Family-owned businesses are instrumental to the U.S. economy, and planning for the successful transition of businesses from one generation to the next is essential for continuity. Tax-related considerations complicate transition planning, and the tax issues became even more complex with the release in August of proposed regulations under Internal Revenue Code § 2704 (REG-163113-02), which limits valuation discounts on transfers of family-controlled business entities for purposes of federal gift, estate and generation-skipping transfer taxes (collectively, “transfer taxes”).
At the heart of the issue is the future of discounts for minority interests. Strong negative public reaction to the proposed regulations and the pro-growth – limited regulation orientation of the incoming administration in Washington call the future of the proposed regulations into question. Will they be finalized? Withdrawn? Withdrawn and replaced with new proposed regulations? Or left to languish for an indefinite period of time?
In very brief summary, the proposed regulations limit the existing regulatory exceptions to the imposition of transfer taxes upon the lapse of a voting or liquidation right in a partnership or corporation, add a 3-year “deathbed” transfer recapture provision related to lifetime transfers resulting in a lapse, narrow the exceptions to “applicable restrictions” that are disregarded in valuation and add a new category of “disregarded restrictions” with respect to interests (as opposed to the entity) which has been interpreted by some to imply a deemed put right at a minimum value for valuation purposes.
We do not know the path forward at present, but we do know that the proposed regulations are not binding and may not be relied upon by taxpayers or the Internal Revenue Service. Nonetheless, for taxpayers filing gift tax returns, “adequate disclosure” is required to run the limitation period for audit; and that requires the taxpayer highlight any position taken on the return that is “contrary” to a proposed regulation.[i] Practically speaking, so long as the proposed regulations remain outstanding, advisors will need to address disclosure considerations with clients filing gift tax returns for gifts of interests in family-controlled business entities.
Treasury received 28,865 comment submissions (of which 9,779 are publicly available for review) on the proposed regulations and held a public hearing on Dec. 1 in Washington. Thirty-seven individuals – affected family business owners and representatives from the professional advisor and valuation communities – presented their comments to representatives from the Treasury Office of Tax Policy (Treasury) and the IRS. The following common themes emerged at the hearing:
- The presumption that families ordinarily act in unison to minimize taxes does not reflect the realities of family dynamics. Family transactions may not be arms-length in the sense of being between strangers, but family members typically have independent goals and objectives.
- Any regulatory expansion of the scope of Code Section 2704 should distinguish operating family businesses from passive investment entities created to pool a family’s wealth.
- The proposed 3-year lookback period for lapse transfers is too long and may be inadvertently retroactive.
- The proposed regulations fundamentally alter established valuation principles for family business entities and raise the potential for a disparity in valuation of the same interests for transfer taxes (higher) and income tax basis (lower).
- The new disregarded restrictions and carve-outs raise the specter of a deemed put right for a minimum value in the valuation of family controlled business interests.
Representatives of Treasury and the IRS offered two assurances at the public hearings. First, the 3-year lookback period would only apply prospectively and second, a deemed put right for minimum value was not intended. Thus, we can safely expect clarification on these two points in any revisions to the proposed regulations.
Operating Business Carve-Out. Many have suggested that the proposed regulations’ new provisions apply only to passive family-controlled entities, and not to operating businesses. Administering different valuation rules for two categories of family-owned businesses would require clear and careful drafting, but analogous distinctions already exist in the Code and Regulations. Such bifurcation would address the request of family business owners that the valuation criteria reflect the realities of the market, so that intergenerational transfers of operating family businesses are not more costly than transfers via sale to non-family members.
Three-year Lookback Rule. Under the current Treas. Reg. § 25.2704-1(c)(1), tax is imposed on the lapse of a voting or liquidation right only if the right is eliminated from the interest to which it relates. Thus, even when the majority owner transfers enough voting interests to become a minority owner, the transfer will not trigger tax because the voting interests were not changed. The proposed regulations make such a loss of control a taxable lapse on the date of the transferor’s death, if it occurs within three years of the transfer. Many suggested that a shorter lookback period (possibly one year) be adopted, as a 3-year period would hamper business succession planning. Based on the wording of the regulations’ effective date provisions, there is concern that a transfer prior to the finalization of the proposed regulations, but within three years of death, would be a taxable lapse if the transferor died after the regulations were finalized. As noted above, Treasury has stated that there will be no retroactive effect of the 3-year rule.
Fair Market Value Redefined. A fundamental concern is that the proposed regulations seemingly redefine the concept of fair market value (FMV). FMV has for decades been universally understood by the appraiser and valuation community to mean the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, acting at arm’s length, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. This definition of FMV is also supported by Treas. Reg. § 25.2512-3(a), a long history of case law, as well as the Service’s own rulings. The proposed regulations seemingly eliminate the presumption of hypothetical parties to an arm’s-length transaction. Instead, Prop. Reg. § 25.2704-3(f) provides that if “a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or otherwise.” Arguably the proposed regulations would essentially require appraisers and valuation experts to abandon well-established methodologies and rely on some new concept of FMV, along the lines of what appraisers call “Investment Value,” meaning the value to a particular investor based on individual investment requirements and expectations.
Another concern is how the proposed regulations affect income tax basis under Code § 1014(f). Given that the purpose of Code § 1014(f) is to ensure consistency between the income tax basis of certain property acquired from a decedent and the value of the property as finally determined for estate tax purposes,[ii] the value for estate tax purposes under Code §2704 should determine the recipient’s cost basis under Code §1014(f), but the proposed regulations only pertain to transfer taxes, not income taxes. Because Code §1014(f) provides that the initial basis of certain property acquired from a decedent “shall not exceed” its final value as determined for estate tax purposes (i.e., the rule does not require that basis be at least as high as the estate tax value), Treasury could potentially use inconsistent valuation methodologies for transfer tax (higher value without restrictions) and income tax (lower value with restrictions) purposes.
Deemed Put Right. There is much angst with what has been interpreted as a “deemed put right” under Prop. Reg. § 25.2704-3 regarding exceptions to disregarded restrictions. A “put right” is defined as a right to receive, upon liquidation or redemption of the holder’s interest, cash or property equal to “minimum value,” which is defined as the interest’s pro rata share of the net value of the entity on the date of liquidation or redemption. If (as it appears) the regulations disregard any limitation on the right to liquidate a family member’s interest that is more restrictive than the put right, then the value of a transferred interest is determined as if it included a put right at “minimum value.” Government representatives have stated that no deemed put right is intended. Clarity is needed to put the deemed put right concern to rest.
What is the path forward from here? Given President-elect Trump’s opposition to the “death tax,” the House GOP’s A Better Way tax reform blueprint proposing repeal of the estate and generation-skipping transfer taxes and the president-elect’s selection of Steven Mnuchin for sSecretary of the Treasury, finalization of the proposed regulations may be significantly delayed, if not abandoned entirely. But until further action, they should be taken into consideration in planning and reporting gifts of interests in family-controlled business entities.