The Internal Revenue Service has issued long-anticipated proposed regulations under Section 2704 of the Internal Revenue Code. These proposed regulations are broad and far-reaching. If the proposed regulations are finalized in their current form, they could limit severely (if not eliminate entirely) valuation discounts for transfers of interests in family-controlled entities.
What Do the Proposed Regulations Do?
The proposed regulations require most restrictions that limit a transferor’s right to liquidate an interest in a family-controlled entity to be ignored for valuation purposes. A transferred interest subject to these regulations will be valued as if the transferee could compel redemption of the interest for an amount equal to the interest’s pro rata share of the fair market value of the entire entity, whether or not a redemption at that price is actually possible.
In addition, under the proposed regulations, if a transferor dies within three years of transferring an interest in a family-controlled entity, the transfer will be treated as having occurred at the transferor’s death, thus potentially causing the transferor to have a phantom asset brought back into his or her estate.
The proposed regulations reflect the belief of the IRS that most restrictions on interests in family-controlled businesses are designed solely to reduce the value of assets for transfer tax purposes, and they ignore the fact that such restrictions are often integral parts of family business arrangements, especially in the case of active operating businesses.
The IRS has broadened the categories of entities that are subject to the new valuation rules to include not only corporations and partnerships, but also limited liability companies and other entities. There is no distinction between operating businesses and entities holding passive assets.
An entity is considered to be family-controlled if family members directly or indirectly (e.g., through another entity or a trust) hold 50 percent or more (by vote or value) of the stock of a corporation; 50 percent or more of the capital or profits interest of a partnership, LLC or other entity; any equity interest with the ability to cause full or partial liquidation of the entity; or, in the case of a limited partnership, any interest as a general partner. The definition of family member is broad, and at a minimum includes an individual and his or her spouse, their ancestors and descendants and their spouses, and the individual’s siblings and their spouses.
If an entity is family-controlled, then the IRS will disregard any restrictions on liquidation of that entity (which generally are what generate discounts) that lapse after a transfer or that may be removed by the transferor or the transferor’s family after the transfer. For purposes of determining whether family members have the ability to remove restrictions, the interest of a non-family member will be disregarded unless it is economically substantial and longstanding.
Example: A owns 100 percent of the interests in Company, which is worth $50 million, and gives 10 percent to his child, C. The application of traditional minority and lack of marketability discounts (often 20-40 percent) would result in the 10 percent interest transferred to C being valued at approximately $3 million-$4 million. Under the proposed regulations, however, the 10 percent transferred to C would be valued at 10 percent of the total $50 million value of the entity — $5 million — even though it is unlikely that any third party would purchase such a 10 percent interest in Company for a price that does not reflect the lack of a broad market for the interest or its minority status.
The proposed regulations are subject to a comment period ending on November 2, 2016, followed by a public hearing on December 1, 2016. While the IRS must consider comments received, it has no obligation to amend its proposal to reflect such comments, and the final regulations could be issued any time after the public hearing. Most of the regulations will be effective immediately after issuance; however, certain provisions will not be effective until 30 days after finalization.
Who Should Take Action?
The comprehensive nature of the proposed regulations means that they will affect a broad range of individuals. Consider contacting your wealth management attorney if you fall under any of the following categories:
- You hold an interest in an entity, directly or indirectly, with one or more family members (including spouses)
- You own a business that you plan to transfer to family members (whether now or in the future)
- You or your family members are beneficiaries of trusts that hold interests in a family-controlled entity or entities
- You hold an interest in real estate (e.g., a cabin) in an entity with one or more family members (including your spouse)
- Your net worth exceeds the current estate and gift tax exemption amount ($5.45 million per individual), and you are contemplating making gifts of interests or assets in an entity to family members
Your wealth management attorney can help determine whether there are affirmative planning steps you should take before the proposed regulations become effective and whether there are other strategic steps you should be taking to minimize your tax exposure and maximize your family’s wealth.
Your wealth management attorney also could help prepare comments to submit on your behalf by the November 2 deadline, which may be especially advisable for individuals with specific concerns about the effects of the regulations on their family operating businesses.