Kitces: A closing window for estate-tax planners
For the past 15 years, Family Limited Partnerships or Family LLCs have been a staple of high-net-worth estate planning, particularly to obtain favorable valuation discounts on gifts or bequests. This has happened in spite of the IRS and Treasury’s efforts to curb the aggressive use of valuation discounts — an effort undermined repeatedly in various tax court cases. That is all set to change, and quickly.
After years of failed attempts to get Congress to update the rules, the Treasury department has decided to pursue its own crackdown, in the form of newly proposed 25.2704 Treasury Regulations. The proposed regulations under Section 2704 are so expansive that they would severely limit the use of valuation discounts for any type of FLP or other family business transfer, where the family will retain control before and after the gift or bequest occurs.
A bit of history: The IRS and Treasury have long petitioned Congress for updates to the IRC Section 2704 rules to more effectively limit valuation discounts for family businesses. Indeed, the IRS has listed valuation discount concerns as a part of its Priority Guidance Plan in every year since 2003, and for several years a crackdown was proposed in the president’s annual budget proposals.
But after repeated failures to gain any traction in Congress, the IRS announced earlier this year at the ABA’s Tax Section meeting in May that it would put forth updated regulations on Section 2704 to try to limit the abuses. Making good on its word, the Treasury proposed its new 25.2704 regulations on Aug. 2, attempting to close a wide range of perceived loopholes in the valuation discounts that apply to family businesses.
Consequently, for those high-net-worth families who are over the estate tax thresholds, just a few months remain to engage in transfer planning to maximize current valuation discounts.
PARSING SECTION 2740
As proposed, the new Section 2704 Treasury regulations would crack down on both lack-of-marketability valuation discounts for family businesses by expanding the scope of Section 2704(b), and also the lack-of-control valuation discounts for such businesses, with a further expansion of Sections 2704(a) and (b).
Changes in ownership intended to trigger a minority discount on shares held at death may no longer produce such a discount.
Under the new Treasury Regulation 25.2704-1(c)(1), any lapse of a restriction or liquidation right within three years of death is treated as a lapse at death, which in turn would be re-included in the decedent’s estate under Section 2704(a). In essence, this three-year lookback provision means that changes in ownership intended to trigger a minority discount on shares held at death may no longer produce such a discount.
For instance, if the family patriarch owned 51% of the family’s stock, and upon his deathbed made a gift of 2%, it would not only be possible to claim a minority discount on the 2% share being transferred, but at death the remaining — now-minority — 49% interest would also be eligible for a discount. Under the new rules, though, while the 2% interest might still be eligible for a lack-of-control discount, if those 2% of shares were transferred within three years of death, the minority valuation discount on the remaining 49% would be invalidated.
Notably, the decedent would still only report the value of 49% of the shares at death — and not necessarily the full 51%, as the other 2% really was transferred — but in determining any potential minority discount, the 49% would be valued assuming the 51% interest was still present, which means no minority discount.
A version of this strategy, where the decedent transfers 2% from a 51% interest just to reduce to minority status on their deathbed, is exactly what occurred in a 1990 Tax Court case of Estate of Murphy v. Commissioner. And this appears to be exactly what the IRS and Treasury were aiming to prevent with the new three-year lookback period. Going forward, it will no longer be feasible to winnow down a majority interest to a minority interest at or near death just to obtain a minority valuation discount on the remaining shares held at death.
WHEN PRACTICE MEETS THE RESTRICTIONS
Under the existing Section 2704(b) rules, certain applicable restrictions that might otherwise reduce the valuation of a family business are ignored if the transferor or his/her family have the right to remove the restriction after the transfer — and if the restriction is more restrictive than what state law already provides.
However, Treasury’s proposal includes the new Treasury Regulation 25.2704-3, which would define an additional category of disregarded restrictions that are ignored when determining the valuation of the business, if the family still has control in the aggregate to eliminate the restriction after the transfer or bequest.
