United States: Owners Of Family Controlled Entities Must Act Quickly In Light Of New IRS Regulations Attacking Valuation Planning

Chapter 14 of the Internal Revenue Code consists of four Code Sections (Sections 2701 – 2704) designed to close valuation loopholes. Prior to Congress's enactment of Chapter 14 in 1990, estate planners had a host of tools available to discount the values of assets their clients transferred during life and at death. Chapter 14 closed most of those loopholes, but many opportunities for discounts remained, particularly when clients created family limited partnerships or other similar entities. Treasury released Proposed Regulations on August 4, 2016, that threaten to eliminate those discounts as well.

Background

Section 2704 is divided into two subparts: Section 2704(a) and Section 2704(b). Section 2704(a) treats lapsing voting or liquidation rights ("disappearing rights") in family controlled entities as taxable gifts or as transfers includible in a decedent's estate. Section 2704(a) is sometimes referred to as the "Anti-Harrison Rule," because it was enacted in direct response to the Harrison case. Harrison involved a father and his two children, all three of whom held a general partner interest in a partnership. The father also held all of the limited partner interests. Each general partner could liquidate the partnership during life, but this right lapsed on the death of that partner. The father died, and, in determining the estate tax value of his limited partner interest, the Tax Court concluded that his right to liquidate the partnership could not be taken into account because it lapsed at his death. As a result, his partnership interest was valued much lower for estate tax purposes than it would have been had the right to liquidate the company been included in the valuation.

For purposes of Section 2704(a), the amount of the gift (or the amount includible in the estate) is the difference between the value of the interests held before the lapse and the value of the interests held immediately after the lapse. For example, FamBiz, Inc. has one class of stock. Mom owns 60% of the outstanding stock. Her two children each own 20%. FamBiz, Inc. restructures so that Mom's stock is converted into non-voting stock. As a result, Mom transfers significant value to her children. Under Section 2704(a), Mom has made a gift, subject to gift tax, of the difference between the value of her stock before and after the lapse of the voting rights.

Treasury Regulation Section 25.2704-1(c)(1) contains an important exception to Section 2704(a). That Treasury Regulation provides that a transfer of an interest that results in the lapse of liquidation rights is not subject to Section 2704(a) if the rights with respect to the transferred interest are not restricted or eliminated. The effect of this exception is that the transfer of a minority interest by the holder of an interest with the aggregate voting power to liquidate the entity is not treated as a lapse even though the transfer results in the loss of the transferor's presently exercisable liquidation right. For example, FamBiz, Inc. has one class of stock. Mom owns 60% of the outstanding stock of FamBiz, and her two children each own 20%. The Bylaws for FamBiz require at least 50% of the vote to liquidate FamBiz. Mom gives 20% of the stock of FamBiz to her daughter and 20% to her son, leaving Mom with 20% and each of her children with 40%. Section 2704(a) does not apply to the loss of Mom's ability to liquidate FamBiz because the FamBiz voting rights were not restricted or eliminated (they didn't "disappear" – they were simply transferred).

Section 2704(b) seeks to eliminate valuation discounts for certain temporary restrictions on the ability of a corporation to liquidate during a period in which transfers are made. Section 2704(b) states that, if a person transfers an interest in a family business and, immediately before the transfer, the family controls the business, then "applicable restrictions" will be disregarded. The Code defines these "applicable restrictions" to include (1) those restrictions that limit the ability of the corporation or partnership to liquidate and (2) that either (a) will lapse by their terms after the transfer or (b) can be removed after the transfer by the transferor, his estate, or a family member. For example, Doug owns 80% and each of his two children, Chris and Claire, own 10% of a general partnership that requires the consent of all the partners to liquidate. At Doug's death, his partnership interests pass to Chris. In determining the value of Doug's partnership interest for purposes of the federal estate tax, the limitation on liquidation will be ignored because Doug's family members, Chris and Claire, can act together to remove the restriction.

