United States: Proposed Rules Complicate Valuation Discounts On Transfers To Family-Controlled Entities

Treasury and the IRS issued long-anticipated proposed regulations (REG-163113-02) on Aug. 2 that are designed to curb potentially abusive valuation discounts claimed by taxpayers when interests in family-controlled entities (FCEs), such as family limited partnerships (FLPs), are transferred.

For decades, many high-net-worth individuals have used FCEs as part of their estate planning. FCEs are used to organize a family's business and investment activities and can be used as vehicles for transferring family and business assets to the next generation, while addressing both tax and nontax issues. The government, however, has been wary of individuals' using FCEs to artificially lower their gift, estate and generation-skipping transfer (GST) tax burdens by claiming (what are in the government's view) unwarranted discounts. The proposed regulations were issued to address this concern, and if they are finalized, the proposed regulations could materially increase the transfer tax value of interests in these entities and dramatically affect the estate plans of many high-net- worth families.

In addition to the significant changes discussed below, the proposed regulations make minor clarifications to existing regulations under Sections 2701 and 2704, which govern the valuation rules of transfers of certain interests in corporations and partnerships, and the treatment of certain lapsing rights and restrictions. The existing regulations refer to only corporations and partnerships. The clarifications of the proposed regulations make it clear that Sections 2701 and 2704 also apply to "newer" types of entities, like limited liability companies (LLCs).

Lapsed voting or liquidation rights

Section 2704(a) treats the lapse of certain voting or liquidation rights as a transfer by gift or at death. This provision was designed to overrule the outcome in Estate of Harrison v. Commissioner, T.C. Memo 1987-8 (Jan. 6, 1987), where a liquidation right lapsed at the decedent's death, reducing the estate tax value of the decedent's interest.

The existing regulations exempt from Section 2704(a) lapses where the individual and his or her family "control" the entity both before and after the transfer. The proposed regulations would add a requirement that the lapse not occur within three years of the transferor's death. This means a lapse of voting or liquidation rights could retroactively become subject to the Section 2704(a) valuation rules if an untimely death occurred, resulting in the value of the deemed to transfer to be added to the transferor's gross estate.

The following example illustrates how the proposed regulations might apply:

Angela owns 84% of the single outstanding class of stock of Angela's Pasta, Inc. The bylaws require at least 70% of the vote to liquidate the company. Angela gives half of her stock to her three children (14% to each). Because the family's ability (acting as a group) to liquidate Angela's Pasta exists both before and after the gifts, Section 2704(a) does not apply to Angela's liquidation of the company. However, if Angela died within three years of making the gifts, the lapse of her ability to liquidate Angela's Pasta would be treated as the lapse of her liquidation right occurring at her death.

If the liquidation value of her 84% interest was $15 million (the estimated value she would have received upon liquidation using date-of-death values) and the value of her 84% interest valued as a going concern (with no ability to compel liquidation) was $13 million, the difference of $2 million (the value of the liquidation right that lapsed) would be added to her gross estate. At a 40% tax rate, this would increase the estate tax by $800,000.

The proposed regulations do not say whether date-of-gift or date-of-death values should be used for valuing the lapse that is added to the gross estate. However, since the example in the proposed regulation states that the lapse is to be treated as occurring at death (not just that the value of the lapse is added to the gross estate), it is reasonable to conclude that date-of-death values should be used.

Disregarding liquidation restrictions

Section 2704(b) disregards certain restrictions on liquidation for transfer tax valuation purposes. The existing regulations exempt restrictions that are no more severe than would apply if the governing instrument were silent on the issue. For example, if the governing instrument requires unanimous consent before an FCE can be liquidated and, without this provision, state law would require only a majority of the interests vote for liquidation, the lower state law voting threshold would be used to value the transferred interest.

The proposed regulations include two new rules that greatly increase the reach of Section 2704(b). The first all but eliminates the state law exception described previously. Under this rule, the state law exception does not apply if the family, acting together, can remove the restriction before or after the transfer. For example, if the family can amend the document to remove the restriction, the restriction is ignored for valuation purposes. In addition, the state law exception does not apply if state law allows another form of entity that could have been adopted and that does not have the exception. For example, some states have "close" corporations, partnerships or LLCs in which ownership is restricted by law to the family of the original owners. Because state law provides for a different form of corporation, partnership or LLC that does not have a statutory limitation on who may own them, the new rule appears to require the close entity restrictions be ignored for valuation purposes.

