If finalized, the proposed regulations will eliminate minority and marketability valuation discounts for transfers of interests in closely held family businesses. The proposed regulations are not effective immediately. Rather, they only apply to transfers made after the final regulations are promulgated, subject to a possible three-year lookback for estate tax purposes.
The new rules target high net worth families which conduct closely held businesses or have significant wealth concentrated in a family business; namely, those who have enough wealth to have federal estate tax exposure. Currently, the exemption amount from the federal estate and gift tax is $5,450,000 per individual. This means that an individual can leave $5,450,000 to their heirs and pay no federal estate or gift tax. A married couple can exempt a combined $10,900,000 from federal estate and gift taxes. For those high net worth families who are over these thresholds, the next few months remain critical to revisit succession planning to use the current rules allowing for valuation discounts.
The cornerstone of estate and succession planning for closely held businesses has been the use of favorable valuation discounts. For example, an LLC is structured to include both managing membership interests (controlling) and limited membership interests (non-controlling, non-voting). The limited membership interests, when gifted or transferred at death, can be discounted for lack of marketability and lack of control.
In 1990, Congress enacted Section 2704 to curtail the perceived abuses with respect to this planning; however, several tax rulings and court cases narrowed the scope of these rules thereby undermining the ability of the IRS to enforce them. As detailed below, the newly proposed regulations essentially reflect the Revenge of the IRS and are designed close the loopholes.
Below please find a summary of the major changes.
“Covered Entities” Subject to Section 2704
As originally enacted, Internal Revenue Code (“IRC”) § 2704 only referred to “corporations” and “partnerships.” The proposed regulations expand this definition to include any entity or arrangement that is a “business entity” within the meaning of Reg. § 301.7701-2(a) that is controlled by the family immediately before the transfer.
Accordingly, LLC’s are now included in the definition. LLC’s are included regardless of whether they are disregarded for federal tax purposes.
New Definition of “Control”
Section 2704 applies to entities subject to family control. Under the existing regulations, “control” for corporations is defined as encompassing at least 50% of the stock by vote or value. The proposed regulations expand the definition of control for LLCs and other entities. “Control” in this setting means ownership of 50% of either the capital or profit interests or the ability to cause liquidation of the entity.
Lapse of Voting or Liquidation Rights
In general, Section 2704(a) addresses the “lapse” of voting or liquidation (control) rights. A “lapse” of a voting or liquidation right occurs where the presently exercisable right is restricted or eliminated. If the lapse occurs during the holder’s lifetime, it is a transfer by gift. Conversely, if the lapse occurs at the holder’s death, it is includible in the holder’s gross estate.
Newly Proposed Regulation: The lapse of a voting or liquidation right in a family owned entity (meaning the entity is controlled by the family immediately before and after the lapse) is a transfer by the individual holding the right immediately before its lapse.
New 3 Year Look-Back Rule: In addition, any lapse of a voting or liquidation right within 3 years of death is treated as a lapse at death (and thereby included in the decedent’s estate under Section 2704(a)).
Example: Father owns 51% of the stock in a closely held business. Within 3 years of death, Father gifts 2% of the stock to his son. Under the current existing rules, Father can claim a minority discount for the 2% gift and at death; furthermore, the remaining minority 49% interest can be discounted for estate tax purposes when Father dies.
However, and under the proposed regulations, if the 2% gift was made within 3 years of death, a lapse is deemed to occur at Father’s death. This results in a “phantom asset” included in the transferor’s gross estate equal to the value of the lapsed voting or liquidation right. This asset presumably would not qualify for the marital or charitable deduction.
Disregarding Certain Restrictions on Redemption or Liquidation
Equally limiting, the proposed regulations provide that the transfer of an interest to a family member in a family business (entity where the transferor and family members control the entity immediately before the transfer) that is subject to a “disregarded restriction” will not be respected and therefore valued pursuant to the generally accepted valuation principles (as if the disregarded restriction simply does not exist).
The key requirement for treating a restriction as an “applicable restriction” and thus “disregarded” stems from the fact that following the transfer, the restriction will lapse or can be removed by the transferor or any members of their family.
Therefore, a “Disregarded Restriction” may be described as one that has the following effects:
- Limits the ability of the holder to compel liquidation or redemption of the interest; or
- Limits liquidation proceeds to less than the “minimum value” of the entity; or
- Defers payment of the liquidation proceeds for more than six months; or
- Permits payment of the liquidation proceeds in any manner other than in cash or other property.
State Law Exception – Virtually Eliminated
Furthermore, the Treasury seeks to curtail estate and succession planning by eliminating a pertinent State law exception which has been around for years. Congress added Chapter 14 to the Code (§§ 2701-2704) to curtail valuation discounts on intra-family transfers of family controlled stock. Section 2704 exempts restrictions on the owner’s ability to liquidate the entity “imposed or required to be imposed” by Federal or State Law. The current regulations state that “an applicable restriction is a limitation on the ability to liquidate the entity that is more restrictive than the limitations that would apply under the State law (often referred to as the “State Default Rule”).
Thereafter, and following the enactment of IRC § 2704, State legislatures substantially tightened their default laws to provide for many restrictions. As the restrictions in the governing agreements were now consistent with the State default law, the restrictions were not considered “applicable restrictions.”
Newly Proposed Regulation: As the State law restriction is not a mandatory requirement (it’s a default rule), restrictions in an entity’s governing documents that are no more restrictive than those under State law will no longer be given effect in valuing the interest. In other words, the State law must be mandatory to be considered a “real restriction,” or the IRS will simply ignore the restriction.
For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Chair of the Trusts & Estates Practice Group, at 973-230-2080 or firstname.lastname@example.org or John A. Grey, Esq., Associate in the Trusts & Estates Practice Group, at 973-230-2088 or email@example.com.