- By Daniel M. Kerrigan, CFA, ASA
- August 25, 2016
While practitioners are by now familiar with the proposed Section 2704 regulations, the following will provide a discussion of certain economic realities that cannot be overlooked. First, some background for those who might appreciate a brief introduction to the issues.
After more than a year of speculation and rumors, on August 4, the Internal Revenue Service (“IRS”) issued proposed regulations under Internal Revenue Code §2704 (the “Proposed Regs”). Clearly, the goal of the Proposed Regs is to limit (or eliminate outright) the application of discounts for lack of control and lack of marketability when valuing interests in family controlled entities for gift, estate and generation-skipping tax purposes.
A bit of history
In 1990, Congress added Chapter 14 to the estate, gift and generation-skipping tax sections of the Internal Revenue Code, which comprised four sections (2701, 2702, 2703 and 2704). Collectively referred to as “special valuation rules,” these sections aimed to close perceived loopholes in laws governing valuations in the gift and estate tax realm. In particular, Section 2704 targeted provisions in partnership agreements that placed restrictions on a partner’s ability to force a liquidation of the entity or allow for the lapse of voting rights. For partnership agreements that include such attributes, Section 2704 required that these restrictions be disregarded for valuation purposes when interests are transferred to a family member. That said, the statute respected such control restrictions when imposed by any federal or state law. Not surprisingly, states subsequently amended their default provisions that once allowed investors to withdraw and liquidate their interests, thereby diminishing the effect of Section 2704. These changes were followed by a number of U.S. Tax Court cases that effectively halted IRS attempts to more broadly apply the existing statues.
The Proposed Regs at a glance
The Proposed Regs would substantially undo certain of the existing provisions of Section 2704 and significantly expand others. In no particular order, important changes include, but are not necessarily limited to, the following:
- Introduction of a Minimum Value Concept: In cases involving the shares of a family controlled entity, the Proposed Regs stipulate a minimum valuation, which they define as an interest’s pro-rata share of the net value of the entity as a whole.
- Introduction of a Disregarded Restrictions Concept: The Proposed Regs stipulate that any restriction that prevents the holder of an equity interest from liquidating the entity or forcing redemption at the aforementioned minimum value must be disregarded for valuation purposes. Also included are “bright line” tests pertaining to family control and attribution of ownership.
- New Position on Default State Law Restrictions: Default restrictions under state law, particularly those restricting a minority owner’s ability to withdraw from, or liquidate altogether, the entity must be ignored for valuation purposes.
Over the past three weeks, much has been written about the Proposed Regs. Articles have attempted to dissect and interpret the language, describe the important history preceding regulations issued more than 25 years ago and wonder aloud about Treasury’s authority to put forth the Proposed Regs in their current form. We encourage readers to seek out these alerts, as many provide a more comprehensive legal interpretation than is presented here.
Valuations following the effective date of the Proposed Regs
Many of the articles address the potential valuation implications of the Proposed Regs, some concluding they mark the end of discounts for lack of control and lack of marketability for asset holding companies and operating businesses alike. Not lost on MPI is the irony that the Proposed Regs reference the widely-applied and understood Revenue Ruling 59-60 when it invokes the “cash equivalent” concept (yet skips over the part about hypothetical parties) while describing the attributes of seller notes issued in redemption of operating company stock. Nonetheless, the inclusion of this concept has significant implications and may leave the door open to certain market realities, while closing others.
When it comes to the valuation and sale of closely-held companies there are a number of immutable truths that one must not lose sight of when contemplating the Proposed Regs. First and foremost, the path to liquidity for an ownership interest in a closely-held operating company may vary, but it is never short. The largest illiquidity penalty is clearly felt by those holding minority equity positions due to the inherent unattractiveness of such investment – regardless of whether or not a family might collectively hold control over such entity. In addition, achieving liquidity for a controlling block in a closely held firm is not without cost, and certainly not instantaneous. These are market realities that the Proposed Regs attempt to blur through the concepts of Disregarded Restrictions and a minimum value rule.
As anyone who has advised a company through a transaction knows, the sale process may consume nine months to one year, assuming the client is prepared to sell and the business is ready for sale. The italicized portion represents important assumptions and speaks to having properly prepared financials and key legal agreements with employees, customers and/or suppliers, among many other factors. Depending on the level of preparedness (or lack thereof), these pre-deal processes might consume an additional six months. Tacking this “prep time” onto the normal deal process may result in a total time to deal completion of 15 to 18 months.
