On August 2nd,  the IRS published its long awaited proposed IRC 2704 Regulations. These proposed rules would make sweeping changes to valuation discounts perhaps almost completely eliminating lack of control discounts with regard to the transfer of an interest in a family owned entity. The IRS has asked for public comment and has scheduled December 1st as the date to hear those public comments. The proposed Regulations are to become effective thirty days after they become final, which suggests that the new rules may become effective sometime in 2017.

Action Step:  If you have clients who are in the process of considering the transfer of an interest in a closely held business to other family members, it would be wise to accelerate that transaction, either by sale or gift, prior to these proposed Regulations becoming final.

History: IRC 2704 was enacted on October 9, 1990. This code section applies, in general, only to closely held family entities. Subsection (a) provides that a taxable event occurs when liquidation or voting rights lapse after a transfer of an interest in the entity; the limitations on liquidation or voting depress the value of the transferred interest but after the transfer they disappear. Under subsection (b) certain restrictions on the ability of the family controlled closely held entity to liquidate, or an interest in the entity to be liquidated or redeemed, are disregarded for estate, gift and generation skipping transfer tax valuation purposes. The IRS is authorized in subsection (b) to publish Regulations that identify other restrictions that also reduce the value of an interest in a family owned or controlled entity will be disregarded, which is clearly the purpose of IRS’s proposed Regulations.

Implications of the Proposed Regulations: The thrust of the proposed Regulations is to virtually eliminate all minority/lack of control valuation discounts for family controlled business entities. The proposed Regulations modify the concept control, they aggregate some transfers within three years of death and at death, and they generally ignore other restrictions on the transfer or liquidation of transferred interests in family owned entities, which greatly curb the use of valuation discounts.

Overview of Some of the Proposed Regulations:  If the proposed Regulations become final:

Expanded Scope of Covered Entities: The description of entities that are covered by IRC 2704 is expanded to cover limited liability companies and ‘other entities or business arrangements’ beyond the statute’s reference to only corporations and partnerships. Now all business and family owned entities are covered, not just corporations or partnerships;

Lapse Treated as Transfer: The lapse of voting and liquidation rights associated with transfers of an interest in a family controlled entity made within three years of the transferor’s death are treated as an additional or second taxable transfer. The lack of control valuation discount is effectively eliminated if the ‘discounted value’ is treated as being transferred later or at death;

Assignee Status Ignored: A valuation discount that is based upon the transferee’s status as a mere assignee, and not an owner or voting participant in the entity, is eliminated. The assignment by a member of an LLC membership interest to an assignee-transferee will not warrant a valuation discount;

State or Federal Law Restrictions Ignored: Restrictions on liquidations imposed by state or federal laws are ignored when the fair market value of a transferred interest is determined. Only those laws that mandate a restriction are to be considered for valuation purposes; default state statutory restrictions on the  liquidation of an entity interest, when a  governing instrument is silent, are to be ignored;

Nonfamily Members in Entity Ignored: If a nonfamily member who is an owner in the entity possesses the ability to block the removal of covered restrictions on transfer or liquidation, that blockage ability will be ignored if that nonfamily member has held the entity interest for less than three years. In addition, the nonfamily members must, in the aggregate, own a substantial interest in the entity even if they owned the interest for more than three years, e.g. 20% or more of all equity interests. The presence of nonfamily owners and their ability to block a liquidation or redemption by family members will no longer be a device that can be used to circumvent these family-owned entity valuation rules.

No Forum Shopping: A handful of states have passed special-entity statutes that are limited to family owned businesses. However, those statutes will not be treated as mandating liquidation restrictions. Family owned or closely held business entities cannot be created in those states that have special family business statutes that contain liquidation or redemption limitations [these are statutes that were primarily put in place for the sole purpose of frustrating the application of IRC 2704(b).]

Deferred Payment of Liquidation Proceeds Ignored: Despite the restrictions in entity governing instruments on transfers or the liquidation of a transferred interest, any governing instrument that defers the payment of liquidation proceeds beyond six months will be ignored. In effect, these Regulations deem a ‘put’ right to the minimum value of the transferred interest, which comes close to its book value. This Regulation will have the effect of eliminating minority discounts (in the absence of a mandatory state or federal law to the contrary.)

Broad Family Attribution: Extraordinarily broad family attribution rules are applied to expand the application of IRC 2704. This enhances the likelihood of finding family control over an entity.

Non-Voting Stock Distinction: Almost all valuation discounts that are associated with the transfer of a non-voting stock in a closely held corporation will disappear. It will be a challenge to apply valuation discounts in valuation-freeze recapitalizations of any family owned entity after the new Regulations are in place.

