Family Business Valuations: The Discount War Rages On

Take-Away: Just about a year ago the estate planning world sounded an alarm when the IRS published proposed IRC 2704 Regulations that would dramatically curtail valuation discounts associated with closely held family businesses and entities. Families then received something of a reprieve after Treasury and Congress received over 28,000 complaints with regard to those proposed Regulations. In response to this outcry, Congress imposed a moratorium on the use of federal funds to finalize, implement, or enforce the proposed 2704 Regulations. Nonetheless, while the proposed 2704 Regulations are not yet in play, and they may never be effective, existing Tax Code sections can still be used to effectively challenge valuation discounts that are normally claimed for the transfer of interests held in family controlled entities. To be safe, there should always be a legitimate, substantial, non-tax reason for using a family owned entity.

Background:

Proposed Regulations: Last August the IRS published proposed Regulations to implement existing IRC 2704. Those proposed Regulations were intended to cause family controlled entities to be valued without customary valuation discounts [lack of control; lack of marketability of the minority interest that is transferred or retained]. In addition, the proposed Regulations subjected those valuations to some artificial assumptions that would not be imposed on identical entities that were controlled by non-family members, e.g. a presumption that a family member would possess the right to compel (or ‘put’) their interest in the entity in order to be cashed out within 6 months of their receipt of the entity interest. These Regulations and presumptions would not apply to an identical business entity that is owned by non-family members, which would cause an unfair result, since the imposition of the proposed valuation rules would cause family members to pay more in gift taxes or estate taxes than would the owners of identical business entities owned by non-family members.
All Family Owned Businesses Covered: Equally frustrating is that the proposed Regulations do not distinguish between an operating business that is owned by family members and a business entity wrapper like a limited liability company (LLC) or family limited partnership (FLP) which is formed to hold real estate or marketable securities, i.e. often formed solely to create valuation discounts out of thin air simply by using an entity wrapper that restricts the transfer of interests in the closely held ‘wrappered’- However, there are some common entity wrappers, like an LLC that is formed to hold commercial real estate, that have legitimate non-tax business purposes and which are not intentionally used to create artificial valuation discounts, e.g. the LLC is used to limit a member’s personal liability for injuries that occur on the leased commercial premises. Nonetheless, legitimate business entities were lumped into the IRS’ category of abusive entity wrappers that would be denied customary valuation discounts.
Moratorium: Due to the number of complaints that were filed in response to the IRS’ proposed 2704 Regulations, we all took a breath when the implementation of these harsh, arguably unfair, valuation rules were been put on hold by Congress earlier this year when it directly refused to fund the finalization or implementation of those Regulations for the foreseeable future.
Lulled Into a False Sense of Security?: Perhaps, too, we all thought after Mr. Trump’s election that the repeal of the federal estate tax was a foregone conclusion, and that there was far less concern about establishing the fair market value of assets transferred between family members. We now know that the promised tax reform may be a lot longer in coming than we had initially anticipated. Additionally, fair market value principles are still highly relevant, even with the repeal of the federal estate tax, if we continue to have the federal gift tax, or the federal estate tax is replaced with some type of deemed capital gain tax at death that still uses fair market value to determine the deemed gain recognition on the owner’s death. In short, we still have to deal with business or entity valuations even if we get some type of tax reform.
Remember the ‘String’ Provisions: While estate planners have literally been fighting a war over perceived unfair proposed IRS Regulations, there are existing provisions in the Tax Code that can still trap an interest that was transferred during the owner’s lifetime, and bring its value back (pulling the string to bring it back) into the owner’s taxable estate for federal estate tax computations, at their full fair market value. Note that it is the value of the lifetime transferred asset that is included in the transferor’s taxable estate, not the asset itself. This reappearance of a phantom asset’s value in the transferor’s taxable estate can create all sorts of problems if someone else ends up paying the federal estate tax imposed on that phantom value, especially when the asset is owned by an individual who is not a beneficiary of the decedent-transferor’s estate.
IRC 2036: Perhaps the most notable string provision of the Tax Code is IRC 2036. That Code section provides that a lifetime transfer of an asset in which the decedent retained a life estate or the right to the income, possession, or enjoyment of the asset, or the right to designate who will enjoy the asset, including gifts of stock in which voting rights are retained, has its full value included in the decedent’s taxable estate, less any consideration received in exchange for the transferred asset (to avoid double counting of values.
Ladybird Deed Example: The classic example of this string provision and its application is the currently popular Michigan ladybird deed. Assume that I transfer the title to my home to my children, but in the body of the transfer deed I retain a life estate and the power to appoint the property at the time of my death; the home continues its classification as my homestead, and I continue to pay the real property taxes and insurance on the home. Upon my death my children will avoid probate over the home; all they have to do is to record my death certificate with the local Register of Deeds (to prove my death) to vest full title to the home in themselves. The goal, too, is that the taxable value will not be uncapped upon my death because my children receive the title from their father. That said, the full fair market value of the home, now owned by my children, will still be included in my taxable estate for federal estate tax calculations, despite the fact that my estate has no access to the home, nor does my estate possess any right to sell the home and use the sales proceeds to pay my debts or pay my estate tax liability. On the bright side, because I retained the life estate in the home that caused its fair market value to be includible in my taxable estate for estate tax purposes, my children will receive a ‘step-up’ in the income tax basis of the home equal to the home’s fair market value computed as of the date of my death. If my children promptly sell the home after my death, they will pay no capital gains taxes due to the tax basis step-up. [IRC 1014]In sum, IRC 2036 can create estate tax problems for heirs, but it can also provide capital gains tax solution to the same heirs.
Adequate and Full Consideration Exception: Making it a bit more challenging to understand or implement IRC 2036 is the fact that if the transferred asset is treated as a ‘sale’ for adequate and full consideration then the asset’s value is not included in the transferor’s taxable estate- IRC 2036 does not apply. Assume that I transfer marketable securities into an LLC in exchange for LLC units; that transfer is a ‘sale’ which requires a valuation of both the securities transferred to the LLC, and the valuation of the LLC units that I received in exchange for the marketable securities. The valuation of marketable securities is pretty easy to obtain. But what if my transfer to the LLC is not marketable securities, and real property instead, or mineral interests. The IRC 2036 adequate and full consideration test still applies to that asset exchange. If the transferor of the asset does not receive adequate and full consideration in exchange for the transfer of the asset, then the full value of the asset is included in the transferor-decedent’s taxable estate, less the value of the consideration received. Consequently, the application of IRC 2036 to a transferor’s taxable estate pretty much swings on if the transferor received adequate and full consideration, or equivalent value, for the value of the lifetime transferred asset.

