Reaction has been swift to the new §2704 proposed regulations (REG-163113-02). Many observers see the proposed rules as the end, or near end, of discounted values for business interests transferred between family members. Family businesses often take the form of limited partnerships, limited liability companies, or closely held corporations. The target of the proposed regulations is the transfer of fractional or restricted interests in business entities that reduce the value of property passed to the next generation. The size of the reduction, or discount, depends on different features of the business, such as the business's organizational structure and governing documents and the laws of the state in which the business is formed.
Looking beyond the dire predictions, the IRS is trying to build a better mouse trap to halt estate and gift tax discounts, but would these proposed regulations really kill those discounts? By cobbling together bits and pieces to create a mouse trap, much like my favorite game from much younger years, can the IRS’s proposed regulations really work?
First, these proposed regulations should not come as a surprise. The idea appeared regularly in the government’s annual revenue proposal, known as the “Greenbook,” from 2005 to 2013. With almost no change, this proposal moved from the Bush administration to the Obama administration during those years, apparently driven by Congress’s intent that the statutes eliminate less-than-legitimate family business interest discounts. The preamble of the proposed regulations is a more thorough explanation of the Greenbook description.
The game board: The IRS has been fighting a losing battle since §2701–§2704, the “Chapter 14 special valuation rules,” came into being. Enacted by Congress in 1990, they were intended to prevent the use of certain “freezing” techniques to reduce the estate and gift tax cost of transferring assets (and future appreciation on those assets) to younger family members without any actual loss in value to the family. Specifically, §2704 was directed at the use of certain lapsing rights and restrictions placed on interests in family entities that were designed to artificially reduce the value of those interests.
The types of transactions targeted by Chapter 14 — and by the new proposed regulations — did not appear without first receiving some form of IRS blessing. These transactions became even more widespread after the IRS issued Rev. Rul. 93-12, 1993-1 C.B. 202, in 1993. Rev. Rul. 93-12 described gifts of stock by a 100% shareholder of a corporation to each of his five children. The IRS ruled that the family's control of the business would not be considered in valuing the now separate interests held by the children. Shortly after the IRS issued Rev. Rul. 93-12, practitioners began writing about the benefits, including discounts, of family limited partnerships for transferring businesses between generations because overall control by the family was not a valuation concern.
States were culpable in part for the expansion of planning to obtain valuation discounts. Section 2704 was enacted at a time when states did not generally have the restrictions on transfer and control that are now commonly part of state laws. Section 2704 and its existing regulations look at whether the restrictions in the family entity’s governing documents (such as the partnership or operating agreement) are “more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction” to determine whether the IRS can ignore the effect of the restriction and limit discounts. This “more restrictive than state law” standard provided states with an incentive to attract family businesses: amend the state laws to include the desired restrictions, thus reducing the estate and gift tax implication, and family businesses would come knocking, or at least not leave the state. Thus, more and more states enacted more and more restrictive control and transfer provisions. The result is now what we commonly see: a partner cannot redeem his or her interest without unanimous approval of the other partners or the stipulated ending period of the partnership, and the ability of businesses to avoid those mandatory laws through the governing documents.
Favorable court decisions also promoted the use of planning techniques to obtain minority and marketability discounts on transfers of interests in family businesses. Courts looked to §2031, Definition of Gross Estate, and §2512, Valuation of Gifts, which provide rules for valuing stocks and business interests. Reg. § 20.2031-3 states the general rule:
The fair market value of any interest of a decedent in a business, whether a partnership or a proprietorship, is the net amount which a willing purchaser whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The net value is determined on the basis of all relevant factors …
“All relevant factors” stands in direct contrast to “applicable restrictions,” as defined in §2704(b)(2), and the “disregarded restrictions” in Prop. Reg. §25.2704-3. Those restrictions are factors that a willing buyer would consider prior to making an offer for the business interest, and that a willing seller would have to acknowledge in asking a price for his or her business interest. The courts apply this standard repeatedly, with the implied blessing of the IRS, who, after all, drafted Reg. §20.2031-3. An astute practitioner would tease out the differences between the relevant factors and the restrictions, because (in theory anyway) relevant factors are still allowed in determining the interest’s value, as the Prop. Reg. §25.2704-3 examples repeatedly state.
A second issue is the applicability of §2704 on the form of many family businesses, such as the limited liability company (LLC). Disregarded for income tax purposes, or alternately treated as a partnership or corporation, brandished as a separate entity for employment and estate tax purposes, the LLC is exactly what it was intended to be — a chimera, a creature with a lion's head, a goat's body, and a snake's tail, for tax purposes. The proposed regulations would attempt to snare the LLC, at least for transfer tax purposes, and make it follow the rules of economic reality, and the IRS will likely be hoping for as little court intervention as possible. The proposed regulations are like a Rube Goldberg machine, with a combination of bits and pieces that, the IRS hopes, would somehow get the job done.
