Proposed Regulations and Valuation Discounts
On August 2, 2016, the Internal Revenue Service (“IRS”) issued proposed regulations which, if enacted in their present form, will significantly limit the use of valuation discounts for interests in Family Limited Liability Companies (“FLLCs”) and other family business entities for purposes of estate, gift and generation-skipping transfer tax purposes.
The IRS has scheduled a public hearing on December 1, 2016 to address the proposed regulations, after which the regulations may be revised and then finalized. The IRS anticipates that the new regulations will apply to transfers occurring as soon as thirty days after issuance of the final regulations. Accordingly, wealthy families that have contemplated gifts or other transfers of family business interests to family members would be wise to act before calendar year-end in effecting the transfers, as it is unlikely that the valuation discounts relied on to date can be depended upon to the same extent thereafter.
The Current Law
Historically, valuation discount for lack of control (commonly referred to as “minority interest discount”) and lack of marketability have been available under Internal Revenue Code Section 2704 and applicable case law for transfers of interests in closely-held business entities.
Under IRC Regulations Section 25.2704-2, if an interest in a family business entity is transferred to or for the benefit of the transferor’s family, any “applicable restriction” (one generally imposed by the entity’s operating or partnership agreement) is disregarded in valuing the transferred interest. A restriction is “applicable” only to the extent that (i) either the restriction by its terms will lapse at any time after the transfer, or (ii) the transferor or any members of the transferor’s family can remove the restriction immediately after the transfer. Notably, under current law, an applicable restriction is defined as a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than any limitation that would apply under state law generally, in absence of the restriction. In recent years, many states have revised their statutes governing partnerships and other family business entities to be at least as restrictive as the maximum restriction on liquidation that could be imposed in a partnership or operating agreement. Accordingly, as the provisions of an entity’s agreement restricting liquidation generally prove no more restrictive than those under state law, such provisions do not qualify as “applicable restrictions” under the current federal law.
The Proposed Regulations
The IRS has long presented challenges to the validity of valuation discounts for transfers of family business interests, viewing the asserted discounts as an opportunity for wealthy families to utilize the family business entity not for a legitimate business purpose, but solely to minimize the family’s tax obligations.
The proposed regulations are designed to prevent abuse of these valuation discounts, by closing perceived loopholes under current law and preventing taxpayers from lowering the gift and estate tax value of the transferred family business interests, unless the transferred interests fall within a redefined and narrow framework.
More specifically, if enacted in their current form, the proposed regulations would effect the following changes to current law:
- A new “lookback” period, ignoring transfers of minority interests made within three years of the transferor’s death, if the entity is controlled by the transferor’s family both before and after the transfer.
- In cases in which there will be continued familial control of the closely-held business entity after the transfer, any restriction on an owner’s right to liquidate her or his interest will be a “disregarded restriction” if the restriction will lapse at any time after the transfer, or if the transferor (alone or with her or his family members) may remove or override the restriction.
- These disregarded restrictions would include any restriction that limits the ability of the holder to liquidate the interest; defers the payment of the liquidation proceeds for more than six months; permits payment of the proceeds in a form other than cash or other property (other than certain promissory notes); or limits the liquidation proceeds to an amount less than “minimum value” (defined as the fair market value of the entity less any outstanding obligations of the entity).1
- A bright-line test will be imposed to avoid a fact-intensive inquiry in determining whether a nonfamily member’s interest sufficiently constrains the family’s ability to liquidate the entity or should be disregarded. Specifically, the proposed regulations disregard a nonfamily member’s interest if it has been held for less than three years before the date of transfer; constitutes less than 10% of the value of all of the equity interests; or constitutes less than 20% of the value of all of the equity interests (when combined with the interests of other nonfamily members).
- A movement away from an evaluation of the restrictiveness of governing law for purposes of determining whether an imposed restriction will be disregarded. Specifically, where an imposed restriction is provided for by federal or state law, but not mandated by such, that law will be disregarded where the interest transferred is to a family member.
- A clarification of the business entities at issue, to specifically include partnerships, limited liability companies, S corporations and other business entities.
The proposed regulations are expansive. If enacted as proposed, the new rules would significantly diminish the use of valuation discounts for family business interest transfers. Accordingly, for high net worth families with taxable estates that exceed the federal estate tax threshold (a threshold that may well be rolled back under a new political administration), it is essential that consideration be given to valuation discount planning before calendar year-end. Transfers effected prior to the issuance of the final regulations – documented on a timely-filed gift tax return disclosing the valuation discount and accompanied by a qualified appraisal – should be respected under current law, and will start the three-year gift tax statute of limitations period running.
In addition to reviewing and potentially accelerating gifts of family business interests, planning to ensure that there is sufficient liquidity to pay a potentially higher estate tax for the retained business interests is prudent as well. Working with a valuation advisor to understand the estate tax value of the ownership interests, and reviewing the terms of current legal documents including estate plans, buy-sell agreements, and life insurance ownership and beneficiary structure, can help as well.
1If a restriction is disregarded under the proposed rules, the fair market value of the interest is determined assuming that the restriction did not exist.
To find out more about whether specific estate planning for your tangible personal property makes sense in your situation, please call your attorney at Ruberto, Israel & Weiner and she or he will arrange for a complimentary meeting with one of the attorneys in our Trusts & Estates Group.
This summary is presented for informational and educational purposes only, does not constitute legal advice, and can not be used for the purpose of avoiding tax penalties. Use of this summary does not create an attorney-client relationship and is not a substitute for legal counsel.