Proposed Regulations Anticipated on Further Limiting Valuation Discounts
Introduction: Planning With Valuation Discounts
An important component of effective estate and tax planning for clients is properly utilizing valuation discounts when transferring closely held business interests to family members. When such interests are transferred, the two most common discounts applied to reduce the value of the interest for transfer tax purposes are (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. While utilizing valuation discounts in transactions can be an effective planning tool when done properly, there is tax authority and guidance that severely complicates these transactions.
Revenue Ruling 93-12 and Enactment of Section 2704
Before 1993, the IRS took the position that a minority interest discount was not available in valuing an interest in an entity that was controlled by family members. The IRS then issued Rev. Ruling 93-12 (revoking Rev. Rul. 81-253), taking the position that a family’s control of the entity, i.e. family attribution, would not be considered in valuing the gifts of minority interests. As a result of this ruling, family controlled entities, such as family limited partnerships (FLPs) and limited liability companies (LLCs) became popular estate planning vehicles to help suppress the value of interests being transferred.
Even before Rev. Ruling 93-12 was issued, Section 2704 of the Internal Revenue Code was enacted in 1990 to curtail the use of valuation discounts in connection with transfers of interests in family controlled entities to family members. The worry was that families creating these entities were imposing restrictions on the transferred interests to reduce the value for transfer tax purposes to the transferor without reducing the economic benefit to the transferee family members. Under Section 2704, the transfer of an interest in a partnership or corporation to a family member triggers certain rules that seek to determine whether the transferor’s family controls the entity before the transfer, either via gift or at death. If so, Section 2704(b) prevents certain “applicable restrictions” on the transferred interest from reducing its value for transfer tax purposes.
In general, an “applicable restriction” is 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. Importantly, because of the state law exception, some states have changed their laws so the state law imposes the restriction and is the default. Additionally, several key Tax Court decisions have limited the applicability of Section 2704(b) where a non-family member received an interest, even a minority one, under the rationale that any liquidation required the consent of such non-family member.
Proposed Amendment To Section 2704
Since the inception of family controlled entities, the IRS has attempted to persuade the courts and Congress that these entities have no purpose other than to shrink value and avoid taxes. Despite its persistence, the IRS has had only limited success with valuation challenges under Section 2704(b) to date. Most IRS challenges have relied on the assumption of family attribution. It is anticipated that forthcoming Regulations under Section 2704 will be used as a substitute for what Congress or Courts have been willing to do. These anticipated Regulations were hinted at in a few places, including the Obama Administration’s 2010 – 2013 fiscal year (FY) budget proposals.
The 2013 FY proposal indicated a forthcoming amendment to Section 2704 that would result in further restrictions on or even elimination of valuation discounts on transfers of interests in family controlled entities. The proposal would create an additional category of restrictions that would be essentially “disregarded” when valuing an interest in a family controlled entity. In other words, any identified restriction on an interest would not reduce the value of the interest. The amendment would apply to a transfer of an interest to a family member, if after the transfer, the restriction would lapse or could be removed by the transferor or the transferor’s family. Among other things, the FY budget proposal provided that disregarded restrictions would include restrictions on a transferee being able to become a full-fledged partner or member of an LLC and even limitations on a holder’s right to liquidate that holder’s interest. The latter is more restrictive than the scope of what appears to be addressed through regulations.
The good news is that the FY budget proposal indicated there would be regulation authority to create safe harbors under which the governing documents of a family-controlled entity could be drafted to possibly get around the application of Section 2704(b). Additionally, the FY budget proposal indicated the new legislation would include provisions dealing with the interaction of the marital and charitable deductions, thus, possibly creating increased deductions if the valuation of the interest in the family controlled entity is higher.
Many estate and tax planning practitioners believe that legislative action will be required to impose additional restrictions on valuing interests in family controlled entities. However, some interpret Section 2704(b)(4) to provide broad legislative authority for the Secretary to issue Regulations covering disregarded restrictions. That interpretation may or may not include the authority to issue Regulations limiting discounts for other reasons. Only time will tell.
While there has been quite the buzz in the estate and tax planning community on the anticipated regulations, as of this writing, they have not been released yet. On May 10, 2015, at a panel discussion at the ABA Tax Section Meeting in Washington, DC, Ms. Cathy Hughes, Estate and Gift Tax Attorney of the U.S. Department of Treasury’s Office of Tax Policy, commented that the Section 2704 proposed regulations have been a project that has long been on the IRS priority guidance plan and that they will have a dramatic impact on the valuation of interests in closely-held limited partnerships and limited liability companies transferred to family members.
While practitioners are hopeful to see guidance issued soon, the effective date of the anticipated regulations may pose a perceived deadline on completing transfers in family controlled entities. If and when the proposed regulations are issued, it is not clear when they will be effective. The effective date is important and will create a limited window of time in which to accomplish transfers without being impacted by the regulations. Treasury Regulations are typically effective on the date final regulations are issued. But in very rare instances, proposed regulations provide that they will be effective when finalized, retroactive to the date of the issuance of the proposed regulations. If this is the case with the anticipated Section 2704 Regulations, they would be effective immediately.
If they have not already done so, advisors who are assisting their clients in transferring interests in family controlled entities to family members (or trusts for the benefit of family members) and want to consider utilizing valuation discounts as part of the planning transactions should alert their clients of the anticipated regulations. The rumors about the legislation are not adverse for every client, however. For example, additional limitations on valuation discounts may actually benefit the client and the next generation with higher deductions and basis step up. But for those clients who will clearly benefit from utilizing valuation discounts, prompt action is warranted.