What are the pieces for the IRS’s new mouse trap? In §2704(b)(4), Congress provided the IRS with the ability to enact regulations that would address additional abusive transactions. The IRS proposes to use that ability and create some new pieces for the mouse trap. Beware, there are many moving parts to the proposed regulations, and how they will work together is still a question that will decided by the courts. However, the focus of the proposed regulations appears to be (i) what happens at the lapse of a restriction or right, specifically the change in the value of the business interest, and (ii) the potential restrictions on the recipient’s ability to dispose of his or her interest.
The change in value.
Defining the entity : Prop. Reg. §25.2701-2(b)(5) would tailor the control tests to the type of entity. Prop. Reg. §25.2701-2(b)(5)(i) would create three separate types of entities: corporations, partnerships and “other business entities.” Prop. Reg. §25.2701-2(b)(5)(iv) would define “other business entities” in to include LLCs through reference to state law. Specific control tests, depending on the business’s category, would apply. These categories would be for estate and gift tax purposes only, and would not affect any other tax, such as income or employment taxes. The goal here is to foil some of the state law that creates so much flexibility in LLCs and to create a bright line test that will apply to LLCs without having to examine the facts surrounding a business’s operations.
Timers : The IRS would use a three-year timer on transfers to create another bright line test for applicable restrictions: if the transfer occurs more than three years before the transferor’s death, then the lapse of the transferor’s right or power would qualify for the exception under Reg. §25.2704-1(c)(1) . The decision looks like a no-brainer (transfer now!), until the business owner realizes what is being transferred, what cannot be retained, and the income cost for the transfer, potentially for much longer than three years. The present value calculation that makes freeze techniques effective for estate tax purposes would then work against the transferor from an income perspective. The three-year limit also applies to limit the utility of transfers to nonfamily members, as discussed below.
State law : Applicable restrictions would have a different relationship with state law. The state law must be mandatory to be considered a real restriction, or the IRS would ignore the restrictions. Those state laws that only apply to family-controlled businesses, and that have optional or alternative statutes without the objectionable restrictions, would no longer be available to restrict (yet not restrict) family businesses. However, the adoption of state law to determine the type of entity could, with state action, still influence the applicable restrictions. States would again have an incentive to tinker with their statutes, this time with the business formation statutes.
Defining the transactions : The proposed regulations would look at partial and complete liquidations, and direct and indirect transfers to family members. The proposed regulations would eliminate the weighted valuation calculations for transfers to nonfamily members. Again, the IRS is using a timer to disregard the nonfamily interest if the transfer to the nonfamily member was made less than three years before the date on which control is being tested – no putting your finger on the scale to tip it in calculating control.
Getting rid of the straw man : As mentioned just above, a common technique in weighting the control calculation is to transfer an interest to a nonfamily member. This interest could be a bare assignee right, with no actual ability of the recipient to become one of the business members or partners, or exert any control over the interest. Oftentimes, the nonfamily member is a charity that would not be interested in continuing to hold the interest (facing a 200% excess business holding excise tax), and would maximize its position by selling the interest off to the only buyer who would want it, the family or business itself. The proposed regulations would eliminate this maneuver, by requiring the minimum three-year holding period, a minimum 10% value of the equity interests, and a minimum 20% value on the combined interests of nonfamily members. In the alternative, any nonfamily member must have the right to receive the business interest’s minimum value, defined above, upon no more than six months’ notice to the business of liquidation or redemption. In essence, the restriction(s) on liquidation would be gone.
Restrictions on the recipient.
Disregarded restrictions : Prop. Reg. §25.2704-3 would be a new piece for the mouse trap. The IRS would create this category as a broad ban on very specific restrictions – limitations on the ability of the recipient to redeem or liquidate a business interest, and the limits on payments due to the recipient on liquidation or redemption, where those restrictions or limitations lapse or can be removed by the controlling family after the transfer. These would be some of the same restrictions as the “applicable restrictions,” defined in Reg. §25.2704-2(b), but focus on the recipient, not the transferor. Indeed, the applicable restrictions still remain in effect, and would be expanded under Prop. Reg. §25.2704-2. Unlike the applicable restrictions, the disregarded restrictions would have no reference to the limits created by state law against which to measure the restrictions on a recipient’s business interests, and these restrictions can come from any governing documents, state law, buy-sell agreements, assignment or gift deeds or “other document” outside of the usual suspect agreements. This disregard for the source of the restriction under Prop. Reg. §25.2704-2(a)(2) and §25.2704-3(b)(2) would be reinforced by Prop. Reg. §25.2704-1(a)(4). Thus, the IRS’s focus on the actual restriction, and whether it is real or contrived, would apply to the transaction, the transferor, and the recipient.
The disregarded restrictions would be specific: (i) limits on the interest recipient’s ability to liquidate the interest; (ii) limits on liquidation proceeds to less than a “minimum value” (defined as proportional value of the interest in the fair market value of the business’s property); (iii) deferral of the proceed payments for more than six months; or (iv) allowing the proceeds be paid by other than cash or property – and family-related promissory notes would not be considered property. There would be further requirements about deductions allowed for the disregarded assets, amounting to an arm’s length, negotiated business loan.
