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Focus on Valuation: Proposed Regulations May Limit Valuation Discounts for Interests in Family-Controlled Entities

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On August 4, 2016, the Internal Revenue Service released much-anticipated proposed regulations to Internal Revenue Code § 2704 (REG-163113-02) that would greatly impact or eliminate discounts when valuing transfers of interests of entities to family members. Valuation discounts are a significant component of estate planning.
August 30, 2016

On August 4, 2016, the Internal Revenue Service released much-anticipated proposed regulations to Internal Revenue Code § 2704 (REG-163113-02) that would greatly impact or eliminate discounts when valuing transfers of interests of entities to family members. Valuation discounts are a significant component of estate planning.

Minority (i.e., less than 50% and/or non-voting) interests in closely-held family entities suffer from a lack of control and/or lack of marketability in that, often times, the interests cannot directly manage the underlying assets of the entity or be transferred without consent from other shareholders/partners/members. Under current tax regulations, discounts for lack of control and/or lack of marketability are generally permitted, which greatly reduces taxes owed when the closely-held interests are transferred to family members.

While the proposed regulations would dramatically reduce the ability to apply valuation discounts, the regulations are NOT effective until they are finalized. In all likelihood, there will be significant comments to the proposed regulations and much discussion at the public hearing scheduled for December 1, 2016. As such, most expect that the earliest the regulations will become final will be sometime in 2017. Therefore, it may be prudent for taxpayers who are considering transferring closely-held interests to family members (or trusts for the benefit of family members) to take advantage of potential valuation discounts and to act sooner, rather than later.

Background

Effective October 9, 1990, IRC § 2704 was enacted to limit the use of valuation discounts in connection with the gifting of interests in family entities. Section 2704 of the Internal Revenue Code provides special valuation rules for purposes of subtitle B (relating to estate, gift and GST taxes) for valuing intra-family transfers of interests in corporations and partnerships subject to lapsing voting or liquidation rights and restrictions on liquidation.

One of the objectives of § 2704 was to prevent taxpayers from imposing restrictions on the transferred interests in an effort to artificially reduce the value of the transferred property for gift tax purposes while there is no impact on the underlying economic value of the property. § 2704(b) provides that certain “applicable restrictions” (that would normally justify discounts for lack of control and/or marketability) are to be ignored in valuing interests in family-controlled entities if those interests are transferred to, or for the benefit of, other family members. However, court decisions and state statutes have limited the applicability of § 2704(b) in many cases by re-characterizing restrictions so that they no longer fall within the definition of an “applicable restriction.”

In 1993, under IRS Revenue Ruling 93-12, the IRS concluded that “in the case of a corporation with a single class of stock, notwithstanding the family relationship of the donor, the donee, and other shareholders, the shares of other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of a controlling interest.”

As a result of this ruling, which limited the applicability of IRC § 2704, family limited partnerships and limited liability companies became popular estate planning vehicles due to the valuation discounts that were allowable for the transfer of minority interests. One of the major provisions included in the recently proposed regulations to § 2704 would seek to essentially reverse Revenue Ruling 93-12 – in that family interests would be aggregated – which would greatly reduce the applicability of minority discounts, as discussed in more detail to follow.

Key Provisions of Proposed Regulations

The main provisions of the proposed regulations to IRC § 2704 are summarized below.

  • Three-year Rule: Transfers that result in a lapse in rights may be subject to a three-year rule, which would require the liquidation value to be included in the transferor’s gross estate at death if the transferor dies within three years of the transfer.

    Currently, under § 2704, if a holder of an interest in a family-controlled entity transfers an interest to a family member and in doing so, either (i) loses the right to liquidate the entity (due to the transferor’s interest falling below a certain threshold) or (ii) loses control with respect to voting rights, there is no lapse of liquidation or voting rights as long as the transferor’s interest still has voting rights and can still participate in a liquidation vote. In these situations, the transfer would not be taxable.