Section 2704(b)(3)(B) (the "state law exception") excepts from the definition of applicable restriction any restriction "imposed, or required to be imposed, by any Federal or State law." Treasury Regulation Section 25.2704-2(b) provides that "an applicable restriction is a limitation on the ability to liquidate ... that is more restrictive than the limitations that would apply under the state law in the absence of the restriction ... a restriction imposed or required to be imposed by Federal or State law is not an applicable restriction." The Tax Court has viewed this language as a regulatory expansion of the statutory exception contained in Section 2704(b)(3)(B).

To avoid the application of Section 2704(b), owners of family controlled businesses have utilized a number of workarounds, including imposing restrictions on an assignee's ability to become a full partner. Additionally, owners of family controlled businesses have used agreements requiring unanimity to remove a liquidation restriction and giving a nominal interest in the partnership to a nonfamily member, such as a charity, to ensure that the family alone does not have the power to remove the restriction. Additionally many states have amended their statutes to provide, for example, that liquidation requires the unanimous consent of all owners unless the agreement provides otherwise. These changes to state law have essentially nullified the state law exception. Because of the perceived erosion of Section 2704, the IRS and Treasury issued Proposed Regulations.

Proposed Regulations

Entities Impacted

Section 2704 discusses interests in corporations or partnerships. The Proposed Regulations clarify that Section 2704 applies to corporations, partnerships, LLCs, and other entities and arrangements that are business entities. The Proposed Regulations also address what constitutes control of a LLC or other entity that is not a corporation, partnership, or limited partnership. Under Proposed Regulation Section 25.2701-2(b)(5)(iv), control of any entity or arrangement that is not a corporation, partnership, or limited partnership would constitute the holding of at least 50% of either the capital or profits interests or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement.

Disregarded Restrictions

While the Proposed Regulations are broad in scope, owners of family controlled businesses and estate planners will likely feel the greatest impact of the Proposed Regulations, if finalized, in a new class of restrictions known as "disregarded restrictions." Disregarded restrictions include those that (a) limit the ability of the holder of the interest to liquidate the interest; (b) limit the liquidation proceeds to an amount that is less than a minimum value; (c) defer the payment of the liquidation proceeds for more than six months; or (d) permit the payment of the liquidation proceeds in any manner other than in cash or other property.1 In the case of a family controlled entity these "disregarded restrictions" will be disregarded if they lapse at any time after the transfer, or if the transferor and family members may remove or override the restriction.

In determining whether the transferor or the transferor's family can remove the disregarded restriction, the Proposed Regulations disregard the interest of a nonfamily member that has been held (a) less than three years before the date of the transfer, (b) that constitutes less than 10 percent of the value of all of the equity interests, (c) that, when combined with the interests of other nonfamily members, constitutes less than 20 percent of the value of all of the equity interests, or (d) that lacks a right to put the interest to the entity and receive a minimum value. If an interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.

The following example, which is taken directly from the Proposed Regulations, illustrates the breadth of the Proposed Regulations:

  • D and D's children, A and B, are partners in Limited Partnership X that was created on July 1, 2016. D owns a 98 percent limited partner interest, and A and B each own a 1 percent general partner interest. The partnership agreement provides that the partnership will dissolve and liquidate on June 30, 2066, or by the earlier agreement of all of the partners, but otherwise prohibits the withdrawal of a limited partner. Under applicable local law, a limited partner may withdraw from a limited partnership at any time, or on the occurrence of events, specified in the partnership agreement. Under the partnership agreement, the approval of all partners is required to amend the agreement. None of these provisions is mandated by local law. D transfers a 33 percent limited partner interest to A and a 33 percent limited partner interest to B.
  • By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on the ability of a partner to liquidate the partner's interest in the partnership that is not required to be imposed by law and that may be removed by the transferor and members of the transferor's family, acting collectively, by agreeing to amend the partnership agreement. Therefore, the restriction on a limited partner's ability to liquidate that partner's interest is disregarded in determining the value of each transferred interest. Accordingly, the amount of each transfer is the fair market value of the 33 percent limited partner interest determined under generally applicable valuation principles taking into account all relevant factors affecting value including the rights determined under the governing documents and local law and assuming that the disregarded restriction does not exist in the governing documents, local law, or otherwise.

