By Drew Grey, CPA, Partner
Many sophisticated estate planning techniques include gifts, sales, or other transfers to family members that utilize significant discounts on the value of the assets transferred. These discounts can range from 15 percent to 45 percent, or even higher. As a result, significant wealth can be transferred to the next generation at discounted values. Some of these techniques include transfers of fractional interests in real property or business entities such as limited partnerships, limited liability companies, or closely held corporations. The size of the discount depends upon a number of factors, including the entity’s organizational structure and provisions of the partnership or operating agreement and of state law that place restrictions on control of the entity and on marketability.
Standard for Determining Value of Interest. The standard for determining the value of a transferred interest for gift and estate tax purposes under the Internal Revenue Code is the fair market value of the interest at the time of the transfer. Fair market value would be reduced for non-controlling interested or other provisions reducing rights of transfer or other limitations. This standard disregarded family relationships in determining fair market value, until the new regulations have been issued.
Internal Revenue Code Section 2704. Internal Revenue Code was enacted in 1990 to prevent perceived abuses by taxpayers related to provisions in partnership or LLC operating agreements that artificially restricted the ability of a partner or member to force a liquidation of the entity. In these instances, Section 2704 provides that these restrictions are disregarded in valuing the interest being transferred to a family member so that no discount is allowed. Until now, this provision has not been used to disregard restrictions imposed by federal or state law or any commercially reasonable restrictions that would normally be used in an arm’s-length business transaction, which has allowed taxpayers to take advantage of lack-of-control and lack-of-marketability discounts for intra-family transfers of closely held entities.
Challenges by IRS Routinely Disregarded by Courts. Over the years, the IRS has tried to expand the reach of Section 2704 beyond typical liquidation restrictions and has argued that many restrictions (including those currently resulting in discounts for lack of control and lack of marketability) should also be ignored for transfers between family members. In most properly structured transactions, the courts have rejected the arguments by the IRS and permitted the taxpayer to take appropriate discounts on the transfer to family members.
New Proposed Regulations Under Section 2704. Under Section 2704, the IRS was given broad authority to issue regulations to implement the statute’s intent. On August 2, after much anticipation, the Treasury Department issued new proposed regulations under Section 2704. Mark Mazur, Treasury Assistant Secretary for tax policy, said in a statement that the proposed regulations that will, if finalized in their current form, eliminate one-half of the currently available valuation discounts a practice “that certain taxpayers have long used to understate the fair market value of their assets for estate and gift tax purposes.”
The proposed regulations, which attempt to significantly limit the ability to claim valuation discounts, appear to be broad and far-reaching, and could be challenged in light of the legislative history of Section 2704. Some commentators have questioned whether they are within the statutory authority of the IRS. While the validity of the Section 2704 regulations may be challenged by taxpayers on the grounds that the regulations are an abuse of discretion by the IRS and beyond the scope of the type of restrictions prohibited by Section 2704, it will take time to know how the courts view this position.
Before the proposed regulations are adopted as final, interested parties can submit written comments, and a public hearing is scheduled for December 1, 2016. The eventual final regulations may differ from the proposed regulations as a result of the commentary that the IRS receives. It may take time before the final regulations are effective however, given the history of the IRS challenging valuation discounts, planning with family-controlled entities now becomes more problematic. Taxpayers may want to consider completing transactions that could be affected by the new regulations before year-end.
The details of the proposed regulations are important, but the bottom line is that they would appear to eliminate one-half of the currently valuation discounts for family-controlled entity interests, even including active businesses owned by a family. The regulations accomplish this, in part, by expanding the class of restrictions disregarded under Section 2704 to include those under the governing documents and even under state law (regardless of whether that restriction may be superseded by the governing documents).
But there are important exceptions. The proposed regulations do not apply to all entities, depending on the level of family control, and when and to what degree any unrelated parties acquired an interest in the entity. Another exception is a commercially reasonable restriction imposed by an unrelated person providing capital to the entity for the entity’s trade or business.
Moreover, one should keep in mind that the estate tax benefit (at a taxpayer’s death) of valuation discounts are often offset by an income tax cost due to the lower tax basis of the inherited property. Entity interests valued without discounts will obtain a higher “step up” in basis at death.
These new regulations are particularly important in the context of intra-family gifts and sales to effectively reduce the estate tax payable at a decedent’s death. If you are interested in making such gifts and/or sales and believe that you would benefit from such valuation discounts, it is imperative that you act promptly.
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The above is not tax advice for any client or matter; it is provided as a topic of general interest to our readers. Each client’s situation contains unique facts.
If you would like to discuss the implications of this important development for your estate planning, please contact Drew Grey at (818) 995-0090 or at firstname.lastname@example.org to receive advice on your specific matter.