Proposed IRS regulations will limit valuation discounts for family-held entities

published in Tax & Family Wealth Update | August 16, 2016

On August 2, 2016, the Internal Revenue Service (IRS) released proposed regulations that, when finalized, will affect clients holding and transferring interests in family-controlled entities. Family limited partnerships (FLPs), closely held limited liability companies (LLCs), and family-owned corporations are effective business and estate planning tools that allow taxpayers to accomplish succession planning for family business interests during their lifetime, as well as to accomplish other non-tax planning objectives. Under current law, minority interests in family-held entities are often valued for estate, gift, and generation-skipping transfer (GST) tax purposes with valuation discounts for a lack of control in the entity as well as a discount for a lack of marketability.

The proposed regulations were issued under Section 2704 of the Internal Revenue Code. Section 2704 and other provisions of Chapter 14 of the Code were enacted in 1990 in an attempt to curtail perceived abuses by taxpayers transferring interests in family-owned entities. The existing Treasury Regulations under Chapter 14 are extremely complex. The general effect of Section 2704 is to decrease or eliminate valuation discounts and increase the value of a transferred interest unless there is compliance with exceptions under Chapter 14. The proposed regulations attempt to limit taxpayers’ ability to use discounts by narrowing those exceptions and expanding other aspects of Section 2704.

Regulations apply to LLCs and other state law entities

The proposed regulations will apply to all entities under state law, including corporations, partnerships and LLCs. This is in contrast to current statute and regulations, which arguably apply only to state-law corporations and partnerships.

Disregard “nominal” interests of nonfamily members

Transfers of interests in family entities to nonfamily members who have the ability to block the removal of a restriction is a recognized exception to Section 2704(b) under current law. However, the proposed regulations only recognize the interest of a nonfamily member if that interest is economically substantial and not “nominal.” A nonfamily member’s interest will be disregarded as nominal (resulting in a higher value for the transferred interest because Section 2704(b) will apply) if any one of the following is true:

  • A nonfamily member held the interest for less than three years before the date of the transfer;
  • The interest makes up less than 10% of the value of all equity interests in the entity;
  • The interest, when combined with the interests of all other nonfamily members, makes up less than 20% of the value of all equity interests in the entity; or
  • The interest does not include a right to put the interest to the entity and receive a minimum value.

Expand situations where restrictions will be disregarded

When valuing an interest transferred to another family member under current law, a transfer that results in the lapse of a liquidation right is not subject to Section 2704(b) if rights with respect to the transferred interest are not restricted or eliminated. However, under the new regulations, the exception is limited to transfers that both (1) occur three years or more before the transferor’s death and (2) do not restrict or eliminate rights associated with ownership of the transferred rights. As such, under the proposed regulations, it appears the following estate-planning techniques would be treated as a lapse of voting or liquidation rights and disregarded for valuation purposes (resulting in a higher value for transfer tax purposes):

  • “Deathbed transfers” that occur within three years of the transferor’s death (regardless of whether the transferor anticipates that death will occur within three years);
  • Restrictions that grant transferees the rights of assignees rather than the rights of partners or members;
  • Default restrictions under federal or state law that are permitted to be changed by agreement of the parties (which includes most state law restrictions on becoming a partner or member or on liquidating an entity);
  • Restrictions that limit the interest holder’s ability to compel liquidation or redemption of the interest (unless they are mandated by federal or state law);
  • Restrictions that permit the payment of liquidation proceeds in any manner other than in cash or property (other than certain notes);
  • Restrictions that limit liquidation proceeds to an amount that is less than fair market value; and
  • Restrictions that defer the payment of liquidation proceeds for more than six months.

What’s the next step?

Although the proposed regulations are significant, they will not go into effect until the IRS publishes its final regulations in the Federal Register. Comments are due by November 2, 2016, with the public hearing set for December 1, 2016. It is likely the IRS will receive significant comments on these proposed regulations. As such, it appears that taxpayers will not be affected by the proposed regulations until the end of 2016 or early 2017. However, clients holding interests in family-controlled entities or considering the formation of family-held entities should contact their counsel to discuss steps that may need to be taken to implement such plans before the end of the year.