These disregarded restrictions would include anything that: (a) limits the ability of the holder of the interest to liquidate the interest; (b) defers the payment of the liquidation proceeds for more than six months; (c) permits the payment of the liquidation proceeds in any manner other than in cash or other property other than certain notes; or (d) limits the liquidation proceeds to an amount that is less than a minimum value. For the purpose of these rules, “minimum value” is the fair market value of the entity, reduced by outstanding obligations (i.e., debts) of the entity.
In practice, this means that a transfer subject to the disregarded restrictions rules would be unable to take advantage of most traditional business valuation discounts — including lack-of-control and lack-of-marketability discounts that wouldn’t otherwise be reflected in the calculation of minimum value — whenever the family will retain control of the business after the transfer occurs, whether a gift during life or a bequest at death.
Notably, certain exceptions do apply to the disregarded restriction limitations. In determining whether the family has the control/ability to remove restrictions after the transfer, nonfamily owners may be considered as long as they have owned the shares for at least three years; have the ability to liquidate within six months; and meet certain minimum ownership guidelines.
In addition, a restriction is not disregarded if each owner has an enforceable put right to receive — via liquidation or redemption within six months — either cash or other property equal to minimum value of the business. That other property, though, cannot be a mere promissory note issued by the entity or other family members, unless the entity is an active trade or business, where at least 60% of the value is non-passive assets.
Most forms of intra-family transfers won’t be able to obtain previously common minority and marketability discounts.
Viewed another way, the proposed regulations would implicitly apply a put right to the valuation of any transfer of the family business to other family members, effectively eliminating most forms of discounts.
In addition to the new three-year lookback for determining lack-of-control discounts on bequests at death, and the new disregarded-restriction rules, other key changes proposed in the new Section 2704 Regulations include:
- Clarification that the rules apply not just to corporations and traditional partnerships, but also to LLCs and any other arrangements that are business entities.
- A narrowing of the rule that allows an applicable restriction to be ignored if it is no more restrictive than state or federal law. Instead, an applicable restriction will only be ignored in the future if it is a restriction required under law (i.e., a mandatory imposed requirement under law). And notably, such mandatory provisions will only be considered if they apply to all entities covered by the law. Special forms of a restrictive entity will be ignored if the state also provides for a non-restrictive version of the same entity — thereby preventing states from trying to dodge the rules by creating a special class of restrictive entities.
- Transfers of a family business interest to an assignee, who — under some state laws may receive an allocation of partnership income, but does not have the full rights and powers of an owner — will be treated as the lapse of rights, which means transfers to assignees will be subject to the three-year lookback for the purposes of valuing a decedent’s ownership interest and any applicable lack-of-control discounts.
THE END OF VALUATION DISCOUNTS
The substantive impact of the newly proposed Section 2704 Treasury Regulations on valuation discounts is that it would end most forms of lack-of-control and marketability discounts for intra-family transfers of businesses, as most such restrictions would easily be captured as disregarded restrictions under the new Section 2704(b) rules. Additionally, the expanded Section 2704(a) rules will not even allow family business owners to attempt to diminish their ownership interests in order to claim a minority or lack-of-control discount at death on their remaining shares, either.
In fact, the proposed Treasury Regulation 25.2704-3(g) provides a series of examples that demonstrate the incredibly broad scope of the new rules.
Example: Samuel and his children Joe and Sally are partners in a limited partnership. Samuel owns a 98% limited partner interest, and Joe and Sally are each 1% general partners. The partnership agreement states that the partnership will automatically liquidate in 50 years — or earlier by agreement of all partners — but otherwise prohibits the withdrawal of a limited partner, which is a marketability and control restriction. This restriction is permitted, but not required, under state law, and the partnership can be amended by the approval of all partners.
Samuel transfers 33% of his interest to Joe, and another 33% of his limited partnership shares to Sally. Because Joe and Sally could change the partnership to eliminate the liquidation provisions after the transfer, though, the marketability and control limitations would be considered disregarded restrictions in valuing the partnership shares. As a result, the transfers would be fully valued at 33% of the fair market value (i.e., the minimum value) of the business, and the valuation discounts would be lost altogether as a result of the new rules.
