United States: New Proposed Treasury Regulations Imperil Valuation Discounts For Family Controlled Entities

New Valuation Rules Apply to Both Entities Holding Passive Investment Assets and Active Trades and Businesses

Limited Window of Opportunity to Implement Planning Securing Valuation Discounts

Prompt Action Required as Regulations are Likely to Become Effective Some Time in 2017

Appraisals Will be Necessary to Complete Planning

* * * *

For several years, the elimination of valuation discounts for transfers of minority interests in family controlled entities has been the target of the Obama administration's legislative proposals, and the IRS has repeatedly warned practitioners that they intended to issue regulations that would sharply curtail such valuation discounts. The day of reckoning has arrived, as earlier this month the Treasury Department released the long-feared regulations eviscerating valuation discounts. If the proposed regulations are finalized, they will have a dramatic impact on the valuation of closely held business interests – both active and passive.

Fortunately, the proposed regulations do not become effective until they are finalized, and in some cases not until 30 days after they are finalized. There is a last chance opportunity to make discounted transfers until year-end, and possibly beyond, when the window may slam shut on most valuation discounts for family controlled entities, dramatically increasing future gift, estate and generation-skipping transfer taxes for their owners.

CURRENT LAW

Under current law, interests in many closely held business entities qualify for valuation discounts in determining fair market value for estate and gift tax purposes. Whether they are shares of stock of a closely held corporation or limited partnership or LLC units in a family controlled real estate company, under existing law the value of those interests, for gift, estate and generation-skipping tax purposes, often are appropriately discounted from their pro rata value of the underlying assets owned by the entity.

In particular, minority or other non-controlling interests in a closely held company should reflect discounts for lack of control and to some degree lack of marketability for gift, estate and generation-skipping tax purposes. This is so because a hypothetical purchaser (the guidepost in determining fair market value) would not pay a proportionate share of the value of a company's underlying assets for a minority stake. Minority owners generally have no hand in the management of the company; rather, the managers are granted the investment, managerial and distribution powers. And often, minority owners have limited rights to sell their interest or withdraw from the entity. A hypothetical purchaser of a non-controlling interest would demand a discount from the proportionate value to reflect this lack of control and liquidity. Discounts of up to 35% or more can be attained. Currently, many gift and estate plans for owners of family businesses are enhanced by such discounts, potentially saving significant transfer taxes.

PROPOSED 2704 REGULATIONS

On August 4, 2016, the Treasury Department published in the Federal Register proposed regulations under Section 2704 of the Code. If the proposed regulations are adopted, which seems likely either in their current form or a slightly modified form, the regulations will virtually eliminate "lack of control" discounts and significantly impact "lack of marketability" discounts for family controlled entities for gift, estate and generation-skipping transfer tax purposes. This is true whether the entity is an active trade or businesses or holds passive assets.

Effective Date

With one exception, the proposed regulations are generally scheduled to become effective for transfers (or lapses of liquidation rights) occurring on and after the date of publication of a Treasury decision adopting the rules as final regulations. The exception relates to a new category of "disregarded restrictions," which generally would become effective only for transfers occurring 30 days or more after the proposed regulations are adopted as final.

A public hearing about the new regulations is scheduled for December 1, 2016, and it likely will take some time after the hearing for the regulations to be finalized. The conventional wisdom is that individuals interested in pursuing discount-related planning will have until at least year-end and possibly into 2017 to accomplish their goals, subject to a new three-year claw back rule (described below), which may apply to certain transfers made before the effective date if the transferor dies after the effective date, but within three years of making the initial transfer.

Covered Entities

Code section 2704 and the new rules apply only to transfers of interests in controlled entities. This begs the questions: what is an entity and what is control? Entities are defined very broadly to include corporations, partnerships, LLCs, and other entities and arrangements that are business entities, regardless of whether the entity or arrangement is domestic or foreign, regardless of how the entity or arrangement is classified for other federal tax purposes, and regardless of whether the entity or arrangement is disregarded as an entity separate from its owner for other federal tax purposes.

The term "control" has different meanings for different types of entities, and family attribution rules apply. For partnerships, control means at least 50% of the capital or profits interests or the holding of any interest as a general partner in a limited partnership. For corporations, control means at least 50% (by vote or value) of the stock. For an LLC, control would constitute the holding of at least 50% of either the capital or profits interests of the entity or arrangement, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity.