Upshot: Even if families do not have to contend with the proposed 2704 Regulations, they still have to keep the Tax Code’s string provisions in mind when they create family owned entities, either those designed to passively hold assets, like a real estate holding LLC, or they set up an operating business where multiple family members are intended to be the owners of that operating entity.

Estate of Powell, 2017 U.S. Tax Court (May 18, 2017): This recent Tax Court decision is a reminder that families still need to be cautious when there are family owned and controlled entities, and more importantly, how ‘bad facts’ will usually lead to bad results when IRC 2036 can be made to apply.

Bad Facts: Son, holding Mom’s Durable Power of Attorney, forms a family limited partnership. Son then, using Mom’s Durable Power of Attorney, transfers $10 million of Mom’s cash and marketable securities to the family limited partnership. Mom then receives a 99% partnership interest in the newly formed family limited partnership, NHP. Mom dies a week later. Mom’s estate tax return includes the 99% limited partnership interests but it claims substantial valuation discounts associated with that 99% interest due to its lack of control of the partnership and the lack of marketability associated with a limited partnership interest included in Mom’s taxable estate.* The bad facts include: (i) virtually all of Mom’s assets are transferred to the partnership- what is she supposed to live on and use to pay her daily living expenses if the partnership now owns all of her assets?; (ii) Son, using Mom’s Durable Power of Attorney, transfers over $10 million of his mother’s assets on a single day, converting liquid assets to an illiquid limited partnership interest- did Mom really intend that her agent-Son could possess the power to transfer all of her assets out of her control using the Durable Power of Attorney that she probably intended to only be used by her Son to pay her bills and to deal with emergency situations?; (iii) only cash and marketable securities were transferred to the partnership- what is the substantial and legitimate non-tax purpose behind transferring cash and marketable securities to a limited partnership? The limited partnership looks more like a wrapper than a business; and (iv) Mom was in poor health, if not already on her death bed, when the transfer of her assets was made by Son to the limited partnership, one week prior to her death- how convenient for Mom to die owning only an illiquid and non-controlling 99% limited partnership interest that was subject to numerous transfer restrictions under the limited partnership agreement! From these bad facts the Tax Court easily found that the sale or transfer of the $10 million in assets in exchange for 99% limited partnership units was not for adequate and full consideration, and thus IRC 2036(a)(2) was applied to reel in the full fair market value of the transferred securities and cash into Mom’s taxable estate.
Tax Court’s Sweeping Conclusions: The Tax Court judge surprisingly also shared some other conclusions in support of this decision. The only owners of the limited partnership were the decedent’s family members. The limited partnership did not conduct any business operations, i.e. it was viewed as strictly a wrapper to hold the cash and securities. While the Son was the general partner of the partnership with control centered in that general partner interest, and the Son arguably had fiduciary duties to all of the other partners, yet the judge concluded that the Son ‘would not have exercised his responsibilities as general partner in ways that would have prejudiced’ his mother’s 99% limited partnership interest. Restated, whether the Son’s fiduciary duties limited his discretion to determine partnership distributions “he owed them almost exclusively to the decedent herself…We conclude that any fiduciary duties that limited Mr. Powell’s discretion in regard to distributions by NHP were illusory and thus do not prevent his authority over partnership distributions from being a right that, if retained by decedent at her death, would be described in section 2036(a)(2).” Accordingly, the Son’s absolute control as general partner over the partnership’s assets was imputed to his mother, albeit retained by her until her death, with the judge pretty much ignoring the general partner’s fiduciary duties to other partners.
‘Family Harmony’: If there is a problem with the Tax Court judge’s Powell decision, since its bad facts were pretty glaring from the start with a predictable outcome for the estate, it was the judge’s suggestion that the voting rights held by family members will be assumed to be exercised ‘in harmony with one another’, and that the voting interests of several family members will be implicitly aggregated to determine who has ultimate control over the family owned entity and thus who holds the right to possess or to enjoy the assets that were transferred to the entity. The Tax Court judge concluded that Son, as general partner, will always dance to the tune his mother played, despite her purported lack of control over the limited partnership and its assets.