The second new rule of the proposed regulations under Section 2704(b) requires that the valuation of the FCE interests be made assuming that the interest owner has a right to have the interest redeemed in cash for its pro rata share of net assets within six months. While the proposed regulations provide some limited exceptions to this rule, the effect of this new rule would be to eliminate virtually all valuation discounts. That is, most interests could never be valued for less than liquidation value (less a discount for the time value of money).

This would appear to be an odd result, because in discussing the reach of Section 2704, Congress said that "[t]hese rules do not affect minority discounts or other discounts available under present law." See H.R. Conf. Rep. No. 101-964, 2374, 2842 (Oct. 27, 1990).

By eliminating marketability, lack of control and other valuation discounts, the proposed regulations significantly depart from the willing-buyer/willing-seller definition of fair market value. Instead, the proposed regulations substitute an artificially high value based on a theoretical liquidation value that no one holding the interests would have a right to receive. If the regulations are adopted in their proposed form, it may become more difficult to transfer family business and investment entity interests to successive generations. The proposed regulations may create an economic incentive to transfer such assets outside the family, rather than subject those assets to transfer tax at an artificially high value.

The following example illustrates how the proposed regulations might apply:

Frederic and his two children are partners in Freddy's Fenders, a retailer of classic cars. Frederic is a 98% limited partner, and his two children are each 1% general partners. The partnership was formed on July 1, 2016, and the partnership agreement provides that Freddy's Fenders will dissolve and liquidate on June 30, 2066, or by the earlier unanimous agreement of the partners. A partner may not withdraw from the partnership before the partnership terminates. Frederic dies, leaving his 98% limited partnership interest equally to his children.

By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on Frederic's ability to liquidate his interest in the partnership that is not required by law and that may be removed by Frederic's family, acting collectively, by agreeing to amend the partnership agreement. Therefore, Section 2704(b) requires the restriction to be disregarded in valuing Frederic's interest in Freddy's Fenders for estate tax and GST tax purposes.

The total date-of-death value of Freddy's Fenders (fair market value of all the assets less liabilities) is $25 million. The fair market value of Frederic's 98% limited partnership interest, reflecting a 35% total discount for lack of control and lack of marketability, is $15,925,000. Under Section 2704(b) (as interpreted by the proposed regulations) the estate tax and GST tax value of Frederic's interest is $24,500,000 (98% of $25 million). This represents an increase of $8,575,000 of value above the interest's fair market value and would increase the estate tax by $3,430,000, assuming a 40% tax rate.

Family-controlled entities and estate planning

FCEs are useful tools in addressing many of the tax and nontax issues high-net-worth families confront as part of their estate planning. For example, an FLP might permit a high-net-worth couple to transfer ownership in family assets to their children while transitioning control over the management of those assets over a period of years. This addresses the need to groom the rising generation in sound management of the family's wealth while shifting some of the benefits from the wealth.

From a tax perspective, the use of an FLP is advantageous because under current law the interests transferred are subject to valuation discounts for lack of control and lack of marketability. This can materially reduce the tax the family will ultimately pay on the transfer of wealth to subsequent generations.


The amendments to Treas. Reg. Sec. 25.2701-2 are proposed to be effective on and after the date the proposed regulations are finalized. The amendments to Treas. Reg. Sec. 25.2704-1 are proposed to apply to lapses of rights created after Oct. 8, 1990, occurring on or after the date the proposed regulations are finalized. Similarly, the amendments to Treas. Reg. Sec. 25.2704-2 are proposed to apply to transfers of property subject to restrictions created after Oct. 8, 1990, occurring on or after the date the proposed regulations are finalized. The amendments to Treas. Reg. Sec. 25.2704-3 are proposed to apply to transfers subject to restrictions created after Oct. 8, 1990, occurring 30 or more days after the date the proposed regulations are finalized.

Next steps

If high-net-worth individuals are contemplating using an FCE as part of their estate planning, they should consider making the transfers before Dec. 1, 2016. In addition, if FCEs have been used in prior planning, those structures should be carefully reviewed in light of the proposed regulations. The new rules can trigger additional taxes even if no additional transfers are made after the rules become effective.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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