Disregarded Restrictions

The crux of the new rules lies in the new category of "disregarded restrictions" – i.e., certain restrictions in an entity's governing documents that now will be disregarded for valuation purposes. The disregarded restrictions are the main mechanism by which the proposed regulations would disallow discounts for lack of control and may substantially limit discounts for lack of marketability.

Generally, any restriction on a shareholder's, partner's, member's, or other owner's right to liquidate his or her interest in an entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members, without regard to certain interests held by nonfamily members, may remove the restriction. In valuing transfers of interests in family-controlled entities, the proposed regulations assume that the entity's governing documents give the holder of the interests a fictitious "put right" to sell the interest to the entity within six months for a "minimum value" equal to at least the interest's pro rata share of the net fair market value of the assets of the entity for cash or property (other than certain promissory notes). Even if the entity agreement is silent as to withdrawal rights and the relevant state law default provisions provide that the holder may not withdraw, that restriction is disregarded under the new rules unless the state law is mandatory! This is a significant change from current law, under which limitations that are no more restrictive than the state law default rules are taken into consideration when valuing a holder's interest.

There is an exception from disregarded restrictions for a commercially reasonable restriction imposed by an unrelated person (such as a lender) providing capital to the entity for its trade or business operations. This exception could be significant for entities carrying on a trade or business. Banks and outside investors often impose restrictions on an entity's owners, and it appears that such restrictions will not be disregarded in valuing the owner's share of the entity.

It is expected that the concept of minimum value will severely limit marketability and minority discounts, although there are a number of ambiguities in the language of the proposed regulations that may allow some such discounting to still occur. For example, certain commercial restrictions imposed by unrelated lenders may reintroduce discounts, and some discounts may be allowed in computing the "interest's share" of the net value of the closely held entity.

Minimum Value

Under the new proposed regulations, an interest in a family-controlled entity is assumed to have a put right to receive a minimum value. Minimum value under the new rules is vastly different from fair market value – i.e., the price a willing buyer would pay a willing seller when both know the relevant facts and neither is under any compulsion to buy or sell. Under the new rules, minimum value is the interest's pro rata share of the net value of the assets of the entity. The minimum pro rata value of the interest is the net value of the assets of the entity multiplied by the interest's percentage interest in the entity.

Consider the following example, which illustrates the estate tax ramifications of the proposed regulations. Let's assume that senior family member A, a New York resident, owns a 48% membership interest in an LLC that operates a business worth $30,000,000. The LLC has no other assets. A's two children own 5% each and manage the business, so the LLC is a covered entity because A and her children together own more than 50% of the LLC. Under the current law, A's 48% membership interest might attract a 35% discount, because A does not manage the LLC and there is no ready market for A's membership interest. A's interest would be valued for estate tax purposes at $9,360,000 ($30,000,000 x 48% = $14,400,000 – $5,040,000 = $9,360,000).

Assuming A has used all of her exemption amount and is not survived by a spouse, if A dies before the regulations are finalized, the combined Federal and New York State estate tax on that amount (using the 2016 rates and exemption) would be approximately $4,300,000. Now let's assume that that A dies after the proposed regulations are finalized. If that is the case, the value of A's 48% interest in the LLC would be net value of the entity ($30,000,000) multiplied by her share of the entity (48%), or $14,400,000. The Federal and New York State estate tax on that amount would be around $6,800,000. The estate tax would have increased by $2,500,000! A's estate tax cost under the proposed regulations is around 35% greater than under current law, consistent with the loss of the 35% discount.

Another example illustrates the gift tax ramifications of the proposed regulations. Suppose, for example, an LLC is owned by two unrelated partners, A and B. Each owns a 50% membership interest in the company. The company owns an office building in New York City worth $50,000,000 and nothing else, and the LLC agreement states that no member can withdraw without the consent of a majority of the membership interests.

Under the current rules, if A gifts a 10% membership interest to a trust for her children, the 10% interest likely would attract valuation discounts because there is no ready market for it and because the members have no control. The combined discount might approach (or even exceed) 35%, bringing the value of the 10% membership interest to $3,250,000. Under the proposed new rules, the 10% membership interest would be deemed to have a "minimum value" equal to the net value of the entity ($50,000,000) multiplied by the share of the entity (10%), or $5,000,000. The size of the gift, and correspondingly the amount of gift tax exemption used by A, would have increased by $1,750,000! And if A had previously exhausted her gift exemption, the additional federal gift tax would be $700,000 ($1,750,000 x 40%).

