TAX UPDATE: Proposed Regulations May Impact Family Entities

Family-controlled corporations and partnerships are often utilized as part of a family wealth transfer plan as vehicles for managing and controlling family assets, especially in the context of succession planning for family businesses. Family-controlled entities are attractive, in part, because of the ability to make gifts or bequests of interests in the entity to family members at a reduced tax cost using valuation discounts. The value of the interests transferred to family members is often subject to valuation discounts because of various restrictions imposed on the recipient’s ability to participate in management, force a distribution or liquidation and/or sell or transfer the interests. With the release on August 2, 2016 of proposed regulations under § 2704 of the Internal Revenue Code (Code),i the Treasury Department (Treasury) signaled its intent to curtail the opportunity to use such valuation discounts. As the expression goes, “the times they are a-changin’.”

The proposed regulations, if and when adopted, reduce the availability of valuation discounts used in valuing transfers between family members of interests in family-controlled entities where the interests are subject to restrictions on liquidation. The proposed regulations also expand the circumstances in which the lapse of certain voting and liquidation rights attached to an interest in a family-controlled entity will be treated as a taxable gift or bequest.

Don’t sound the alarm quite yet. Although proposed regulations can be useful indicators of the Treasury’s position and interpretation of the law, they are generally not binding on either the Treasury or on taxpayers, and taxpayers cannot rely on proposed regulations to support a tax position or for planning purposes. There is a 90-day public comment period for the Code § 2704 proposed regulations, during which interested parties may submit written comments, and a public hearing is scheduled for December 1, 2016. Thus, any final regulations, if adopted, may be substantially different from these proposed regulations. If adopted, the new regulations will not be effective until the date of publication of a Treasury decision adopting the proposed regulations as final at the earliest. Nevertheless, changes are coming and these proposed regulations denote their likely extent and direction.

As a reminder, every individual’s tax and wealth planning situation is unique and we encourage you to consult with your trusted legal and tax advisors to determine how the proposed regulations might impact you.

OVERVIEW

Code § 2704 is designed to capture gratuitous transfers of value between family members in the context of family-controlled business entities. Thus, this section treats the lapse of certain voting or liquidation rights as a transfer subject to tax in the context of a family-controlled business entity. Likewise, Code § 2704 imposes special valuation rules for purposes of federal gift, estate, and generation-skipping transfer taxes (collectively, “transfer taxes”) for transfers of interests in corporations and partnerships that are subject to certain lapsing rights and restrictions. These “applicable restrictions” usually reduce the transfer tax value of an interest, but do not reduce the interest’s economic value to the recipient family member, and therefore generally are to be disregarded in determining the fair market value of the transferred interest for transfer tax valuation purposes. There have, however, been exceptions to this general rule.

PROPOSED REGULATIONS

The proposed regulations limit the existing regulatory exceptions to the imposition of transfer taxes upon the lapse of a voting or liquidation restriction, and further restrict valuation discounts for transfers between family members of interests in family-controlled corporations, partnerships, limited liability companies and other business entities or arrangements, whether domestic or foreign. The proposed regulations make a number of proposed changes, including limitations on deathbed transfers, expanding the concept of “control” of certain entities, modification of the concept of applicable restrictions, the addition of a new category of “disregarded restrictions,” and a new definition of “family control.”

New Rule for Deathbed Transfers

The current regulations exclude from transfer taxation the lapse of voting or liquidation rights if the lapse occurs as a result of a transfer and, following that transfer, those interests retain the voting or liquidation right. Although the rule operates properly in most scenarios, it allows a transfer by which the transferor loses his or her controlling interest in an entity to escape transfer taxation on the loss of this right. The Treasury believes that this exception should not apply when such transfers occur at or shortly before the transferor’s death. Accordingly, the proposed regulations limit the exception to lifetime transfers occurring more than three years before the death of the transferor. If such a transfer occurs within three years of death, the value of the lapsed interest will be includible in the transferor’s estate for estate tax purposes.