    Under the proposed § 2704 regulations, the current rules (i.e., no lapse in liquidation or voting rights when the above conditions are met) would no longer apply if the transferor dies within three years of the transfer and instead, the transfer would constitute a lapse in rights and therefore, be taxable. We believe this regulation was proposed to curtail “deathbed” transfers that shift control away from the transferor.
  • Covered Entities: Covered entities would now also include limited liability companies and other entities and business arrangements, in addition to the corporations and partnerships previously covered. Additionally, closely-held operating companies (as well as asset holding companies or partnerships) “controlled” by a family are expected to be subject to IRC § 2704.
  • Control: The term “control” is expanded to include ownership of at least 50% of either capital or profits interest of the entity or other business arrangement (in addition to interests with the ability to cause the full or partial liquidation of the entity). Further, in determining the ownership of family members, the individual family member interests will be aggregated. Both of these provisions will greatly reduce the applicability of minority interest discounts going forward.
  • Assignees: The provisions would limit the ability to avoid §2704 restrictions by transferring a closely held business interest to an assignee rather than to a partner or shareholder, thus eliminating any discount based on the transferee’s status as an “assignee.”
  • Disregarded Restrictions: The proposed regulations include the creation of a new category of “disregarded restrictions,” which effectively treats transfers of interests in family-controlled entities as if the holder of the interest has a put right to sell the interest back to the entity within six months for a value equal to, or greater than, a pro rata share of the net asset value of the entity in return for cash or property. The assumed put right would drastically reduce marketability discounts for minority interests in family-controlled entities.
  • Unrelated Parties Not Recognized: One of the requirements for treating a liquidation restriction as an applicable restriction (that is disregarded in valuing the interest) is that the restriction later lapses or the family can remove the restriction. For example, in the past, family-controlled entities could transfer a small interest to a nonfamily member (i.e., a charity or employee) in order to prevent the family from being able to liquidate the entity without unanimous consent, thus supporting lack of control discounts for valuation purposes.

    Under the proposed regulations, in determining whether the family can remove “disregarded restrictions,” the interests of unrelated parties would not be considered unless certain conditions are met. Specifically, the nonfamily member must either: (i) have held the interest for more than three years, (ii) own a substantial interest in the entity, or (ii) have the right, upon six months’ notice, to be redeemed or bought out for cash or property (not including a promissory note issued by the entity, its owners, or anyone related to the entity or its owners). Given the unlikeliness of these criteria being met, it will be difficult for family-controlled entities to justify valuation discounts via transfers to unrelated parties.
  • Non-State/Federal Liquidation Restrictions: The provisions would ignore restrictions on liquidation that are not mandated by federal or state law in determining the fair market value of the transferred interest.

What it Could Mean for Interests in Family-Controlled Entities

Although the §2704 regulations have been proposed, they have yet to be finalized. A hearing will be held December 1, 2016, to go over the proposed regulations. The provisions of the proposed regulations applicable to voting and liquidation rights are proposed to apply to rights and restrictions created after October 8, 1990, but only to transfers occurring after the date the regulations are published as final regulations.

In all likelihood, there will be significant comments to the proposed regulations and much discussion at the public hearing. As such, most expect that the earliest the regulations will become final will be sometime in 2017. Further, while it is unclear exactly when the proposed regulations will go into effect, it is believed that there will be no “grandfathering” of pre-existing entities as it relates to future transfers; only transfers made prior to the effective date of the new regulations will be “grandfathered” in. Therefore, it may be prudent for taxpayers who are considering transferring closely-held interests to family members (or trusts for the benefit of family members) to take advantage of potential valuation discounts and to act sooner, rather than later.

The valuation experts at RubinBrown provide accurate, objective and timely valuations to private and public operating companies, asset holding companies, financial institutions, private equity/hedge funds and high-net worth individuals and families. Our seasoned team of valuation professionals specializes in providing valuation services for financial reporting purposes, tax planning and compliance, transaction advisory, litigation disputes and bankruptcy. All valuation work is performed in accordance with the most current U.S. and international accounting guidance and promulgations, which results in a high quality work product that withstands the requisite audit and regulatory scrutiny.

 

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

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