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.

Timing

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.