Last week, we considered (i) the context in which the recently proposed regulations under Section 2704 of the Code would eventually be applied, (ii) the principles underlying Section 2704, (iii) the valuation of an interest in a closely-held business, generally, and (iv) the failed legislative efforts to address the issues covered by the proposed regulations. Today, we turn to the proposed rules themselves.
The 2016 Proposed Regulations – In General
The preamble to the proposed regulations could have been lifted verbatim from the 2010 through 2013 Green Books. Indeed, any tax adviser would be hard-pressed to say that he had no idea what was going to be included in the proposed regulations (which is why their prospective effective date is generous).
There are two main themes that permeate the regulations, and they reflect the legislative intent behind Section 2704.
First, if there is a lapse of any voting or liquidation right upon the transfer of an interest in a business entity, and the individual transferor who held such right immediately before the lapse holds control of the entity – with members of his family – both before and after the lapse, such lapse will be treated as a transfer by such individual by gift, or as a transfer which is includible in his gross estate, whichever is applicable.
In other words, because the lapsed right can be restored after the transfer by the transferor and his family, the lapse must have been provided only for valuation purposes, and did not have an independent, non-tax purpose, or so the theory goes.
Second, a restriction that limits the ability of a business entity to liquidate will be disregarded in valuing the transfer of an interest in the business to a member of the transferor’s family if the transferor and members of his family control the entity before the transfer, and the restriction may be removed by them after the transfer.
This echoes the first theme: a restriction that may be toggled on and off by the transferor and his family must not be meaningful, other than for valuation purposes, or so the theory goes.
The elements shared by these themes are (i) the presence of “transferor/family control” of an entity both before and after the transfer of an interest in the entity, and (ii) the ability of the transferor and his family to restore any lapsed rights and to remove any restrictions.
The 2016 Proposed Regulations – Specific Provisions
The following discussion will focus upon what I regard as the principal “entity-planning-related” changes to the current regulations.
The proposal would clarify that Section 2704 applies to the transfer of an interest in a single-member LLC (and not just to corporations and partnerships, as is literally stated in the statute), even if the LLC is disregarded as an entity separate from its owner for tax purposes.
In other words, an LLC’s classification for other purposes of federal tax law is irrelevant for valuation purposes. A taxpayer’s transfer of a membership interest in his wholly-owned LLC will be treated as a transfer of an interest in a business entity – the LLC – not as a transfer of an interest in its underlying assets; and, thus, the value of such an interest will be determined in accordance with the terms of the LLC’s operating agreement, state law, and – more to the point – the regulations under Section 2704.
This proposed change is aimed at the Tax Court’s decision in Pierre, where the Court determined that valuation discounts may be applied to value the transfer an interest in an LLC that was wholly-owned by the transferor and that she had funded with liquid assets.
Three-Year Rule for “Deathbed (?) Transfers”
The proposal would address so-called “deathbed transfers” (a misnomer) that result in the lapse of a liquidation right.
You will recall the provision in the current regulations under which the transfer of an interest conferring a right is not treated as a lapse of that right if the right is not reduced or eliminated, but simply transferred to another.
For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not treated as a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control.
This kind of transfer is a staple among estate planners. It enables them to divide the ownership of a business between the taxpayer and his family (e.g., his spouse) without significant economic consequences, while positioning the taxpayer’s interest to be valued as something less than a controlling interest.
The proposed regulations are aimed at exactly this situation. They do not eliminate the exception, but narrow its application to transfers occurring more than three years before the transferor’s death. Thus, if the transferor dies within three years of the transfer, a lapse of a right covered by Section 2704 will be deemed to have occurred upon his death.
For example, in what turns out to be more than three years before his death, D transfers one-half of his X Corp. stock in equal shares to his three children. Section 2704 does not apply to the loss of D’s ability to liquidate X Corp. because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had D died within three years of the transfers, the transfers would have been treated as the lapse of D’s liquidation right, occurring at D’s death.
This results in the creation of a phantom asset in the estate on which estate tax will have to be paid. Query how a taxpayer and the executor of his estate may pay for payment of the tax.
According to the proposal, this rule will apply to lapses occurring on or after the date the rules are finalized. Thus, they may cover transfers (and lapses) that have already occurred (before the proposals are finalized) if the transferor dies after the effective date of the regulations and not more than three years after the transfer.
I think it likely that the effective date will be amended to clarify that it covers transfers occurring after the effective date. (This was the approach taken when the subjective “in contemplation of death” provisions of Section 2035 of the Code were replaced by a similar three-year rule.)
The application of this proposed rule is bound to have some unintended consequences; a relatively young, healthy transferor who is hit by the bus while crossing the street is covered as much as a bed-ridden octogenarian who is adjusting his holdings for estate tax valuation purposes. However, the proposed bright-line test is reasonable when one considers its “actuarial underpinnings” and the universe of taxpayers whose estates it is likely to cover.
State Law Restrictions
The proposed regulations would refine the definition of “applicable restriction” by eliminating the comparison to the liquidation limitations of state law.
You will recall the provision in the current regulations that limits the definition of an applicable restriction to one that is more restrictive than the default rules under state law. Under this regulatory exception, a restriction will not be disregarded for valuation purposes if it is not more restrictive than the default rule under the applicable state law.
The proposal would remove this exception. The reasoning for the removal is consistent with the purpose of Section 2704. Any restriction that is not imposed or required by federal or state law is a restriction that the transferor and his family can remove or replace with a less restrictive one. It is an applicable restriction that will be disregarded for valuation purposes.
If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction did not exist (that is, as if the governing documents and the local law were silent on the question) and, thus, there is deemed to be no such restriction on liquidation of the entity.