Notably, upon Samuel’s death, his remaining 32% interest would also be ineligible for any minority or marketability discount if bequeathed to a family member, whether Joe and/or Sally, or a surviving spouse, because the restrictions would again be disregarded, since they could be removed by the family after the transfer/bequest.
Fortunately, if the business includes ownership by, or distributions to, nonfamily members as well, a more favorable result may occur, subject to certain nonfamily ownership requirements discussed earlier. The rules for disregarded restrictions apply primarily in situations where the family retains control over the business — including the ability to change or remove restrictions — after the death or transfer of the original owner.
Nonetheless, most forms of intra-family transfers won’t be able to obtain previously common minority and marketability discounts once the new rules take effect.
At this point, the Treasury’s proposed regulations are just that: proposed. Per the standard process for considering the adoption of new regulations, they will now go into a public comment period running through Nov. 2, followed by a public hearing on Dec. 1. After that, the IRS and Treasury must consider the comments before issuing final rules, which in turn would not be effective until 30 days after being entered into the Federal Register.
Even so, the IRS and Treasury have been building up to this change for the better part of 13 years. And while some family business groups are already gearing up objections and a few tax commentators have already raised the question of whether the IRS and Treasury are overreaching — as arguably if Congress really wanted to eliminate all family valuation discounts, they could have made Section 2704 more restrictive in the first place — it seems highly likely that some form of these rules will be finalized soon. A realistic timeline would be for the final regulations to be issued and take effect sometime in 2017.
THE TICKING CLOCK
Fortunately, though, the new rules would only apply to transfers that occur after the effective date. This means that families holding business entities have a limited number of months to engage in transfer planning now, before the new rules take hold. This may include accelerating current gifts of shares of a family business — while minority and marketability discounts still hold — and possibly even beginning the process of forming an FLP or FLLC to facilitate the beginning of a transfer process.
Family dynamics around gifting and the ownership of the family business should still trump the tax consequences alone.
The limited time horizon to take advantage of the implied leverage of discounted gifts means very affluent families may even use some or all of their lifetime gift tax exemption just to maximize the available transfers. And of course, gifts made now will not only enjoy the benefit of valuation discounts, but as with any inter vivos gifting, will also shift all future appreciation out of the original owner’s estate, too.
On the other hand, while the new rules won’t apply until after the effective date, a death that does occur after the effective date will be subject to the three-year lookback period in determining whether or not any family business bequest is eligible for minority or marketability discounts. It wouldn’t necessarily be bad to transfer shares of the family business — which would still lock in any current valuation discounts on transfers that occur now. Yet a risk remains that gifting enough to get the original owner down to a minority interest may not mean a minority discount can be enjoyed when the time comes.
Of course, it’s important to remember that gifts, once made, are irrevocable, and that family business owners should be ready to make such gifts in the first place. If the business owner isn’t ready to make the gift, and/or isn’t comfortable with who will receive the shares — either outright or in trust — then trying to maximize the valuation discounts of gifting before the rules change is a moot point. Family dynamics around gifting and the ownership of the family business should still trump the tax consequences alone.
It’s also important to remember that the new rules will only be relevant for those who have estate tax exposure in the first place, which means generally those families with more than $5.45 million individually or $10.9 million as a couple of combined assets, plus a few states whose estate tax exemptions are still lower. Thus, family businesses that are below this threshold for estate tax exposure, and that don’t anticipate rising above the threshold going forward, still won’t need to worry about the new rules at all. The new rules may arguably be good news for those clients, potentially allowing their estates to claim higher valuations reported on Form 8971, resulting in more favorable step-ups in cost basis at death.
Nonetheless, for the subset of ultra-high-net-worth families facing estate tax exposure, where the wealth is either centered around a family business or can/will be transferred into a family business, the clock is ticking to complete transfers for potential minority or marketability discounts. While it remains to be seen exactly when in 2017 the new rules will take effect — and there may be some strategies that remain or new loopholes that emerge — it appears to be only a very limited matter of time before intra-family valuation discounts are drastically curtailed.
So what do you think? Will the proposed crackdown on FLP discounts impact your planning with clients in the coming months? Do you have clients you’ll be reaching out to about this? Please share your thoughts in the comments below.