Publication

08 August 2016

IRS Proposed Regulations Seek to Limit Planning Opportunities

Last fall, we alerted our clients to the IRS’s threatened release of new rules imposing additional (and likely unsupported) restrictions on valuation interests in family controlled entities. Well, the IRS wasn’t bluffing. The IRS has now issued the new proposed rules. If these rules are finalized in the current form, families will face severe limits on valuation discounts for transfers of family-controlled entities for federal transfer tax purposes (these include estate, gift and generation-skipping transfer tax). While unknown at this point, these rules may be effective as soon as December 1, 2016 or shortly thereafter. If you or your family are considering making a business succession plan, you should contact your Miller Johnson attorney or one of the attorneys listed on the right hand side of this alert to better understand how the proposed rules affect your succession plan and how to capture the planning opportunities available under current law.

Some Background

Family owned businesses often reflect the legacy and hard work of several generations of family members. Patriarchs and matriarchs often want to transition business ownership and leadership to successive generations. However, the IRS imposes gift, estate and generation skipping taxes on transfers of family owned businesses. These taxes can threaten the operation and even the existence of successful family owned businesses. Succession planning experts at Miller Johnson use numerous sophisticated techniques to transfer business interests to the next generation with limited transfer tax consequences. One important aspect of family succession planning is the appropriate use of valuation discounts. Valuation discounts reflect the economic reality that a minority interest in a closely-held company is not equal to a pro rata share of the company’s underlying assets. As a result, valuation discounts allow families to leverage their gift, estate and generation skipping tax exemptions.

When parents transfer interests in family-controlled entities, discounts may apply for (i) lack of control due to the transferor’s minority interest in the closely held interest and (ii) lack of marketability due to the closely-held interest not being readily sold or traded in the marketplace. Several other types of discounts may also apply depending on the type of security involved. Proper use of valuation discounts can have a powerful impact in estate and succession planning but the IRS especially scrutinizes transactions among family members.

The Internal Revenue Code (the “Code”) has a long history of treating family business transactions differently than other commercial transactions. The new proposed regulations interpret IRS Section 2704 of the Code. This Section, among other things, prevents certain applicable restrictions on the transferred interest from reducing its value for transfer tax purposes. As mentioned in the prior alert, an “applicable restriction” is generally any restriction that limits the ability of the corporation or partnership to liquidate, but does not include any restriction imposed by federal or state law. So, if a restriction in the governing documents of the family business entity limits the ability of the entity to liquidate, but a family member can override that limitation somehow, the restriction is disregarded for purposes of valuation, i.e. limited or no discounts. State laws and the Tax Court have properly limited the applicability of Section 2704(b) over the years.

As noted in the prior alert, many estate and tax planning practitioners believe that legislative action will be required to impose additional restrictions on valuing interests in family controlled entities. But some interpret Section 2704(b)(4) to provide broad legislative authority for the Treasury to issue regulations covering disregarded restrictions. The Treasury apparently agreed with that interpretation.

What Happened

On August 2, 2016, the U.S. Treasury issued proposed regulations under Section 2704 of the Code (published in the Federal Register on August 4) that place new restrictions on the common practice of realizing valuation discounts on transfers of family-controlled entities. Based on commentary heard through the estate planning and tax community, Treasury seems to believe these regulations were necessary to close a tax loophole on what it perceived to be an understatement of fair market value of family controlled interests for transfer tax purposes. And the regulations appear to do just that.

The Proposed Regulations

The proposed regulations are 50 pages long and are available at the following link:
https://www.federalregister.gov/articles/2016/08/04/2016-18370/estate-gift-and-generation-skipping-transfer-taxes-restrictions-on-liquidation-of-an-interest

Most notably, the proposed regulations:

  • Severely limit or eliminate valuation discounts for lack of control, even for operating businesses.
  • Impose new rules on how applicable restrictions are analyzed, specifically with regard to the effect of a lapsing and removable restriction in the hands of the recipient.
  • Implement attribution rules among an individual’s family and estate for purposes of determining control of a closely held entity.
  • Disregard a passive recipient’s involvement in the closely held entity as a basis for any discount.
  • Disregard certain restrictions, including restrictions on liquidation of the closely held entity, if those restrictions are not mandated by federal or state law. For example, Michigan’s Limited Liability Company Act says the Operating Agreement or Articles of Organization control as to restrictions on liquidation. That means the restriction is not mandated—it can be overridden—so it will be difficult to find restrictions that will reduce the value.
  • Treat transfer of a closely held interest within 3 years of death that causes a lapse of certain rights as an additional transfer subject to transfer tax.
  • Include LLCs and other business structures into the grouping of applicable closely held entities subject to the rules (corporations, partnerships and limited partnerships).
  • The effective date of these rules is not uniform and is confusing in application. Some are scheduled to apply for transfers occurring after the regulations are final. Others are scheduled to apply to certain rights and restrictions created after October 8, 1990, but only after the regulations are final. There are other exceptions to these effective date rules as well.

What’s Next?

A public hearing is scheduled in Washington for December 1, 2016 on these new rules, with an opportunity to provide commentary (typically by attorneys and accountants) by November 2, 2016. After the hearing, the rules could be finalized in the form of final regulations, shortly thereafter.

If the proposed regulations are finalized in current form, they would overturn well-settled law that for decades has allowed valuation discounts to be applied to these interests as part of a family’s overall business succession plan. In short, valuation discounts for lack of control would go away, with very little wiggle room to work with to achieve discounts. The result would be less ability to leverage lifetime transfer tax exemptions and a substantial increase in transfer taxes payable at the transfer of the interests, whether during life or at death.

What To Do Now

We don’t know if the proposed regulations will be adopted, changed (perhaps significantly) or remain proposed indefinitely. We are expecting the tax and estate planning community to strongly oppose them and provide constructive comment, which may delay the issuance of final regulations. Some of the authors of this alert are involved in the discussion and criticism of the proposed regulations at the national level, so more information will be gathered in the upcoming months. Given that final regulations do not yet exist and Treasury has broadcasted its position on these types of family-controlled transfers, it’s important for those who want to implement any business succession planning to take action soon. We recommend that you contact your Miller Johnson attorney or one of the attorneys listed on the right to better understand how the proposed regulations affect your succession plan and whether the circumstances warrant implementing the plan before the proposed regulations become final.