- By Todd G. Povlich, CFA, ASA
- June 10, 2015
December 2015 Update: Since September, as reported by taxanalysts® and Bloomberg BNA, IRS officials seem to have clarified comments made earlier in the year pertaining to the extent of new regulations. IRS officials have stated that the current statute is being reviewed, but that proposals in the 2013 Greenbook are not necessarily indicative of current thinking. It is hard to predict what will transpire and when new rules will be issued. Notwithstanding the apparent change, we continue to recommend that clients discuss the implications of potential new regulations under 2704 with their legal advisors.
The Trusts & Estates community has been abuzz about potential new interpretations regarding Internal Revenue Code Section 2704 since Catherine Hughes spoke at the ABA RPTE Conference in Washington, D.C. in late April. Ms. Hughes is an Estate and Gift Tax Attorney-Advisor in the Office of Tax Policy of the US Treasury Department. To summarize, Ms. Hughes indicated that proposed rules under Section 2704 were very much in the works, and expected to come out prior to the ABA Tax Section Conference in the Fall (9/18-9/20). At the New York State Society of CPA’s Estate Planning Conference on May 21, 2015, Jonathan Blattmachr postulated that the rules could come out “anytime between next week and the end of the summer.”
The proposed rules are known as the “valuation discount rules” or “disregarded restrictions” and are thought to be a new tool in the government’s stance against business valuation discounts taken on interests in family owned companies and partnerships for gift and estate tax purposes. The timing comes as a surprise to some, because the proposal was not in the latest “Greenbook” (General Explanations of the Administration’s Fiscal Year Revenue Proposals – released every February); the latest proposal appears to be in the FY 2013 Greenbook. Since that time, it seems that the administration has concluded that these rules do not need Congressional authorization, but rather can be implemented through new Treasury Regulations.
It is hard to tell how this will play out in the months ahead, but let’s start with what appeared in the FY 2013 Greenbook:
- 2704(b) states that “applicable restrictions,” typically those restrictions listed in the entity’s operating or partnership agreement, and which would normally justify discounts, are to be ignored;
- Several judicial decisions and State statutes, which came about after the enactment of 2704(b), effectively re-characterized these types of restrictions so that they fall outside the definition of an “applicable restriction”;
- Treasury is proposing to put into place a new set of “disregarded restrictions” that would apply when valuing an interest in a “family controlled entity” in connection with an intra-family transfer, if, after the transfer the restriction will lapse or may be removed by the transferor and/or the transferor’s family;
- The regulations are said to replace the disregarded restrictions with certain assumptions to be specified;
- Disregarded restrictions would include (1) the owner’s right to liquidate the interest (withdrawal rights), if such restrictions are more onerous than a standard set by the regulations and (2) any limitations on transferees being admitted as full owners to the entity (i.e., bypassing the assignee stage);
- Safe harbors may allow family entities to draft documents in such a way as to avoid the application of Section 2704;
- The regulations would become effective for any transfers occurring after enactment (i.e., immediately).
Richard Dees told Bloomberg BNA in May that, “My concern is that the regulations may limit the availability of minority ownership and lack of marketability discounts for valuing equity in family-owned companies… they may revive the concept of family attribution under the pretext of limiting liquidation and other restrictions… reinstating family attribution is specifically contrary to the history of the legislation enacting Section 2704 and, therefore, any such regulations are likely to be invalid.”
At this point, there are clearly more questions than there are answers. In fact, based on the bullet points above, there may be new opportunities to create tax efficient structures that fall within the boundaries of new safe harbors. A fair guess is that the discussion will eventually include the business valuation-related question, “Upon withdrawal, what does the owner get?” Does the owner get cash, a note at AFR, or fractional interests in underlying assets? What if the company is not liquid enough to satisfy the payment? Can you then force liquidation? How long does the company have to make payment?
There has also been some talk about the possibility that the new rules will apply only to holding entities, and that operating companies would be exempt. There is precedence in the Code for such a distinction, albeit for different purposes. Section 6166 provides for the extension of time for payment of estate tax for estates where more than 35% of the adjusted gross estate consists of an “interest in a closely held business.” Section 6166 defines a closely held business as something involved in carrying on a trade or business, whether organized in the form of a proprietorship, partnership or corporation, and then goes on to define the concepts of “holding company” and “passive assets.”
Only time will tell as to how this will play out. MPI will be keeping a close eye as the year progresses and will be prepared to deal with the potential new regulations, no matter what path they take. In the meantime, planning advisors may want to consider recommending wealth transfers to certain clients in the very near term. This may be especially critical for those clients with significant wealth tied up in liquid assets that would normally be transferred through partnership or LLC structures.
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 Source:Bloomberg BNA, Diane Freda, “Guidance on Material Participation For Trusts, Estates May Emerge in Stages.”
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