In most cases, partial illiquidity remains even after a deal is completed, as transaction consideration often includes a mix of cash, seller notes and earn-outs. Regarding cash received, it is common for 10% to 15% of total consideration to be placed in escrow to cover potential indemnity claims against the seller, with this escrow period typically ranging from 12 to 18 months. Seller notes, themselves a closely-held instrument, often carry maturities of two to five years and are fully subordinated to other lenders. Earn-outs may be most vexing, as they typically represent payments of potentially uncertain amounts over a one- to three-year period. Lastly, it is important to point out that the rise of private equity over the past few decades has cemented the concept of “rollover equity,” where the seller retains a minority stake in the acquired firm. Ironically, all other factors held constant, even the IRS must concede (and it appears the Proposed Regs would acknowledge) that the valuation of rolled equity would demand some allowance for illiquidity.
Generally accepted valuation methods appear to dictate that the “cash-equivalent” fair market value of a controlling interest reflects a meaningful discount for lack of immediate liquidity. It would be difficult to understand how one might view this allowance as having the effect of reducing the value of the transferred interest (for transfer tax purposes), but not ultimately reducing the value of the interest to the transferee.
Additional takeaways :
- Although the Proposed Regs allude to a conceptual put right as a guardrail on valuation, the economic impact of an actual right merits consideration. The concept of all shareholders possessing a right to put their equity to the company at a price above the economic worth of the block is shocking. This would effectively convert what is designed to be long term (patient) capital into potentially explosive securities. This prospect would lead to a reduction in that firm’s ability to adequately plan its capital budget, as well as significant capital rationing to the point of underinvestment in value-creating (or value-sustaining) projects. We would also expect that a firm’s current or prospective lending partners might have a few things to say about this. This fictitious situation (and non-market security feature) could be so financially devastating that few companies would even consider such a redemption policy. Nonetheless, this is precisely the construct implied by Treasury’s hypothetical put right concept.
- The Proposed Regs provide for a bright line test when non-family ownership would impact the application of the certain provisions. This begs the question – would the failure to meet this bright line test somehow protect a board of directors from treating one class of shareholders (such as family-owned minority block) as having legal rights beyond those enjoyed by other (non-family) minority shareholders, particularly when that company’s articles of incorporation specifically state otherwise? This seems like a recipe for a breach of contract, breach of fiduciary duty and/or shareholder oppression case.
- Corporate governance is needed in the family context when there are multiple parties with potentially disparate views on managing assets, operations, personnel and business affairs. Part and parcel of appropriate corporate governance are a variety of restrictions on an owner’s unilateral rights. The Proposed Regs seem to discount the fact that such governance is the bedrock of effective operational and capital management.
- The Proposed Regs require a closer review and analysis of the valuation impact of negative investment attributes such as personal goodwill, size of entity, and customer concentration. These issues are market realities and should not be captured through discounts for lack of control or lack of marketability. Might employing a structure to independently shift personal goodwill or intellectual property provide another planning opportunity?
- Is the IRS conceding the issue of entity-level taxes on trapped-in capital gains on asset holding companies, as these amounts would certainly be paid in connection with company liquidation?
Despite the length of the Proposed Regs and the significant amount of time that obviously went into its drafting, they create as many questions as they do answers. What is clear, however, is that the Proposed Regs represent an attempt to change current interpretations and applicability of widely-recognized guidance such as Revenue Ruling 93-12 and 59-60 as it applies to estate planning and ownership succession aspirations. If the Proposed Regs are issued in final form, as currently drafted, the cost of maintaining a multi-generational family business may become prohibitively expensive. To that end, we encourage our clients to meet with their trust and estate counsel, wealth advisors and CPAs to evaluate the potential impact of the Proposed Regs, and to encourage commentary from the professional community.
MPI, a prestigious national consulting firm founded in 1939, specializes in business valuation, forensic accounting, litigation support and corporate advisory work. MPI provides fairness opinions, sell-side and buy-side advisory services through its investment banking affiliate MPI Securities, Inc. MPI conducts every project as if it is going to face the highest level of scrutiny, and its senior professionals have extensive experience presenting and defending work product in front of financial statement auditors, management teams, corporate boards and fiduciaries, the IRS, other government agencies, and in various courts.