IRS Proposes New Rules Designed to Restrict Valuation Discounts in Family Transfers

Partnerships and LLCs are common choices of entity for family-owned businesses, due to their flexibility and the many uses to which they can be put – including pooling of family assets, succession planning, asset protection, and confidentiality of ownership.

The transfer of partnership and LLC interests among family members is subject to gift and estate tax based on the fair market value of the interests. Valuation discounts are typically applied to reduce the value (and thus the tax cost) of the transferred interests because of various restrictions imposed on the interests that result in a lack of marketability, a lack of control, and restrictions on liquidation. Section 2704 of the Internal Revenue Code was enacted with the goal of limiting these discounts, typically in the context of family limited partnerships.

Under Section 2704(b), if there is a transfer of an interest in a family-controlled entity to a family member, then restrictions on liquidation of the entity that either lapse after the transfer or may be removed by the transferor or family members (“applicable restrictions”) may not be taken into account in applying discounts. There are certain exceptions to this. “Applicable restriction” does not include “any restriction imposed, or required to be imposed, by any Federal or State law,” even including state law restrictions that can be overridden in the entity’s governing documents.  Further, in determining whether the family can remove the restriction after the transfer, interests in the entity owned by non-family members are taken into account. Taxpayers have commonly avoided these rules by transferring a nominal interest to a non-family member to ensure that the family alone does not have the power to remove what would otherwise be a disregarded restriction.

On August 2, 2016, the Treasury Department (IRS) issued proposed regulations under Section 2704 with the goal of curtailing valuation discounts. The proposed regulations closely mirror a legislative initiative begun back in 2009 but subsequently abandoned.  The proposed regulations now (i) expand the definition of family control, (ii) impose new restrictions on “deathbed” transfers and  (iii) add a new class of “disregarded restrictions” that will be ignored if, after the transfer, the restriction will lapse or may be removed—without regard to certain interests held by nonfamily members—by the transferor or the transferor’s family. The disregarded restrictions could have a dramatic effect on lack of control and lack of marketability discounts and sharply reduce the exceptions currently available under “applicable restrictions.”

Control

The proposed regulations provide that control of a business arrangement or an entity (i.e., a corporation, partnership, or LLC) means (i) the ownership of at least 50% of the capital or profits interests of the entity, or (ii) ownership of any equity interest that has the ability to cause the full or partial liquidation of the entity. Interests held indirectly and through family members are aggregated with an individual’s interest to determine whether this threshold is met.

Deathbed Transfers

The current regulations permit the lapse of voting or liquidation rights if the lapse occurs as a result of a transfer and, following that transfer, those interests retain the voting or liquidation right. A flaw in this rule is that it allows a transfer by which the transferor loses his or her controlling interest (such as a transfer that leaves the transferor with an interest below the level required to be able to force liquidation of the entity) in an entity to escape transfer taxation on the loss of this right. The proposed regulations limit the exception to lifetime transfers occurring more than three years before the death of the transferor. For transfers occurring within three years of death, the value of the lapsed interest will be includible in the transferor’s estate for estate tax purposes. The value included in the transferor’s estate would not qualify for a marital or charitable deduction.

Disregarded Restrictions

The inclusion of new “disregarded restrictions” is the most expansive change in the proposed regulations, and shift the focus not to the type of restriction but to their effect. A “disregarded restriction” as defined by the new rules includes one that: “(a) limits the ability of the holder of the interest to liquidate the interest; (b) limits the liquidation proceeds to an amount that is less than a minimum value; (c) defers the payment of the liquidation proceeds for more than six months; or (d) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes” tied to an active trade or business. In determining whether the disregarded restrictions can be removed by the family, interests of unrelated parties will be generally ignored.  Likewise, state law restrictions on liquidation that are not mandatory will now be ignored. Intra-family transfers of family-controlled entities will be valued assuming the holder has a six-month put option to sell the interest to the entity at the “minimum value” in return for cash or property (other than promissory notes, in certain situations). Minimum value is defined as a pro rata share of the “net value of the entity,” which is further defined as fair market value of the property held by the entity, reduced by the outstanding obligations of the entity.

Effectiveness/Conclusions

The IRS has scheduled a December 1st public hearing on the new proposed regulations; comments and outlines of topics to be discussed at the hearing are due by November 2nd. Because the regulations will apply prospectively, transfers made prior to their effective date would not be subject to the new restrictions, although it is unclear how transfers subject to the three-year rule would be affected. If passed in their current form, the proposed regulations will have wide-ranging effects on the use of family limited partnerships and LLCs. Until such time, there is no way to predict their effect, but taxpayers should as always be mindful of these and similar developments and examine their estate plans regularly.

The text of the proposed regulations can be found at the following link:

https://www.federalregister.gov/articles/2016/08/04/2016-18370/estate-gift-and-generation-skipping-transfer-taxes-restrictions-on-liquidation-of-an-interest

About the Author

George E. Morrison
George advises corporate clients on formation, succession, and transactional issues as well as general business matters. He is involved in all areas of corporate practice, including mergers and acquisitions, liquidations, reorganizations and corporate governance. George has extensive experience advising borrowers and lenders in commercial lending transactions and in the preparation of third-party closing opinions.