This language in the Proposed Regulations could, potentially, lead to the elimination of the lack of control (or minority interest) discount in the family held business context.

Assignees

Individuals were avoiding Section 2704(a), which treats lapses of voting or liquidation rights as deemed transfers, by granting family members these rights as "assignees." The Proposed Regulations amend Treasury Regulation Section 25.2704-1(a) to add "the transfer of a partnership interest to an assignee that neither has nor may exercise the voting or liquidation rights of a partner is a lapse of the voting and liquidation rights associated with the transferred interest." In other words, even if the transferor family member can continue to exercise the voting or liquidation rights associated with the transferred interest, the transfer is treated as a deemed gift that includes the value of the voting and liquidation rights.

Transfer of Minority Interests within Three Years of Death

As discussed above, Treasury Regulation Section 25.2704-1(c)(1) contains an important exception to Section 2704(a), which provides that a transfer of an interest that results in the lapse of liquidation rights is not subject to Section 2704(a) if the rights with respect to the transferred interest are not restricted or eliminated. In other words, if the voting and liquidation rights inherent in the interest a person is selling or gifting are the same as they were in the hands of that person, then Section 2704(a) will not apply. The IRS has felt that transactions such as this, where, in the example above, Mom gifts 20% of her 60% interest to her daughter and 20% to her son leaving her with a 20% interest, are abusive in the deathbed context. As such, the Proposed Regulations would limit this exception by allowing it to apply to only those transfers that occur more than three years before death.

State Law Exception Eliminated

The Proposed Regulations eliminate the state law exception. The preamble to the Proposed Regulations provides that "the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments." With regard to the exception contained in Section 2704(b)(3)(B), the Proposed Regulations clarify that the terms "federal" or "state" only refer to the United States or any state, including the District of Columbia. A restriction is imposed or required to be imposed by law if it cannot be removed or overridden and is mandatory by the applicable law, is required to be included in the governing documents, or otherwise is made mandatory. Even if a restriction may not be removed or overridden directly or indirectly, such restriction will still be an applicable restriction in two situations (such situations are generally those where an otherwise mandatory provision can be avoided).

Operating Business Exception Eliminated

The Proposed Regulations would apply to family-controlled corporations, partnerships, and LLCs, with no exception for those that own operating businesses. We would point out that this is in contrast to President Obama's proposal, which would have eliminated discounts for the valuation of entities other than those conducting active trades or businesses.

Conclusion

In conclusion, because we do not know when the Proposed Regulations will be finalized, persons who are considering gifting or selling interests in family entities should consider implementing such gift or sale in the very near future to take advantage of discounts while they are still available. The Treasury Department has scheduled a public hearing on the Proposed Regulations for December 1, 2016. In our view, any contemplated gift planning should be completed well in advance of this date to provide the greatest flexibility.

Footnotes

1 For these purposes, property does not include a note or other obligation issued directly or indirectly by the entity, other holders of an interest in the entity, or persons related to either. One exception applies to the note of an entity engaged in an active trade or business to the extent that the liquidation proceeds are not attributable to passive assets, the note is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value equal to the liquidation proceeds.

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
Similar Articles
Relevancy Powered by MondaqAI
Moritt, Hock & Hamroff LLP
Kramer Levin Naftalis & Frankel LLP
Ostrow Reisin Berk & Abrams
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Moritt, Hock & Hamroff LLP
Kramer Levin Naftalis & Frankel LLP
Ostrow Reisin Berk & Abrams
Related Articles
 
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
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

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 or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq 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 of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions