If you own a family business and are considering transferring interests in your business to other family members through a succession plan, it’s important to gain a thorough understanding of the potential impact of recently proposed Treasury Regulations under Section 2704 of the Internal Revenue Service Code. These regulations, if enacted as proposed, would effectively end valuation discounts for transfers of interests in many family owned businesses; substantially increasing the transfer tax cost of lifetime transfers for estate inclusion and eliminating a significant estate planning technique for business owners.
Timeline for the Proposed Regulations
The Internal Revenue Service released the Section 2704 Proposed Regulations on August 2, 2016, and they were published in the Federal Register on August 4, 2016. The Proposed Regulations are not effective immediately. A public hearing is scheduled for December 1, 2016 and Final Regulations are expected sometime in 2017, perhaps as early as January. These long-awaited Regulations target what are considered abuses in valuation discounts for gifts or transfers of interests in family owned businesses.
What are Valuation Discounts?
Currently, if a business owner transfers a portion of his business to his children or to a trust for the benefit of his children, the tax value of such a gift may be reduced by certain discounts, such as for lack-of-marketability and lack-of-control, which may range from 30 to 40 percent. If the Final Regulations are similar to The Proposed Regulations, most or all available discounts for minority interests in family-controlled entities would be eliminated and business owners will be faced with significantly higher estate and gift tax costs when transferring interests in all family owned businesses, including operating businesses.
Key Provisions of the Proposed Regulations
Covered Entities Expanded:
Although Section 2704, when it was enacted, dealt only with corporations and partnerships, the Proposed Regulations open the door to include limited liability companies (regardless of whether they are disregarded as separate entities for federal tax purposes) and any other business entities, domestic or foreign. For a limited liability company or other entity that is not a corporation, partnership or limited partnership, control requires the holding of at least 50 percent of the capital or profits.
Three Year Look Back:
The Proposed Regulations attempt to eliminate deathbed transfers. Any lapse of a voting right or liquidation right by reason of a transfer within three years of the individual’s death is treated as a lapse occurring on the individual’s date of death and, as a result, is included in the individual’s gross estate under 2704(a). In other words, the three year rule creates a risk that the minority discount for lifetime transfers may be added into the individual’s gross estate if the individual dies within three years.
The Proposed Regulations create a new category of “Disregarded Restrictions” that must be ignored in establishing the value of interests in family controlled businesses for estate, gift and generation skipping transfer tax purposes. The following are the four restrictions under the Proposed Regulations:
- A restriction on an owner’s ability to liquidate or redeem his interest;
- A restriction which limits the liquidation proceeds to an amount that is less than “minimum value” (essentially fair market value less debt);
- A restriction which defers payment of liquidation proceeds for more than six months; or
- A restriction which allows the payment of the liquidation proceeds in any manner other than in cash or other property.
A transfer of an interest that is subject to a disregarded restriction will be valued under generally accepted valuation principles as if the disregarded restriction does not exist in the governing documents, local law or otherwise. These rules are at the core of the changes in the Section 2704 Regulations that result in a disallowance of valuation adjustments for transfers of an interest in a family controlled business. In determining whether the family can remove “disregarded restrictions,” there is an exception. The interests of non-family members or unrelated parties are not considered unless under certain conditions
What Happens Next?
It is imperative that you, as a family business owner, consider the impact of these Proposed Regulations. The Proposed Regulations, once final, will drastically reduce the availability for business succession planning and the use of the valuation discounts especially for federal estate, gift and generation skipping transfer tax purposes. Therefore, the time to plan is now – before December 31, 2016 – to continue to take advantage of current valuation rules.
The scope of this article is to provide an overview of recent legal developments. Please consult with your business succession attorney at The Lynch Law Group to determine how the Proposed Regulations relate to your particular business interests.