Action Item: It is anticipated that Treasury will soon issue new regulations that will affect the valuation discounts applicable to intra-family transfers of interests in closely held entities. It may be advisable to review your personal situation and your estate plan and, if such transfers were being considered or planned, implement them before these proposed regulations are issued.
In an effort to curb perceived abuses in valuation discounts for transfers of interests in family entities, Section 2704 of the Internal Revenue Code (the "Code") was enacted in 1990 as part of new Code Chapter 14. (The other provisions of Chapter 14 deal with certain corporate freeze techniques, grantor retained annuity trusts ("GRATs") and qualified personal residence trusts ("QPRTs"), which have been the topics of prior Alerts, and buy-sell agreements in family contexts.) Code Section 2704(b) provides that if an interest in a family controlled entity is transferred to a family member any "applicable restriction" is disregarded in valuing the transferred interest. It defines "applicable restriction" as a restriction that limits the ability of the entity to liquidate if, after the transfer, such restriction lapses on its own or can be removed by the transferor or any member of the transferor's family, acting alone or collectively. "Family" for this purpose includes the transferor's spouse, the ancestors and lineal descendants of the transferor and the transferor's spouse, the transferor's brothers and sisters, and the spouses of those ancestors, descendants and siblings. (Subsection (a) of Section 2704 deals with lapsing voting and liquidation rights which have been less important in the estate planning context.)
Section 2704(b) was targeted at restrictions commonly employed in shareholders, partnership and operating agreements of closely held entities that were perceived by the government to be included only or primarily to depress the value of interests in such entities for gift and estate tax purposes but which do not actually affect the economic interests of the transferee. Such restrictions would require, for example, a high percentage or all of the shareholders, partners or members (referred to here as "owners," for simplicity) to agree to liquidate the entity, or limit (or eliminate) an owner's ability to sell or transfer his or her interest or limit the rights of transferees to become full owners after the transfer. (Even though the statute refers to the ability of the entity to liquidate, case law and the current regulations have interpreted the statute to apply also to restrictions on an owner's ability to liquidate his or her own interest.) A family controlled entity's operating agreement typically would include restrictions that fall into this category, such as (i) a restriction to preclude transfers that have not been approved by a manager (or that fall outside transfers to members of a carefully circumscribed group), which is desirable to preclude the admission of unwanted owners or (ii) a restriction on the ability of an owner to "cash out" or have her interest redeemed.
As anyone who invests in a non-family controlled hedge fund or private equity structure well knows, such an investment is not freely transferrable, and withdrawal is either precluded or restricted. A minority owner's investment is illiquid and nonmarketable to an extent that directly correlates with the parameters of those restrictions. These restrictions indeed depress freely traded values and valuation experts necessarily take them into account when valuing an interest in an entity subject to those restrictions. Section 2704(b)'s scrutiny is limited to transfers to members of the owner's family where the family controls the entity at the time of the transfer and is deemed able to act together to remove the restriction after the transfer, notwithstanding that different branches of the same family—and often members of the same family branch—do not necessarily act in concert and would not be likely to agree to remove a restriction after a transfer is made.
Section 2704(b) also contains two exceptions, one that is narrow in scope and the other that is, in essence, a safe harbor. The narrow exception provides that a restriction that would otherwise constitute an applicable restriction will not be treated as such if it imposed in connection with financing obtained from an unrelated party. The broader exception applies to any "restriction imposed, or required to be imposed, by any Federal or State law." Consequently, so long as the entity's operating agreement is not more restrictive than what is imposed by state law, the agreement's restrictions will not be "applicable restrictions," and cannot be disregarded for valuation purposes. Many states have enacted taxpayer-friendly legislation to supply default provisions that apply if the operating agreement does not override them. For example, limited liability company laws often provide that there is no inherent right to transfer a membership interest without consent and that if a member does transfer his or her interest, the transferee does not have a right to become a member and is only an assignee with limited rights. Thus, the second exception has essentially swallowed the rule, with the result that Section 2704(b) will apply to fewer situations.
For a number of years, the Obama Administration's budget proposals included proposed statutory changes to restrict or eliminate valuation discounts on transfers of interests in family-controlled entities, and the "Greenbooks" explaining those proposals have outlined some of what was intended to be included if changes were to be made to the statute. The Section 2704 legislative proposal was omitted from the Administration's fiscal year 2014 and 2015 budget proposals. The speculation has been that this reflects the Treasury Department's intention to bypass Congress and instead "legislate by regulation," adding an additional category of restrictions that may be disregarded in determining the value of interests in family controlled entities that are transferred to family members. The basis for this authority stems from Section 2704(b)(4), which provides that the "Secretary [of the Treasury] may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor's family if such restriction has the effect of reducing the value of the transferred interest [for gift or estate tax purposes] but does not ultimately reduce the value of such interest to the transferee." Recently, it has been reported that Treasury official Cathy Hughes said (without specifically addressing the Section 2704 Regulation project) that various Treasury initiatives are likely to be delivered prior to the September meeting of the American Bar Association's Tax Section (which is September 17-19, 2015). It is therefore possible and perhaps likely that proposed regulations under Section 2704 could be issued before the end of the summer.
It is not clear at this time whether such regulations, when issued, will be prospective or retroactive (for example, to the date or the day after the date the proposed regulations are published in the Federal Register). The scope of these regulations and what safe harbors may be included are also areas of uncertainty. Some have suggested that minority discounts will be disallowed or restricted, although the legislative history indicates otherwise. Even so, discounts for lack of liquidity and lack of marketability will likely be impacted and could be significantly reduced.
We recommend that our clients who own interests in family controlled entities review their estate plans and evaluate their personal timeline for giving or selling interests in such entities to family members. Now may be an appropriate time to take action, before the new regulations are published. Note, too, that for some, the elimination of certain discounts will be advantageous. An appreciated asset owned at death receives an adjustment, known as a "step up", in its basis for income tax purposes. This means a beneficiary who receives the asset from a decedent will pay less income tax when he later sells it. For those individuals who do not expect to be subject to estate tax due to the higher exemption from the federal estate and gift taxes—currently $5,430,000 per person—the loss of a discount means a higher value, a larger basis, and a diminished tax burden on the family.
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.