Expansion of “Control”

The proposed regulations clarify that control of a limited liability company or of any other entity or arrangement that is not a corporation, partnership or limited partnership means the ownership of at least 50% of either the capital or profits interests of the entity or arrangement, or ownership of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement. When calculating percentage interests held by family members, the interests of an individual, the individual’s estate and members of the individual’s family are aggregated, whether held directly or indirectly through a corporation, partnership, trust or other entity.

Modification of “Applicable Restrictions” and New Category of  “Disregarded Restrictions”

The proposed regulations retain the general rule that restrictions on the right to liquidate family-controlled business interests that lapse at any time after a transfer to a family member or which may be removed by the transferor and family members will be disregarded for purposes of valuing the transferred interest. The proposed regulations retain (with only slight modification) the existing exceptions to this rule for commercially reasonable restrictions imposed by an unrelated third party in connection with financing, restrictions required under federal or state law, and options described in Code § 2703. The proposed regulations introduce two new features. Most significantly, they remove the exception for restrictions that are not more restrictive than generally applicable state law. The proposed regulations also provide a new exception for restrictions where all of the parties have a put right.

The proposed regulations bifurcate restrictions that will not be taken into account when valuing certain transferred interests into two distinct categories. The first category are restrictions that apply to complete or partial liquidations of the entity, described in Regulation 25.2704-2 and which continue to be called “applicable restrictions,” and in the second category are those restrictions that apply to the ability to redeem or liquidate an interest in the business entity, which are described in Regulation § 25.2704-3 and are called “disregarded restrictions.” Regulation § 25.2704-3 specifically enumerates the four types of disregarded restrictions:

■   Restrictions on the ability to liquidate the transferred interest;

■   Restrictions that limit the liquidation proceeds to an amount that is less than a minimum value;

■   Restrictions that defer the payment of the liquidation proceeds for more than six months; And

■   Restrictions that permit the payment of the liquidation proceeds in any manner other than in cash  or other property, other than certain notes.

Regulation § 25.2704-3 also modifies the rule for determining the family’s ability to remove a restriction by ignoring the rights of non-family member interest holders to remove a restriction unless those non-family member interests meet certain criteria, described below.

New Definition of Family Control

The Treasury believes that taxpayers have avoided the Code § 2704(b) rules by transferring a nominal interest to a non-family member, such as a charity or an employee, to ensure that the family alone does not have the power to remove what would otherwise be a disregarded restriction. Thus, under the proposed regulations, the ability of a non-family member to participate in the removal of a disregarded restriction will be recognized only if none of the following conditions apply:

■   The interest has been held less than three years before the date of the transfer of an  interest to a family member;

■   The non-family member’s interest is less than 10% of the value of all of the equity interests;

■   The aggregate interests of all otherwise countable non-family member interests constitute less than 20% of the value of all of the equity interests; and

■ The interest lacks a right to put the interest to the entity and receive a minimum value.

Effective Date

If adopted as final, the proposed regulations will be effective on and after the date of publication of a Treasury decision adopting them as final in the Federal Register at the earliest. The regulations are proposed to apply to:

■ Lapses of rights created after October 8, 1990, occurring on or after the date the regulations are published as final;

■ Transfers of property subject to applicable restrictions created after October 8, 1990,  occurring on or after the date the regulations are published as final; and

■ Transfers of property subject to disregarded restrictions created after October 8, 1990,

Occurring 30 days or more after the date the regulations are published as final.

Although families have utilized valuation discounts when transferring interests in family- controlled entities for decades, the proposed regulations are anticipated to significantly limit the availability of these discounts. We advise you to consult with your trusted tax and legal advisors to determine how the proposed regulations may affect you, your family and your wealth transfer plan.

If you’d like to learn more, contact us  at 904-551-3536.

 

Source: Suzanne L. Shier, Wealth Planning Practice Executive and Chief Tax Strategist/Tax Counsel

© 2016, Northern Trust Corporation. All rights reserved.

 LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.

1 REG-163113-02 (Aug. 2, 2016)