18 August 2016

Proposed regulations issued impacting valuation of interests in family entities

Jeremy B. Crickard
Partner | US

On August 2nd, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) issued proposed regulations dealing with the special valuation rules under Internal Revenue Code Section 2704. The proposed regulations modify the existing regulation dealing with lapsing (i.e., disappearing) voting and liquidation rights under Section 2704(a) and restrictions on the ability to force a liquidation of an entity under 2704(b), and add a new set of regulations under Section 2704(b) that establish a new type of restriction that will be ignored for valuation purposes, referred to as “disregarded restrictions.” The proposed regulations, if adopted in their present form, would significantly reduce the amount of minority and lack of marketability discounts that could apply when valuing interests in family controlled entities for gift, estate and generation-skipping transfer tax purposes (collectively referred to as “transfer taxes”).

Although the regulations would not be effective until the final regulations are published (and in some cases, 30 days after the final regulations are published), they will apply to lapses of rights and transfers of property subject to restrictions created after October 8, 1990. Therefore, simply creating an entity before the effective date of the proposed regulations will not be sufficient to avoid the application of the new rules. Rather, actual transfers of property before the effective date will be necessary to avoid the application of the new rules.

Because the public hearing on the proposed regulations will not be held until December 1, 2016, it is likely that the final regulations will not be published until after the end of 2016. This gives those clients who would otherwise desire to make transfers of interests in entities to family members the opportunity to create the entity if not already created and then to make gifts or sales of the interests in the entity before the end of 2016.

The first significant change relates to the rules that apply to lapsing voting and liquidation rights. Under existing regulations, a transfer of an interest that reduces the interest below an amount needed to force the liquidation of an entity will not be considered a lapse under Section 2704(a) provided that those interests have been “transferred” rather than “restricted or eliminated.” Consequently, under the current rules the transferor can transfer a small portion of their ownership interest during their lifetime so as to reduce his or her ability to force the liquidation of the entity. As a result, the transferor owns a smaller interest at death (often a minority interest). Under the current rules, such a lifetime transfer would effectively reduce the value at death of the retained ownership interest as long as the transferred interests had the same rights to liquidation as they had before the transfer. Under the proposed regulations, if that same transfer occurs within three years of the transferor's death, the transferred interest will be aggregated with the interests owned at death. This aggregation effectively eliminates the ability to reduce the estate tax value of an interest in a family entity by lifetime transfers that leave the transferor with a minority ownership interest (unless the transferor survives three years from the date of transfer).

The second principal change to the existing regulations deals with “applicable restrictions,” which are essentially restrictions that might be included in a partnership or LLC agreement designed to prevent an owner from forcing the liquidation of the entity. These restrictions on liquidation generally reduce the value of an ownership interest in an entity for federal transfer tax purposes. Under the existing regulations, if such a restriction on liquidation is no more restrictive than what is already provided for under state law, then the restriction is not an “applicable restriction” and will not be ignored for purposes of determining the value of the interest. The proposed regulations would modify the rule so that this exception will only be available if the restriction is mandated by state or federal law. Consequently, if the state's default rule can be overridden by the operative agreement, it will not be treated as imposed by state law.

Finally, the proposed regulations add a new type of restriction that will be ignored when valuing an interest in an entity for federal transfer tax purposes, referred to as a “disregarded restriction.” A disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity. Adding this additional restriction is intended to further reduce certain planning techniques designed to minimize transfer taxes. While there is an exception for a “put right,” even this exception is rather limited since it requires that the party exercising the put right generally must be paid the undiscounted fair market value for their interest and payment in full now must be made within six months. This exception is expanded slightly for entities engaged in a trade or business in that such entities can make payment in the form of a promissory note, but many family entities may have difficulty qualifying for this exception.

In sum, the proposed regulations are aimed at reducing the effectiveness of certain estate planning techniques often used with respect to family entities. While the regulations are presently issued in proposed form only, and they have yet to be finalized, the proposed rule changes if finalized would likely have a substantial impact on planning with interests in family entities. For individuals that are considering doing any planning of this nature it is advisable to speak to your attorney to consider planning options to take advantage of the opportunities afforded by the rules as they currently exist.

Jeremy B. Crickard Partner | San Diego, Rancho Santa Fe

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