Author: Allison A. Kazarian, Paster & Harpootian, Ltd.
On August 2, 2016, the IRS released proposed regulations under Internal Revenue Code section 2704. If the proposed regulations are finalized as written, they will have a significant impact on the valuation of interests in family-controlled entities for estate, gift, and GST tax purposes due to new limitations on discounts for lack of control.
The proposed regulations, if finalized, will make the following changes to § 2704:
Three-Year Recapture Rule. The proposed regulations narrow the current exception to § 2704(a), which provides that a transfer of an interest resulting in the lapse of a voting or liquidation right is not subject to 2704(a) if the rights associated with the transferred interest are not restricted or eliminated. The proposed regulations adopt a three-year recapture rule. The exception for rights with respect to transferred interests that are not restricted or eliminated continues to apply unless the transfer occurs within three years of the transferor’s death. If a transfer results in the lapse of the transferor’s right to force liquidation and such transfer occurs within three years of the transferor’s death, it will result in a deemed transfer of the value of the lapsed right at the transferor’s death.
Transferee with Assignee Status. The proposed regulations clarify that § 2704(a) applies to lapses of rights resulting from transfers made to assignees that do not participate in management. For example, when a partner in a general partnership dies and under state law the deceased partner’s estate receives an assignee interest entitled to participate in profits but not management, such transfers may still be treated as taxable lapses.
Disregarded Restrictions. Section 2704(b) currently provides that restrictions on liquidation rights shall be disregarded for valuation purposes when an interest of a family-owned business is transferred among family members and the restriction can be removed by the family. The proposed regulations adopt additional “disregarded restrictions,” which include any restriction that (1) limits the interest holder to liquidate or redeem his interest; (2) limits liquidation proceeds to less than a “minimum value” (defined as a pro rata share of the net value of property held by the entity less outstanding obligations of the entity); (3) defers payment of liquidation proceeds for more than six months; or (4) permits payment of liquidation proceeds by a note from the entity or family members unless the note meets certain specifications.
A transfer of an interest that is subject to a disregarded restriction will be valued as if there is no such restriction. However, the “disregarded restriction” will not be ignored for valuation purposes if the entity has nonfamily members that meet the following tests: (1) the nonfamily members have held interest for at least three years; (2) the nonfamily member’s interest is equal to at least 10% of the entity’s equity interests or capital and profits interest (and 20% in the aggregate with other nonfamily members); and (3) the nonfamily member has the right to redeem the interest with six months’ notice for “minimum value” payment.
Marital and Charitable Deductions. The proposed regulations clarify that if restrictions are disregarded for purposes of valuing an interest in an estate, it will also be disregarded when valuing the interest for purposes of the marital deduction. Interests transferred to charity are not subject to § 2704 because § 2704 only applies to family member transfers.
Covered Entities. The proposed regulations clarify that § 2704 applies to corporations, partnerships, limited liability companies, and other entities and business arrangements.
Effective Dates. Comments have been requested, and a hearing is scheduled for December 1, 2016. It is anticipated that final regulations will be issued and take effect sometime in 2017.
The “disregarded restrictions” rules will become effective 30 days after the proposed regulations are finalized.
The provisions related to voting and liquidation rights apply to rights and restrictions created after October 8, 1990, but only to transfers that are completed after the regulations are finalized. However, it is unclear whether the three-year recapture rule will apply to a transfer of interest completed prior to the date the regulations are finalized. Therefore, there is a potential that transfers may be recaptured even if such transfers are made before the regulations are finalized.
Please join the Estate Planning Committee on Friday, October 28, 2016, for a brown bag lunch on Estate Planning for Closely Held Business Owners. Jeffrey W. Roberts and Johanna L. Wise Sullivan of Nutter McClennen & Fish LLP will provide an overview of key issues and planning points that attorneys should keep in mind when engaging in estate planning for a business owner. The program will include an overview of different tax structures (C corporations, S corporations and LLCs), other structural issues (women-owned businesses and business succession planning), and drafting considerations. It also will include a discussion of planning options, including the use of discounted valuations, freezing techniques and liquidity issues. Section 2704 will be discussed.