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Aug. 2 — Proposed IRS rules to rein in estate valuation discounts add a new category of restrictions that would be disregarded in valuing transfers of family interests.
Estate, gift and generation-skipping transfer taxes apply to the transfer of assets from one person to another either by gift during a decedent's lifetime or by inheritance at death.
By using aggressive planning tactics to lower the taxable value of transferred assets, certain taxpayers or their estates that hold closely held businesses can end up paying less than they should in taxes, said Mark Mazur, assistant secretary for tax policy at the Treasury Department, in a blog post.
The proposed regulations (REG-163113-02, RIN:1545-BB71), released Aug. 2, will “close a tax loophole that certain taxpayers have long used to understate the fair market value of their assets for estate and gift tax purposes,” he said.
Ron Aucutt, a partner at McGuireWoods LLP that advises clients on such matters said he welcomes the regulations. While they will significantly reduce the benefit of using entities like family-owned corporations and partnerships to lower the value of assets subject to estate and gift taxes, generally if finalized the rules will provide more clarity and efficiency, he told Bloomberg BNA Aug. 2.
The proposed regulations address restrictions on the liquidation or redemption of interests in family-controlled entities under tax code Section 2704. They 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.
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,” the Internal Revenue Service said.
The agency defines “minimum value” as the interest's share of the net value of the entity on the date of liquidation or redemption.
Dennis Belcher, also a partner at McGuireWoods, said the provisions on disregarded restrictions is “where you're going to hear a lot of people scream.”
“In the past, Congress was not able to tax a right that you didn't have or an interest that you didn't have, and state law would govern how much interest you had and what to do with that,” he said. “Now we're going to disregard state law, so that's a pretty big step.”
Aucutt, however, noted that the only state law that would be disregarded is such that could be changed or overridden in a family-owned entity's governing documents. He also noted that there are exceptions in the rules in connection to certain federal and state laws.
Aucutt said there were several provisions that he was glad were included in the proposed regulations.
One of them is the aforementioned exception that says restrictions required by mandatory federal or state law are still going to be given effect in valuation, and will not be disregarded, he said.
“There will be people who see it a little differently because restrictions imposed by state law are specifically addressed by these regulations, but what they do is limit the effect on estate law” to statutes that are truly mandatory and can't be avoided by either choosing to refer to a different statute or making changes to an entity's governing documents, he said.
The rules also provide relief to operating businesses, Aucutt said.
For purposes of determining minimum value, the only outstanding obligations of the entity that may be taken into account are those that would be allowable—if paid—as deductions under Section 2053 if those obligations instead were claims against an estate, the proposed rules say. “For example, and subject to the foregoing limitation on outstanding obligations, if the entity holds an operating business, the rules of §20.2031-2(f)(2) or 20.2031-3 apply in the case of a testamentary transfer and the rules of §25.2512-2(f)(2) or 25.2512-3 apply in the case of an inter vivos transfer,” the IRS said.
This nod to operating businesses is important, Aucutt said. “Maybe they could have gone or should have gone farther. But they’ve at least acknowledged the greater legitimacy that operating businesses have and why it’s more important to respect the restrictions that apply to an operating business,” he said. Belcher also agreed with that change.
Aucutt said he was glad to see the regulations included a clarification that the same rules are going to apply for determining the amount of a marital deduction or a charitable deduction as for determining the initial amount of the transfer.
The rules not only apply to a limitation on redeeming or liquidating an interest altogether, but also on a limitation on the manner in which the redemption or liquidation proceeds can be paid, which Aucutt said he found surprising.
“A disregarded restriction includes limitations on the time and manner of payment of the liquidation proceeds,” the IRS said in the proposed rules. “Such limitations include provisions permitting deferral of full payment beyond six months or permitting payment in any manner other than in cash or property.”
“In other words, a person can take their partnership interest and withdraw from the partnership and ask the partnership to redeem” the interest, he said. “Let’s say it’s a 10 percent interest and the partnership is worth $1 million, then these rules say that they need to be able to liquidate and redeem their interest for $100,000, not less. And that they must be paid within six months. And that they can’t be paid in just a promissory note that is within the family,” Aucutt said.
In this respect, the rules were broader than anticipated, he said, adding that even so, it was a reasonable inclusion.
While being overall pleased with the rules, Belcher said, there were two provisions that he questioned.
The proposed regulations narrow an exception within the definition of a lapse of a liquidation right to transfers occurring three years or more before the transferor’s death. Current rules only require that the lapse occur before death in order to be excepted from Section 2704, Belcher said.
“I know that having a three-year rule is a bright-line test, but I was hoping we’d get away from arbitrary time periods,” he said. “Congress has done a great job of moving away from that and now we’re moving back to it.”
He was also wary of the clause that says in a family-controlled entity, any restriction on an owner's right to liquidate his or her interest will be disregarded if the transferor or the transferor's family removes the restriction.
Always going back to family attribution is somewhat worrisome, he said. “The Treasury's tried to get family attribution in, and this is a step toward family attribution by assuming all family members act as one,” Belcher said. But “that's not what happens in the real world,” he added.
In November 2015, an IRS official told practitioners at an American Institute of CPAs meeting that the guidance would not be based on previous Obama administration Greenbook budget proposals, though advisers were skeptical (08 DTR S-13, 1/13/16).
Aucutt said, unsurprisingly, the proposed regulations “follow the Greenbook pretty closely.”
The Greenbook said that restrictions would be measured against standards prescribed in regulations, not against default state law, and that is included in the rules, Aucutt said.
The proposed regulations also include a provision that says in determining whether a restriction may be removed by family members, certain interests held by charities or others who aren't family would be deemed to be held by the family, he said.
Another common provision is the clarification on marital and charitable deductions, Aucutt said.
The proposed regulations are scheduled to be published in the Federal Register Aug. 4. The IRS has scheduled a Dec. 1 public hearing on the proposal; comments and outlines of topics to be discussed at the hearing are due by Nov. 2.
Aucutt said although he is mostly favorable toward the rules, other wealth planners might not be so welcoming.
“The estate planning community was expecting to get proposed regulations that they would have a hard time accepting and agreeing with,” and that rhetoric will be reflected in comments and at the public hearing, he said.
Some points will be valid, but in looking back at criticism heard in anticipation of the rules, much of that “has been overstated,” Aucutt said.
Belcher said overall he was also pleased with the regulations. He was especially glad to see that the IRS and Treasury gave practitioners effective dates starting after the final regulations are published in the Federal Register.
“It will give all of us an opportunity to go through the plans that we’ve done in the past and see where we need to make any adjustments or whether we need to take advantage of the current rules before these become the existing rules,” Belcher said.
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Text of REG-163113-02 is in TaxCore.
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