Proposed IRS Regulations Could Drastically Change Estate Planning
Published: October 4, 2016
On August 2, 2016, the Internal Revenue Service released the anticipated proposed regulations (REG-163113-02) that would, if enacted, result in a massive disruption in gift, estate and generation-skipping tax planning. In short, the proposed regulations would prevent taxpayers from applying most minority interest discounts and lack of marketability discounts (valuation discounts) to the intra-family gifts of family-controlled private entities. These proposed regulations specifically target the gifting of family limited partnership and limited liability company interests as well as minority interests in family- controlled operating businesses.
The IRS has been trying to mitigate/eliminate the use of valuation discounts in the gifting of intra-family interests in privately-held businesses for decades. Up to this point, the biggest assault by the government occurred in 1990 when Congress enacted Section 2704 of the Internal Revenue Code. The goal of Section 2704 was to eliminate valuation discounts for intra-family gifts in family-controlled entities in situations where the discounts were caused by restrictions in the ability of the entity to liquidate, but the restrictions could be removed by the family. Section 2704 applied to both corporations and partnerships but did not apply to limited liability companies.
The effectiveness of Section 2704 has been less than what the IRS desired due to a combination of the following factors.
Courts have determined that the liquidation restrictions described in Section 2704 apply only to restrictions on the ability to liquidate an entire entity, and not to restrictions on the ability to liquidate a transferred interest in that entity.
The owner of a controlling interest in a family-controlled entity is allowed to make gifts of minority interests to multiple family members without triggering the limitations inherent in Section 2704. In other words, as long as no individual transferee would have the power to liquidate or control the entity (even though the family as a whole would have such control), the gifted interests could be valued using valuation discounts.
Since the passage of Section 2704, a number of states have made changes to state partnership regulations related to liquidation rights of partners that support restrictions on liquidation rights language that are contained in many partnership agreements. These changes in state law allow taxpayers to use valuation discounts without triggering the limitations inherent in Section 2704.
Taxpayers have avoided the application of Section 2704 through the transfer of nominal partnership interests to a nonfamily member to ensure that the family alone does not have the power to remove a restriction. The inability of the family to solely control liquidation of the entity prevents Section 2704 from applying to gifts of minority interests to family members.
Since the passage of Section 2704 in 1990, the use of limited liability companies has skyrocketed. Section 2704 does not apply to limited liability companies.
The IRS is now attempting to implement a set of proposed regulations that will give them an upper hand in fighting valuation discounts for family gifting. The IRS believes that it has the power to implement these new regulations without congressional approval. While the details of the proposed regulations are complex, a summary of the significant changes are:
The IRS has been especially frustrated by “deathbed” transfers of minority interests. The proposed regulations have a bright-line test that states that valuation discounts will not be applicable to any transfer of equity to family members that occurred within 3 years of a taxpayer’s death. The value of the valuation discounts taken when the gift was made will be added back to the value of the estate.
The IRS will now disregard restrictions on liquidation that are not mandated by federal or state law in determining the fair market value of the transferred interest.
Some taxpayers would gift assignee interests to maximize the applicable valuation discounts of gifts to family members. The proposed regulations will disregard valuation discounts applicable to the inherent limitations of an assignee interest.
Unless certain strict conditions are met, the IRS will disregard the ability of nonfamily member owners to block the removal of covered restrictions. These conditions require nonfamily owners to own a substantial interest in the entity, to have owned the interest for at least 3 years, and have the right to be redeemed or bought out for cash or property.
The proposed IRS regulations will now apply to limited liability companies.
There will be a public hearing on the regulations on December 1, 2016. The IRS is accepting written and electronic comments on the proposed regulations through November 2, 2016. According to an IRS pronouncement, some of the elements of the proposed regulations will become effective once the regulations are finalized and other elements will become effective 30 days later.
The proposed regulations, if enacted, will have significant ramifications to the entire estate and gift planning marketplace. While the ramifications will be numerous, we believe the key things to keep in mind include:
The proposed regulations will possibly eliminate a key strategy used in gift, estate, and generation-skipping tax planning.
The proposed regulations will essentially create a new definition of value that does not mirror the reality of many situations. A controlling shareholder of a family-controlled entity can make two identical gifts of minority interests; one to a family member and one to a charity. Under these proposed regulations, the gift to the charity will be eligible for valuation discounts while the gift to the family member will not.
The proposed rule of ignoring valuation discounts on gifts made within 3 years of a transferor’s death will apply to gifts made prior the implementation of the regulations. This means that if the proposed regulations become final as of 12/31/16, gifts made by a donor as long ago as 1/1/14 could be impacted.
We believe that taxpayers and their estate planning professions should seriously consider transfers of family-controlled equity prior to the implementation of these regulations. If the regulations are finalized as proposed, we expect to see a major rush of gifting reminiscent of 2012, when the threat of a lower estate tax exemption prompted many taxpayers to make sizable gifts.
If you have questions on the proposed regulations or their impact on the valuation of a family-controlled entity, please contact one of our valuation experts.