Two Practical Examples:

  • Deemed Deathbed Transfer: Dad owns 51% of a business. Dad transfers 2% of the business to his son, so Dad owns 49%. If Dad’s transfer to his son is within three years of Dad’s death, a lapse-transfer is deemed to have occurred at the time of Dad’s death. Thus, the drop in value of Dad’s interest attributable to the reduction of Dad’s interest in the business from 51% to 49% [from a controlling interest to a minority interest] is captured on Dad’s death as a deemed second transfer from Dad’s taxable estate to his son. If the transfer of the 2% interest to Dad’s son had occurred more than three years prior to Dad’s death there would be no deemed taxable transfer of the discount amount at Dad’s death.
  • Deemed Put Right: Dad owns a controlling interest in a closely held corporation. Dad gifts 1% of the stock in the corporation to his son. There exists a restrictive stock transfer agreement that limits the transfer of stock in the corporation by a shareholder, e.g. no subsequent transfers of the stock by son for at least two years after the gift. The existence of this restriction on future transfers contained in the restrictive stock transfer agreement arguably diminishes the value of the stock that is gifted to son. However the restrictive agreement’s transfer limitation will now be ignored. The son will be deemed to hold a right to compel the redemption of his gifted stock within six months of his receipt of the gift, regardless of what the restrictive agreement provides. Reading into the entity’s governing document a ‘put’ or redemption right eliminates a minority discount and potentially impacts any claims to assert a lack of marketability discount.
    Thus, the inability of a transferee under a restrictive governing agreement to force the redemption of their interest will be completely disregarded as a value depressing limitation.

Preliminary Conclusions: The proposed Regulations appear to eliminate all minority valuation discounts predicated on a lack of control in closely held entities, which includes an active business as well as passive family owned asset holding entities. The scope of these new valuation rules extends back three years in time once enacted, thus enabling the IRS to attack valuation discounts claimed prior to the time the proposed Regulations become final. Many provisions in state law or entity governing instruments will be disregarded, including: (i) those that limit the ability of the holder of the interest to liquidate that interest; (ii) those that limit or defer the payment of liquidation proceeds [or a partial redemption] longer than six months after the interest is liquidated; (iii) those that permit the payment of liquidation [or partial redemption] proceeds in the form of property other than cash; and (iv) those that limit liquidation or redemption proceeds to less than minimum value as defined by the Regulations. Suggested responses to these proposed Regulations might include some of the following strategies:

  1. Accelerate Succession Planning: Clients who own closely held family owned and operated businesses who are approaching retirement, or who are starting to implement a succession plan, might want to accelerate those plans while the opportunity exists to exploit valuation discounts based upon a lack of control or a lack of marketability.
  2. Review Entity Governing Documents: A review of existing terms of stock purchase agreements,   LLC operating agreements, or comparable entity governing instruments is warranted in light of the proposed Regulations and the expanded scope of applicable restrictions that will now be ignored.
  3. Sales of Interests: The proposed Regulations are intended to prohibit many, if not most, valuation discounts that are associated with a family-owned enterprise transfers. Consequently, the sale of an interest in the entity to family members could be viewed as a bargain sale with an indirect gift to the family member. Pending sales transaction documents should take into account the risk of a subsequent deemed indirect gift of the discounted price/value amount to the family member. Probably a lot more thought will be given to the use of defined-value clauses like those that were successfully used in the Wandry Tax Court case if transferors are uncertain of the impact of these valuation Regulations on the value of the interest that is the subject of the transfer.
  4. Review Estate Planning Documents: With the creation of a second deemed transfer on the death of the transferor within three years of the transfer, attention needs to be given to the allocation of the estate tax liability that may be associated with this phantom
  5. Tenants-in-Common Ownership: IRC 2704 deals solely with family owned Rather than hold title to an asset in an entity, e.g. real estate titled in the name of an LLC, consider taking title to the asset among the family members as tenants-in-common, which form of ownership is not an entity. Or, exploit valuation discounts with the assets that are held by the entity, but not the entity itself, e.g. a family owned LLC owns a 40% tenant-in-common in real estate, where the discount in value applies to the asset, not to the entity interest that is to be transferred. Note, however, that a tenant-in-common agreement among family members might still be classified by the IRS as a partnership entity. Rev. Proc. 2002-22.
  6. Promissory Notes: As noted, IRC 2704 applies to closely held entities. A promissory note is not an Consider the sale of a closely held business interest to an intentionally defective grantor trust (IDGT), perhaps preferred stock in a corporation, in exchange for an installment note given to the transferor. The transferor pays the income tax on the IDGT’s income since the trust is a grantor trust for income tax reporting purposes; thus, some of the transferor’s estate assets will be consumed to pay the income tax on the trust’s income. The transferor has thus converted their closely held entity interest to an installment promissory note, perhaps a note that only pays market-rate interest for several years. That installment promissory will be the subject of substantial valuation discounts, dependent upon the terms of the note and the collateral security for the note’s repayment. The installment note could also be the subject of a grantor retained annuity trust (GRAT) that is created by the transferor.
  7. Former Spouses: Perhaps a closely held business entity was divided in a divorce, and the former spouses each own a substantial interest in the entity. As former spouses they will not be treated as family members for the purpose of applying IRC 2704, yet they may have the same children who could benefit from transfers of the closely held entity. Engaging a former spouse in planning with the entity interest might make sense in a limited number of situations [assuming the former spouses are still able to talk to one another after their divorce!]

We can expect a lot of commentary and debate over the next several months on these proposed Regulations and how they will impact conventional estate planning, especially for small business owners. It is hard to tell if there will be a mad rush, like there was in 2012 when faced with the repeal of sizeable federal transfer tax exemptions, to implement estate plans before the end of 2016, in fear of a sudden change in valuation rules that result when these proposed Regulations become final. It is clear, however, that these proposed Regulations are potentially ‘game-changing’ that clients will need to be made aware of as this year comes to a close.