Note that the amount paid or the timing of the payment is treated with a bright line cut-off: if there is a deferral, or a deferral is allowed, for more than six months after the transferee notifies the business of his or her intent to liquidate or redeem the interest, then that provision is disregarded for valuation purposes.
In place of the state law restrictions, the IRS proposes to use a “minimum value.” The IRS would define this state law replacement as the proportional interests of the fair market value of the business on the liquidation/redemption date. The minimum value would also consider the specific rights of the business interests, meaning profit, capital, or other rights held by the business interests. Prop. Reg. §25.2704-3 broadens the reach to assets in other businesses if the family business itself holds other business interests. Instead of just the second business’s interests being valued for estate tax purposes, the proposed regulations would drag that second business’s assets into the valuation. Thus, the IRS is hoping, complex business structures would be compressed and merged to better reflect the economic reality of the transferred interests.
These disregarded restrictions would be ignored for valuation purposes if, immediately before the transfer, the transferor and/or his or her family control the business and, after the interest is transferred, either all of the restriction or part of the restriction lapses, or the transferor, or his or her family, may remove the restriction or restore the power. Fair market value is determined using the standard under §2031 (and also under §2512 for transfers during the transferor’s lifetime), the broad fair market value parameters of which are noted above. The only deductions allowed would be those obligations that would be allowed under §2053 – bona fide claims against an estate, on terms bargained for at arm’s length.
There is a specific, but not patently exclusive, exception to limiting expenses to bona fide claims under §2053. If the family business is an “operating businesses,” then the family business would be able to apply the rules under Reg. §20.2031-2(f)(2) or §20.2031-3 for testamentary transfers, and Reg. §25.2512-2(f)(2) or §2512-3 for lifetime transfers, go make deductions for business reasons. The proposed regulations define operating business as having at least 60% of the value of its assets used in the business, and the assets cannot be passive. How much leeway does this provide? Some observers find the exception to be meaningless in the real world. As Allyson Versprille noted in our Daily Tax Report, observers warn that the IRS may find the proposed regulations struck down if the IRS does not appropriately consider real life scenarios before finalizing the regulations. Also important to note is that while the regulations should consider real life scenarios, the statutes do not, as Estate of Smith v. United States,103 Fed. Cl. 533 (2012), indicated.
Is this a better mouse trap?
The IRS has had a fair amount of success by using other strategies to minimize discounts. Applying §2036 and §2038 – retained and revocable powers – to limit or eliminate discounts by getting assets included in an estate under §2035 has been effective in trapping the slow moving mice where the facts of a family business transfer are not very good. These arguments are more common and familiar to the thinking of the courts – property is a bundle of sticks, and not all the sticks were transferred – and thus more enforceable by a court’s standards. There is nothing in the new regulations that supersede those arguments. What the new regulations do is provide “bright line” rules that would be meant to apply despite the courts’ rulings, and removing the moving target of state law. The question is whether the courts will accept the proposed limits, or opt to accept discounting for other “relevant reasons” under the fair market value test under §2031.
Also note that these proposed regulations would use asset values of a business, not the business as an operating business, as the basis for its valuation under §2704. The Ninth Circuit Court of Appeals case, Giustina v. Commissioner, 586 Fed. Appx. 417 (2014), refused to allow a split consideration of the assets and the ongoing business, and remanded the case for valuation as an ongoing business. This approach, favorable to a family business, may also become a target under the proposed regulations.
One, slight, potential benefit of the proposed regulations would be for the beneficiaries. The increased value for estate tax purposes means that the later sale of the business would have a higher basis than if the interest had been discounted for estate tax purposes. Furthermore, the estate pays the estate tax (if not forced into liquidation to pay the tax, thus removing later income potential). The same valuation will also apply to any property transferred as marital property. Frankly, the benefit, if any, will depend on what the family proposes to do with the company, the company’s cash position, and its ability to borrow against its assets, if it has not prepared for the eventuality of paying estate tax.
The special valuation statutes and accompanying regulations have not worked for some thirty years. Why propose broader regulations now in place of the long-standing request for legislation? One observer wondered whether the Obama administration abandoned the legislative route via the Greenbook as a righteous argument for proposing these changes. Others speculated on the IRS’s authority to create these regulations. Coincidentally, Daniel Hemel at the University of Chicago Law School recently released a draft paper, The President’s Power to Tax, that examines authorization to create regulations and applies game theory to late-term regulatory proposals. Assuming Professor Hemel’s interpretation of authorization is correct and that this cost-benefit approach describes the timing of these proposals, one might expect relatively quick adoption, with or without changes from public comments, of the proposed regulations.
* * *
As you can see, there would be a lot of moving parts that have to coordinate in order for family business transfers to avoid the mouse trap and emerge with a discount. On the other hand, there would be a lot of moving parts the proposed regulations have to coordinate to make the trap work, not to mention the cooperation of one of the biggest game pieces, the courts.
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