The proposal also clarifies that an applicable restriction does not include a restriction that is imposed or required to be imposed by law. A provision of law that applies only in the absence of a contrary provision in the governing documents, or that may be superseded with regard to a particular entity (whether by the shareholders, partners, members and/or managers of the entity or otherwise), is not a restriction that is imposed or required to be imposed by law.
Although I have no argument with this position in the case of a family-owned investment company holding marketable securities (in which liquid assets to pay a withdrawing owner are available or can be readily obtained), its application to a family-owned business or real estate entity seems unreasonable. Most closely-held operating businesses, including those that are family-owned, seek to limit the withdrawal of capital from the entity for bona fide business reasons and, so, restrict the ability of an owner to liquidate his interest in the business.
Taxpayers have attempted to avoid the application of Section 2704 through the transfer of a partnership interest to an assignee, rather than to a partner. Again, relying on the regulatory exception for restrictions that are no more restrictive than those under state law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have the rights or powers of a partner, taxpayers have argued that an assignee’s inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under state law. Thus, taxpayers have argued that the conversion to assignee status of the transferred partnership interest is not an applicable restriction.
The proposed regulations provide that a transfer that results in the restriction or elimination of any of the rights or powers associated with the transferred interest (an assignee interest) will be treated as a lapse, within the meaning of Section 2704, the value of which will be taxable.
New Disregarded Restrictions
As indicated in the Obama administration’s Green Books, and pursuant to the authority granted under Section 2704 itself, the IRS has identified a new class of restrictions that are to be disregarded for valuation purposes.
According to the proposal, where an interest in a family-controlled entity is transferred, any restriction on an owner’s right to liquidate his interest (as opposed to liquidating the entity) will be disregarded for valuation purposes if the transferor and/or his family may remove or override the restriction.
Under the proposal, a “disregarded restriction” includes one that:
- limits the ability of the holder to liquidate the interest, or
- limits the liquidation proceeds to an amount that is less than a “minimum value”, or
- defers the payment of the liquidation proceeds for more than six months, or
- permits the payment of the liquidation proceeds in any manner other than cash or “other property” (generally excluding promissory notes).
For purposes of this rule, the “minimum value” of an interest is defined as the interest’s share of the net value of the entity on the date of liquidation or redemption. It is basically a liquidation value: the interest’s share of the proceeds remaining after the deemed sale of the entity’s assets at fair market value, and the deemed satisfaction of its liabilities.
Again, if we are considering a family investment vehicle holding marketable securities, I have no issue with the proposal. Such an entity can easily generate the liquidity needed, or distribute marketable assets, to redeem or liquidate a member’s interest in a timely manner.
What about a family-owned operating business? The IRS acknowledges the “legitimacy” of such a business. For example, a provision in an agreement that permits the payment of the liquidation proceeds by way of a promissory note will not be disregarded under the proposal if the proceeds are not attributable to passive investment assets, and the note is adequately secured, provides for periodic payments, bears a market rate of interest, and has a present value equal to the minimum value.
Even so, the IRS ignores the fact that close businesses will often require a “haircut” on the redemption price for someone’s interest, in part to dissuade owners from withdrawing, whether to prevent competition or to preserve capital for the business, or for some other valid business purpose.
It should be noted that the proposed regulations include an exception to these otherwise disregarded restrictions. Unfortunately, it requires the inclusion of certain provisions in the partnership or shareholders’ agreement that are rarely found even in a business owned by unrelated persons. Specifically, the exception applies if:
- each owner has the right to put his interest to the business in exchange for cash and/or other property at least equal to the minimum value; and
- the full amount of such purchase price must be received within six months after the owner has given notice of his intent to exercise his put right; and
- such “other property” does not include a note, unless the entity is engaged in an active business and the note satisfies certain requirements.
If a restriction is disregarded, the fair market value of an interest in the entity is determined assuming that the disregarded restriction did not exist. The fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums.
Ignoring Certain Unrelated “Owners”
In determining whether the transferor and/or the transferor’s family has the ability to remove a restriction, any interest in the entity held by a person who is not a member of the transferor’s family will be disregarded under the proposal if, at the time of the transfer, the interest:
- has been held by such person for less than three years; or
- constitutes less than 10 percent of the equity in the entity; or
- when combined with the interests of all other persons who are not members of the transferor’s family, constitutes less than 20 percent of the equity in the entity; or
- any such person, as the owner of an interest, does not have an enforceable right to receive in exchange for such interest, on no more than six months’ prior notice, the “minimum value.”
If an ownership interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.
This provision is aimed at the suspect practice of trying to avoid the application of Section 2704 through the transfer of a nominal business interest to a nonfamily member, such as a charity or an employee, to “ensure” that the family alone does not have the power to remove a restriction.
In the case of a charity, it is likely that this practice has been limited to investment entities that hold marketable securities. A charity would likely not be interested in acquiring an interest in an operating business with its potential for generating unrelated business taxable income and a limited ability to monetize its ownership interests.
Two bills have been introduced in the House of Representatives this month that seek to void the proposed regulations. Neither of these will get very far.
As mentioned in an earlier post, the IRS has scheduled hearings on the proposed regulations for December 1, 2016. It is expected that many comments will be submitted by the November 2 deadline and, hopefully, considered.
Ignoring the fact that the results of the Presidential and Congressional elections may render the proposed regulations moot, my hope is that the IRS will refocus the proposals so that they are limited to family-owned investment entities, and not operating businesses.
As for investment entities, the regulations should distinguish between those that hold real estate and those that hold marketable securities and cash equivalents. Only the latter are appropriate subjects for the proposed rules.
Assuming the IRS proceeds with the hearings scheduled for December 1, and assuming it accepts some of the changes being suggested by the professional community, the regulations will likely not be finalized until at least early 2017. If the IRS rejects this commentary, the regulations may become effective on December 1.