Transfers Within Three Years of Death

The new rules also seek to curtail certain transfers that result in the lapse of the power to liquidate occurring on the decedent's deathbed. Suppose, for example, that A owns 75% of an LLC, and the LLC's operating agreement authorizes the owners of two-thirds of the entity to liquidate the entity. A's transfer of 5% to her daughter and 5% to her son would reduce her stake such that she could no longer unilaterally liquidate the company.

Under the current rules, the gifts of 5% likely would have qualified for valuation discounts, and if A were to die owning 65%, that interest likely would have qualified for valuation discounts as well, because even though A owned a 65% stake, she could not liquidate the company without the consent of other owners. Under the new proposed regulations, however, if the transfers by A were made within three years of A's death, there would be a deemed transfer of the value of the lapsed liquidation right at A's death, because the transfers caused A to lose the ability to force the liquidation of the partnership.

There is some uncertainty in the language of the proposed regulations concerning the effective date of this rule with respect to the lapse of control. It may (or may not) apply to lapses of liquidation rights that occur within three years of A's death but before the regulations are finalized. The deemed transfer of the power to cause a liquidation could result in a transfer of value that exceeds the "minimum" value described above. Clients who wish to make transfers that would reduce their stake in an entity to a non-controlling interest before the proposed rules become finalized, should keep in mind this so-called three-year claw back rule.

Tenancy-In-Common Interests

The new rules apply only to controlled entities. Although the term entity is broadly defined, a tenancy-in-common form of ownership does not appear to be an entity for these purposes. Transfers of fractional interests in real estate attract discounts under current law, and those discounts may continue. Furthermore, if an entity owns a fractional interest in real estate, then presumably, when determining the minimum value of the entity, the determination of the net value of the entity would take fractional interest discounts into account.

This assumes that the tenancy-in-common will not be recharacterized as an entity by the IRS. If the participants carry on a trade, business, financial operation or other business venture and divide profits from the operation, the IRS may be able to recharacterize the tenancy-in-common. Mere co-ownership of property that is maintained and rented or leased does not constitute a separate entity. The IRS issued Revenue Procedure 2002-22, which sets forth complex, "safe-harbor" rules that practitioners often consider when assessing if a tenancy-in-common is likely to be recharacterized as an entity. Careful attention must be paid to the degree of business activity and other factors described in the Revenue Procedure because subtle distinctions can impact whether an arrangement will be respected as a tenancy-in-common for tax purposes.

LIMITED WINDOW OF ESTATE PLANNING OPPORTUNITIES

The only good news about the proposed Treasury regulations is that they do not become effective until they are finalized, which may not be until sometime in 2017. Clients who are considering gifting or selling minority interest in family controlled entities should promptly move forward with their plans. The interest rates that the IRS uses to value many transfers for estate and gift tax purposes continue to be near historic lows. Many strategies that have been effective in the past, such as GRATs and sales to intentionally defective grantor trusts, will continue to be effective (barring future legislation). Even after the regulations are finalized, these strategies will continue to be viable ways to reduce estate and gift taxes, albeit without the added benefit of leveraging the valuation discounts.

You should keep in mind that when you gift or sell an interest in a family controlled entity, you will need a qualified appraisal. We expect that appraisers will be inundated with requests, so this is another reason why prompt action is essential.

Currently, individuals are able to transfer $5,450,000 free of Federal estate, gift and GST tax during their lives or at death. A married couple is able to transfer $10,900,000 during their lives or at death. (There is no New York gift tax.)1 Due to the portability of the Federal estate tax exemption, any unused Federal estate tax (but not GST tax) exemption of the first spouse to die may be used by the surviving spouse for lifetime gifting or at death.

Through coordinated use of their Federal gift and GST tax exemptions, individuals can create trusts with an aggregate value of up to $5,450,000 ($10,900,000 per couple), which may benefit several generations of descendants, while insulating the assets from Federal gift, estate and GST taxes.

Individuals who are the owners of closely held businesses who have not fully used their exemption may want to swiftly move forward with gifting programs that secure the use of valuation discounts before the proposed regulations become effective. Individuals who have already exhausted the use of their exemptions through prior gifting may want to leverage their gifting and the valuation discounts even further through sales to grantor trusts before the window shuts.

The annual exclusion gifting amount remains at $14,000 (or $28,000 if spouses elect to split gifts) for gifts made in 2016. This amount is subject to indexing in future years.

The following are some estate planning techniques that remain particularly attractive under the current tax laws.

