or eliminated. For example, under this exception, a lifetime transfer of a minority interest by the holder of an interest with the voting power to compel the entity to acquire the holder’s interest is not a lapse, even though the transfer results in the loss of the transferor’s presently exercisable liquidation right. IRS argues that such transfers occurring on the deathbed of the transferor have minimal economic effects, but result in a transfer tax value that is less than the value of the interest, either in the hands of the decedent prior to death or in the hands of the decedent’s family after death. The proposed regulation seeks to foreclose this result.
Specifically, the regulation amends Treas. Reg. § 25.2704-1(c)(1) to provide that all transfers within three years before the taxpayer’s death that result in the loss or restriction of a voting or liquidation right are considered a lapse, even if the taxpayer’s rights with respect to the transferred interest are not restricted or eliminated. The prior exception continues to apply, but only for those transfers occurring more than three years before the transferor’s death.
Refine the Definition of “Applicable Restriction” by Eliminating Comparison to Liquidation Limitations of State Law
At the heart of IRC § 2704 is IRC § 2704(b)(1), which provides that if a taxpayer transfers an interest in a corporation or a partnership to a family member and the taxpayer and members of his family have control of the entity immediately before the transfer, any “applicable restriction” is disregarded or ignored in valuing the transferred interest. An “applicable restriction” is defined as a restriction that limits the ability of the entity to liquidate, but (after the transfer) will lapse or can be removed by the taxpayer or his family. In other words, the “applicable restriction” doctrine is designed to prohibit marketability discounts if the restriction is little more than a fiction designed to result in a favorable valuation.
Where the enforcement of the provision gets dicey is with the exceptions. IRC §2704(b)(3)(B) excepts from the definition of an “applicable restriction” any restriction “imposed” by federal or state law. Treas. Reg. § 25.2704-2(b) has established that a restriction on the ability to liquidate is not an "applicable restriction" if it is no more restrictive than limitations that would apply under state law without the restriction. Treasury and the IRS state in the preamble to the proposed regulations that current regulations have been “rendered substantially ineffective in implementing the purpose and intent of the law by changes in state laws and other subsequent developments. “
Specifically, states have passed laws designed to be at least as restrictive as the maximum restriction on liquidation that could be imposed in a partnership agreement. For example, many states have legislated that a limited partner may not withdraw from a partnership unless the partnership agreement provides otherwise. As such, the liquidation restrictions in partnership agreements generally do not constitute “applicable restrictions” because they are generally no more restrictive than those under state law. With no applicable restriction to disregard, a valuation discount can be applied.
To prevent this result, the proposed regulations eliminate the § 25.2704-2(b) “more restrictive than the limitations that would apply in the absence of the restriction under local law” exception. They also affirmatively provide that an “applicable restriction” includes a restriction that is imposed under governing documents or local law.
Creation of an Assignee Interest
Some taxpayers have also argued that transferring an interest to an assignee is a way to avoid the finding of an “applicable restriction” under §2704(b). The proposed regulations foreclose this argument by amending Treas. Reg. § 25.2704-1(a) to confirm that a transfer that results in the restriction or elimination of any of the rights or powers associated with the assignee’s interest is a lapse. This is true, IRS explains, regardless of whether the right or power is exercisable by the transferor after the transfer because the statute is concerned with the lapse of rights associated with the transferred interest.
Transfers to a Non-Family Entity
Taxpayers have long avoided the determination of an “applicable restriction” under §2704(b) by transferring nominal partnership interests to a nonfamily member (such as a charity) to ensure that the family alone does not have the power to remove the restriction (one of the statutory requirements of finding an “applicable restriction”). That was the fact pattern in Kerr v. IRS, 292 F.3d 490 (5th Cir. 2002), where—contrary to IRS’ urging—the court ruled that the taxpayers’ marketability discounts were entirely appropriate. The proposed regulations would foreclose this result by providing that an interest of a non-family member is disregarded for purposes of determining the existence of an “applicable restriction” where:
- The interest has been held for less than three years
- The interest constitutes less than 10 percent of the value of all equity interests,
- When combined with the interests of other nonfamily members, the interest constitutes less than 20 percent of the value of all equity OR
- The non-family member lacks a right to “put” the interest to the entity and receive a minimum value
Regulations Identifying Restrictions Not Covered by Section 2704(b)
IRS asserts in the preamble that Congress has given the Secretary broad discretion in IRC § 2704(b)(4) to issue regulations identifying restrictions not covered by the statute that should be disregarded. It is pursuant to this power that the proposed regulation seeks to disregard transfers to non-family entities. It is also pursuant to this power that the proposed regulations identify a new category of “Disregarded Restrictions.” Such restrictions on an owner’s right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse any time after transfer or if the transferor (or family members)--without regard to certain interests held by nonfamily members--may remove or override the restriction. If a restriction is “disregarded,” the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist.
Disregarded restrictions include those that:
- Limit the ability of the holder of the interest to liquidate
- Limit the liquidation proceeds to an amount that is less than minimum value
- Defer the payment of the liquidation proceeds for more than six months OR
- Permit the payment of the liquidation proceeds in any manner other than in cash or other property (other than certain notes)
For purposes of this definition, “minimum value” is the interest’s share of the net value of the entity on the date of liquidation or redemption.
Coordination with Marital and Charitable Deductions
The proposed regulations provide that to the extent the special valuation assumptions of IRC § 2704(b) apply, the same value generally will apply in computing the marital deduction attributable to that interest (although other factors can apply).
Because § 2704(b) does not apply to transfers to nonfamily members, any portion of an entity interest passing to a non-family member under the proposed regulations would be valued without regard to the special valuation assumptions of § 2704(b). Thus, if the non-family member is a charity, the interest generally will have the same value for both estate tax inclusion and deduction purposes.
The proposed regulations are subject to a 90-day comment period. After that time, the IRS can finalize the regulations. Final regulations are effective 30 days after issuance. The proposed regulations state that they will apply to lapses of rights created after October 8, 1990, occurring on or after the date these regulations are published as final. Furthermore, the amendments to §25.2704-2 are proposed to apply to transfers of property subject to restrictions created after October 8, 1990, occurring on or after the date these regulations are published. Section 25.2704-3 is proposed to apply to transfers of property subject to restrictions created after October 8, 1990, occurring 30 or more days after the date these regulations are published as final. It remains to be seen the full impact of these implementation dates, but it appears they will only apply to transfers occurring after any final regulations are implemented.
Although they have been a long time in coming, these proposed regulations will still likely send some shock waves through estate planning offices around the country. We will follow the comments submitted during the comment period and keep you posted as the proposed regulations move forward. It is likely that challenges to the authority of IRS to promulgate portions of these regulations will ensue.