Proposed Regulations Would Eliminate Many Valuation Discounts Associated with Transfers of Interests in Family Entities
- On October 20, 2016
On August 4, 2016, the Treasury Department published proposed regulations which would eliminate most valuation discounts in connection with transfers of interest in family controlled entities
Statutes affecting the ability to discount the value of family controlled entity were enacted in 1990. Discounts were subject to two factors: (i) lapses of voting and liquidation rights in family controlled entities and (ii) restrictions that prevent liquidation of family controlled entities.
The first prong of the statute treats any lapse of a voting or liquidation rights in a corporation or partnership as a taxable transfer, where the value of such rights become taxable. However, when voting or liquidation rights are transferred to a family member, there is not a lapse, and therefore not a transfer. However, the planning under the Proposed Regulations provide a new “survival” feature which can nullify planning to avoid their being a lapse.
The second prong of the statute also provides that any restriction relating to liquidation of an entity is disregarded in valuing an interest in a corporation or partnership that is transferred to a family member if the transferor and family members control the entity. These restrictions did not include (i) commercially reasonable restrictions imposed by a third party in a financing transaction or (ii) any restriction imposed, or required to be imposed, by any Federal or State law. In this type of planning, due to the fact that many state statutes for business entities have a rules limiting the liquidation of an entity, this “State law” exception has provided heighten discount planning – that is, until the issuance of these Proposed Regulations.
The Effect of the Proposed Regulations
Not only do the Proposed Regulations undo the above rules under the statute, they contain additional rules which can affect planning.
First, in the event a transferor were to die within three years of certain transfers (most transfers would fall into this category), then valuation discounts cannot be taken. This provision essentially attacks any deathbed transfers that could shift away control from the transferor.
Second, the Proposed Regulations have introduced a provision that disregard restrictions which limit the ability of an entity to liquidate or an owner to withdraw. Essentially, this eliminates the current “State Law” exception which has been heavily relied upon by practitioners in providing valuation discounts for planning involving family entities.
Third, the Proposed Regulations provide that certain restrictions are to be ignored in valuing any interest in a family controlled entity. These provisions eliminate the ability to discount the value of an interest in a family controlled entity based on a party not being able to liquidate or redeem such an interest. The Proposed Regulations also provide that interests of unrelated parties are not considered in determining whether such restrictions can be removed, unless unusually stringent conditions can be satisfied (which is unlikely).
Fourth, the Proposed Regulations affect “covered entities.” Covered entities are defined as corporations, partnerships and limited liability companies -basically, business entities. Most notably, it does not include an interest in an asset (e.g., a promissory note) held outside of an entity and undivided interests in real estate or art (e.g., a tenant in common interest in real estate).
Fifth, an exception to these rules does apply in the event of a “commercially reasonable restriction” for entities with trade or business operations.
Issues To Consider
One major impact of the Proposed Regulations is a limitation on lack of control discounts. This would cause valuations of closely held interests to be higher and disallow increased transfers of wealth to future generations. Lack of marketability discounts would also be affected by these Proposed Regulations.
The three-year rule imposed by the Proposed Regulations would treat any transfer made within three years of death where a liquidation or voting right is transferred, to be treated as a lapse of a voting or liquidation right, even if such right is transferred to a member of the transferor’s family. What is not entirely clear at this point with the three-year rule would be in effect for situations where planning was completed prior to the Proposed Regulations becoming effective and the transferor died within three years of such planning – likely, those transactions would be “grandfathered” out of the Proposed Regulations but that has not yet been made clear.
The Proposed Regulations are not effective immediately. The Proposed Regulations only apply to transfers made 30 days after these regulations are made final.
A hearing on the Proposed Regulations is scheduled for December 1, 2016. Most proposed regulations are not finalized for two years or more. The IRS will likely receive many comments for consideration, which presumably will mean that the final regulations will not be issued any time soon after the December 1 hearing. If the IRS makes this a high priority project, then the regulations conceivably could be finalized sometime in mid-2017.
In any event, clients will have an additional 30 days after the regulations are finalized to plan before the new provisions become effective.
With the Proposed Regulations essentially eliminating business entities for wealth transfer planning, such planning, as we currently know it, may be eliminated sometime in 2017. Therefore, it is advisable to enter into such planning now. The penultimate reason for engaging in planning now is to allow for greater discounts to allow families to transfer wealth. Although there are other mechanisms that can be used to transfer wealth after the Proposed Regulations become final, the current wealth transfer climate allows planners to take advantage of more available resources to transfer wealth now for their clients.