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 Withdrawn? Withdrawn and replaced with new proposed regulations?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.
What Your Peers Are Reading
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.