Grantor Retained Annuity Trusts

Grantor Retained Annuity Trusts ("GRATs") are a popular technique used to transfer assets to family members without the imposition of any gift tax and with the added benefit of removing the assets transferred into the GRAT from the transferor's estate (assuming the grantor survives the initial term).

In a GRAT, you transfer assets to a trust, while retaining the right to receive a fixed annuity for a specified term. The retained annuity is paid with any cash on hand, or if there is no cash, with in-kind distributions of assets held in the trust. At the end of the term, the remaining trust assets pass to the ultimate beneficiaries of the GRAT (for example, your children and their issue or a trust for their benefit), free of any estate or gift tax.

The GRAT can be funded with any type of property, such as an interest in a closely held business or venture, hedge fund, private equity fund, or even marketable securities. The most important consideration is whether the selected assets are likely to appreciate during the GRAT term at a rate that exceeds the IRS hurdle rate (an interest rate published by the IRS every month). The hurdle rate is 1.4% for transfers made in September of 2016. Other factors to take into account in selecting the assets to be gifted are whether the assets currently have a low valuation or represent a minority interest (which may qualify the assets for valuation discounts for lack of control and lack of marketability under current law, but which may no longer qualify for such discounts once the new proposed Treasury regulations are finalized).

There is some speculation about whether you can fund a GRAT now with discounted assets and later, after the proposed regulations are finalized, pay the annuity with undiscounted assets. This certainly would increase the likelihood of success. The treatment is uncertain, and this may be clarified by the IRS in the future, perhaps with the imposition of a duty of consistency.

Generally, the GRAT is structured so as to produce no taxable gift. This is known as a "zeroed out" GRAT. Under this plan, the annuity is set so that its present value is roughly equal to the fair market value of the property transferred to the GRAT, after taking into account any valuation discounts. There is virtually no gift tax cost associated with creating a zeroed out GRAT.

The value of the grantor's retained annuity is calculated based on the IRS hurdle rate – the lower the IRS hurdle rate, the lower the annuity that is required to zero out the GRAT. Currently, this rate is 1.4% for the month of September 2016.

Why is the interest rate important? Because if the trust's assets appreciate at a rate greater than the interest rate, the excess appreciation will pass to the ultimate beneficiaries of the GRAT free of any transfer tax. Thus, any asset that you think will grow more than 1.4% a year may be a good candidate for funding a GRAT.

Other benefits of a GRAT bear mentioning. The transfer to a GRAT is virtually risk-free from a valuation perspective. If an asset for which there is no readily attainable market value is transferred to a GRAT, and the IRS later challenges the value that you report for gift tax purposes, the GRAT annuity automatically increases in order to produce a near zero gift. Accordingly, there is essentially no gift tax exposure.

GRATs also enjoy an income tax advantage. A GRAT is a "grantor trust," meaning that you must pick up all items of income, credit and deduction attributable to the trust property on your personal income tax return. Being saddled with the income tax liability may seem like a burden, but it is actually a great estate planning advantage, in that it allows the trust property to grow income tax free for the beneficiaries, while reducing your estate.

It is important to note that the existing rules that make GRATs so attractive may change in the future. Many bills requiring that the annuity term of a GRAT have a minimum of ten years have been introduced, and President Obama targeted this popular technique in his fiscal 2017 budget proposals. There may be no better time than the present to consider GRATs – while the IRS hurdle rate remains low and valuation discounts are available.

Sales to Intentionally Defective Grantor Trusts

A sale to an intentionally defective grantor trust ("IDGT") can be an extremely effective planning strategy that takes advantage of the current market conditions, and in the case of a sale of a minority interest, valuation discounts. You would create an IDGT for the benefit of your children, grandchildren and more remote descendants. If there is an existing IDGT, all the better.

An IDGT provides two independent planning opportunities. First, you will pay the income tax on the income generated by the trust, including capital gains tax, thereby allowing the trust to grow for your children and their issue unencumbered by the income tax, while reducing your estate. In addition, you may engage in transactions with an IDGT without any income tax consequences.

For example, you can sell low basis property to an IDGT without recognizing a gain. President Obama's 2017 budget proposals would eliminate virtually all of the estate and gift tax advantages if a grantor engages in a sale, exchange or "comparable transaction" with his or her grantor trust. The proposal has yet to be passed and would be effective with regard to all IDGTs that engage in such transactions after the date of enactment. If you are contemplating any non-gift transactions with a grantor trust, such as a sale, exchange, lease or loan, you may wish to consider advancing the transaction before Congress may enact such legislation.