Family Attribution: Historically family attribution has not been applied to family owned businesses and entities, which is why (and how) valuation discounts have been applied when multiple family members own an interest in the same entity or business. Family attribution has regularly been rejected by courts in a pure valuation situations, and each family member is considered to be independent to vote his/her interests separate from the other family members without any implicit control or implied understanding that the interests will always be voted as a unit. The lack of family attribution then compels valuation discounts for a lack of control or a lack of marketability for each family member’s separately owned interest in the entity. Powell seems to informally apply some type of family-control attribution among family members, i.e. that they will act in harmony with one another, thus Mom continued to have indirect control over the assets that she transferred into the partnership. The Tax Court judge concluded that the Son would not act in a way, as general partner, that would prejudice Mom’s limited partnership interest in the entity, or the judge presumed that any time Mom needed money she knew it was available from the partnership. This conclusion of family members acting in harmony with one another is a bit of a game-changer for estate planners. Normally federal courts charged with valuing closely held family business interests do not impose family attribution rules, since the presumed attribution inevitably leads to the murky waters of personalities and motives which are too subjective to support objective valuations on which transfer taxes are imposed.
Family Attribution Example: Dad owns 48% of a corporation. Mom owns 48% of the same corporation. Son owns 4% of the same corporation, Mom or Dad’s 48% interests in the corporation will be subject to valuation discounts on their deaths due to the fact that a 48% voting interest is a non-controlling interest in the corporation. If family attribution applied, i.e. family members are viewed as a single unit who act in concert or harmony with one another, then on Dad’s death he will be deemed to control all 100% of the corporation, thus precluding the use of any valuation discounts, even though, on paper Dad controls only 48% of the corporate votes.
Conclusion: The proposed 2704 Regulations are currently on hold, which is a good thing. But if those proposed Regulation had been applied, they would have achieved much the same result as what occurred in the Powell decision, where the Tax Court presumed family harmony [another way of saying family attribution] in order to find the mother’s implicit retained control over the transferred assets, thus triggering IRC 2036 estate inclusion at full value of the decedent’s transferred assets. For clients who consider forming a family controlled entity, it is critically important that they always identify, and whenever possible document, the legitimate, non-tax, business purpose for the entity- estate planning and centralization of management over the transferred assets does not cut it these days. If at the end of the day, the entity appears as nothing more than a wrapper that is designed to create artificial valuation discounts, and the transferor retains, directly or indirectly, control over the assets transferred to the entity, then don’t plan on claiming any valuation discounts, and expect to deal with IRC 2036 when the senior family member dies. If it looks like a duck, walks like a duck, and sounds like a duck, there is a pretty good chance that a judge will call it a duck. A legitimate business purpose, not greed to create valuation discounts out of thin air, should always drive a family’s decision to form an entity.
* Postscript- Read the Durable Power of Attorney: This rendition of bad facts is actually a bit misleading, as there was one final step in the planning process- that also backfired. That last step in the process was that Son, using Mom’s Durable Power of Attorney, also formed a charitable lead annuity trust (CLAT.) Mom’s 99% limited partnership interest was then transferred by Son, again using his Mom’s Durable Power of Attorney to the CLAT. The CLAT directed that any income from the 99% interest would be paid to the family foundation, and upon Mom’s death (remember, she died one week later) the CLAT assets were to then pass out of the CLAT to Mom’s children. The Son argued in the Tax Court that Mom did not even own the 99% limited partnership interest- the CLAT was the owner. The Tax Court judge found that the transfer to the CLAT was voidable, because the Durable Power of Attorney held by Son only gave him the right to make annual exclusion gifts using the Durable Power of Attorney. The transfer of the 99% limited partnership interest exceed the authority given to Son under the Durable Power of Attorney, so consequently Mom up until her death, possessed the right to void the transfer made by her agent. This finding of the Tax Court is a reminder that Durable Powers of Attorney are narrowly construed by courts [state and federal] and if an agent exceeds his/her authority, the transaction entered into by the agent is voidable. The IRS has successfully asserted this argument in the past when agents made lifetime gifts using a Durable Power of Attorney, when no authority to make gifts was contained in the instrument. The lifetime gifts were reeled back into the decedent’s estate, since those gifts were voidable at the moment of the decedent’s death. Thus, if planning is taking place for a disabled or mentally incapacitated principal, make sure that the Agent possesses the necessary scope of authority to actually implement the plan.