Valuation discounting utilizing family-owned entities has been a popular estate and gift tax planning technique for several decades. New proposed Regulations to Internal Revenue Code section 2704, which tax professionals have been anticipating for years, were published in August, 2016. The proposed Regulations could significantly impact the continued ability to generate valuation discounts when transfers of family-owned entities are involved.
Family business owners and their advisers have to be proactive in advance of the anticipated effective date of the new rules and update existing family business succession plans or implement new ones. Otherwise, it may be too late.
The IRS is soliciting comments in advance of a hearing scheduled for December 1, 2016. The rules will not take effect until 30 days after the date the proposed Regulations are published as final regulations, which is anticipated to occur sometime in 2017. The proposed Regulations generally apply to transfers occurring after the date the regulations are published as final regulations. A copy of the proposed Regulations can be found at https://www.regulations.gov/document?D=IRS_FRDOC_0001-1487
In 1990, the IRS enacted a series of Internal Revenue Code provisions adopting special valuation rules aimed at limiting the ability of a taxpayer to transfer appreciating property to family members while retaining some interest in or control over the property, or in a manner that resulted in an overvaluation for gift tax purposes. IRC sections 2701-2704 cover these transactions, called “estate freezes,” and these provisions impose a number of rules regarding the valuation of property for transfer tax purposes. IRC section 2704, entitled “Treatment of Certain Lapsing Rights and Restrictions,” generally provides that when a closely-held interest is transferred within the family, a restriction limiting voting or the ability of the entity to liquidate which can be removed by the family is disregarded when valuing the transferred interest for gift or estate tax purposes.
IRC section 2704 placed limits on the use of valuation discounts, but it did not eliminate them. In fact, under current gift and estate tax law, the IRS and courts have regularly approved discounts ranging from 30% to 40% when valuing the transfer of an interest in a closely-held entity when the transferee of the gifted interest does not have the right to liquidate the entity or withdraw as an owner. If finalized, the proposed Regulations could eliminate or significantly reduce this valuation discount for gift and estate tax purposes.
The Proposed Regulations
The proposed regulations would limit valuation discounts in several ways. The new rules:
- Read into governing documents of family-owned entities a “put” right for each owner to sell his or her interest for the fair market value of the owner’s proportionate share of the entity’s net assets.
- Impute a gift which offsets the effect of discounting for estate tax purposes that might otherwise be available to a controlling owner who transfers interests within 3 years of his or her death.
- Disregard control exercised by non-family member owners, unless certain exceptions are met – viz. the non-family member has been an owner for more than 3 years, owns a substantial interest in the entity, or has a meaningful “put” right.
- Expand the types of entities covered by IRC section 2704 beyond corporations and partnerships so as to include limited liability companies and other entities or business arrangements.
Because of the far-reaching scope of the proposed Regulations, challenges are anticipated to the Treasury’s authority to enact such rules. “Safe harbors” may be provided for and some commentators have suggested that the final regulations may, like IRC section 6166, distinguish between operating companies and entities holding only “passive assets” (such as a family limited partnership which owns only marketable securities or similar investments) and deny a valuation discount only in the case of a family entity holding passive assets.
Do the proposed Regulations actually offer a tax savings opportunity for many family-owned businesses?
A report of the Joint Committee on Taxation, entitled “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System,” dated March 16, 2015, suggests that 99.8% of estates will owe no federal estate tax. For business owners not subject to federal estate tax or where the avoidance of a built-in capital gain is more beneficial than the applicable state estate tax, the inability to discount the value of a family business interest may actually inure to the benefit of these taxpayers and their families.
Here’s why: the undiscounted value of an interest in an entity which is includable in the taxable estate of a decedent will receive a “step-up” in basis under IRC section 1014. When no estate tax is due, the higher undiscounted valuation may actually serve to eliminate or minimize the capital gains tax due when an inherited interest in a family business is ultimately sold by the beneficiary. Also, a higher date of death valuation can allow the beneficiary to depreciate a greater sum under the applicable IRC sections.
Time will tell if the proposed Regulations will be a net revenue loser for the Treasury.
Planning strategies to consider in advance of the effective date
All family business owners should review their existing agreements and determine whether the proposed Regulations adversely impact or can cause a future dispute over valuation clauses or other provisions in existing shareholder, operating or buy/sell agreements. For those closely-held business owners facing a federal or state estate tax, or where the use of discounting can minimize or eliminate exposure to that tax, planning opportunities utilizing currently recognized discounting techniques should be considered and implemented in advance of the anticipated effect date of the proposed Regulations.
- Consider gifts or sales to grantor trusts, including a Spousal Lifetime Access Trust. By including a spouse as a beneficiary of a grantor trust, this planning technique provides an opportunity to address a future need for spousal support. In the not-so-distant past, estate planners addressed a “fiscal cliff” that never materialized. A substitution power in a grantor trust can also serve as a hedge to address future tax planning opportunities. For example, a grantor may ultimately decide to swap assets with the grantor trust so as to take advantage of the step-up in basis available under IRC section 1014 in an instance where the capital gains tax exposure exceeds the estate tax savings offered by the grantor trust.
- Confirm the amount of life insurance or other liquid assets in place to satisfy an expected federal or state estate tax obligation. Given the potential for the proposed Regulations to impose a tax on “phantom” assets which were gifted during the look-back period, this analysis is critical under the proposed regime and it can forestall an unwanted or forced sale of a family-owned business on the death of an owner.
- Consider implementing a Grantor Retained Annuity Trust (“GRAT”), which is an irrevocable trust that pays the grantor an annuity payment for a term of years. The annuity payment is determined with reference to the federal interest rate under IRC Section 7520, which for August 2016 is only 1.4%. When the assets transferred to a GRAT outperform the Section 7520 rate, the remaining value passes to the residuary beneficiaries outside the transfer tax system. When the value of a family-owned business interest is discounted, a lower annuity payment is required to reduce the value of the gift to the GRAT, typically to zero or near zero. Depending on the facts, funding a GRAT prior to the effective date of the regulations can leverage more wealth out of a taxable estate.
Estate planning professionals should monitor the proposed Regulations and public comments. At a minimum, the proposed Regulations present planners with an opportunity to meet with existing family business owner clients to review their current documents and discuss their objectives in light of the benefits and detriments of valuation discounting. Where applicable, family trusts should be created and funded utilizing currently available discounting strategies in advance of the effective date of the new rules.