An ideal way to lock into valuation discounts would be to sell a minority interest in a closely held business or venture to an IDGT. That minority interest can be sold at a price taking into account discounts for lack of control and lack of marketability. Keep in mind that the elimination of valuation discounts is likely imminent, so you must act fast to take advantage of this strategy.

Under this plan, you would sell property to the trust and take back a note with fixed payments of interest and principal. Any property can be sold to an IDGT, but ideally the property would have a low current valuation, good prospects for appreciation and features that enable it to qualify for valuation discounts. If the principal on the note equals the fair market value of the property sold, no taxable gift results. In addition, if the assets earn more than the required interest rate, the excess earnings may retire the principal of the debt, leaving valuable property for your children.

As mentioned below, the interest rates that can be used for this purpose are currently extraordinarily low. Unlike with GRATs, however, such plans may have valuation risks that need to be considered, particularly if the property sold is an interest in a closely held business or venture.

Although sales to intentionally defective grantor trusts have been used widely for decades, in some recent audits, the IRS has attacked the technique on two fronts: first, by taking the position that the note given to the grantor by the trust in exchange for the purchased property should be ignored, resulting in a gift of the full value of the property transferred; and second, by attempting to treat the note as "equity" in the trust rather than "debt," resulting in the inclusion of the asset transferred to the trust in the grantor's gross estate for estate tax purposes. Although most practitioners believe that the IRS's positions conflict with the Internal Revenue Code, Treasury Regulations and prior case law, these audit challenges, coupled with the Treasury's recent legislative proposals – which target sales to grantor trusts – may be an indication that the IRS intends to attack such sales more vigorously.

The IRS recently brought a high profile challenge to a sale to a grantor trust in two companion Tax Court cases. In these cases, which involved a husband and a wife, the grantor sold assets to the trust in exchange for a promissory note that contained a "defined value formula." The formula provided that if the value of the assets were later determined by the IRS or a court to be different than the appraised value, the number of shares purchased would be adjusted to avoid the imposition of a partial gift tax. Both cases settled in March 2016, without the Tax Court having ruled on the efficacy of the defined value formula.

There is a prior court case that supports the validity of this technique, but the IRS has made clear that it will continue to challenge defined value transactions. Therefore, it is possible that "standard" sales to grantor trusts that do not incorporate defined value formulas may be less susceptible to attack by the IRS. If you are considering a sale or exchange with an IDGT, you should consult your tax advisor regarding the potential risks and benefits of the various ways in which the transaction can be structured.

Intra-Family Loans

Another technique that works very well in a low interest rate environment is an intra-family loan. Each month the IRS publishes interest rate tables that establish the lowest rate that, if properly documented, can be safely used for loans between family members without producing a taxable gift.

Currently, these interest rates are near historic lows. The short-term rate for loans of up to three years is 0.61% for September 2016. The mid-term rate for September 2016, for loans of more than three years and up to nine years, is 1.22%. The long-term rate for loans exceeding nine years is 1.9% for September 2016. Funds that are lent to children, or a trust for the benefit of children, will grow in the senior family member's estate at this extraordinarily low interest rate, essentially creating a partial estate freeze plan. Those funds, in turn, can be put to use by the junior family member to purchase a residence or to be invested in a manner that hopefully will beat the interest rate.

Making a loan to a trust for your children may be even more advantageous than making a loan outright, if the trust is intentionally structured as a grantor trust for income tax purposes. Ordinarily, the interest payments on the note must be included in your taxable income, but if the payments are made by a grantor trust, they will have no income tax ramifications to you (though of course the children do not get a deduction either).

TAKE ADVANTAGE OF PLANNING OPPORTUNITIES NOW

The new proposed treasury regulations under Code section 2704 will have a dramatic impact on estate planning with family controlled business entities. Clients interested in transferring interests in such entities should seriously consider acting before 2017. The Federal gift, estate and GST exemptions are $5,450,000, and individuals have extraordinary multi-generational estate planning opportunities to use these exemptions through lifetime gifting. Selecting the optimal wealth-transfer technique and the right assets to gift are of paramount importance. However, it is important that you consider the timing of your gifts before the new rules eliminate certain valuation discounts that make these techniques so powerful.

Footnote

1 Under current law, lifetime gifts made within three years of death are included in the estate for New York estate tax purposes if they are made by decedents dying before January 1, 2019.

Originally published August 2016

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.