Proposed regulations released August 2, 2016 would permanently and profoundly change estate planning for families that own a controlling interest in a privately held corporation, partnership, or limited liability company. For these families, estate planning techniques often take advantage of valuation discounts to mitigate the estate and gift tax burden associated with transfers during life or at death. If adopted, the proposed regulations would restrict or eliminate available discounts, thus directly increasing the tax associated with certain transfers. 

The Internal Revenue Service has requested comments on the proposed regulations by November 2, and will hold a hearing on December 1. Thus, taxpayers should have until at least year-end to complete transfers under the current rules. In addition, even if the regulations are finalized in something close to their current form, portions of the regulations likely will be subject to challenge on the grounds that they exceed the scope of the statute.

What Are Valuation Discounts?

Valuation discounts are downward adjustments to valuation. Broadly speaking, they account for features that render the property less appealing to a hypothetical buyer. There are many types of discounts, but the most common for estate planning purposes are “discounts for lack of marketability” and “discounts for lack of control.” Following is a hypothetical illustration of each:

Susan, John and Ted form a partnership. Their partnership agreement provides that no one can withdraw from the partnership nor sell his or her interest without the consent of the other two. Each of them has an equal vote in all matters relating to the partnership.

If John wanted to sell his interest, he cannot do so without the consent of both Susan and Ted. This means that he can’t easily convert his interest into cash. As a result, it is worth less than its pro rata share of the total value of the partnership. This is a discount for lack of marketability.

If John did get Susan and Ted’s consent to sell, he might have a hard time finding a buyer willing to pay him the full value of the underlying interests, even reduced by a marketability discount. This is because the prospective buyer would be only a minority interest holder and would not be able to control the direction of the entity. Therefore, the interest would be further discounted for lack of control.

These valuation principles are generally accepted in the law as reflective of business reality.  Nonetheless, the IRS is wary of discounts in the intra-family context for two primary reasons.  First, it is widely assumed that a senior generation would not exercise its rights in a manner that would harm the junior generation family members. Second, particularly with respect to non-operating investment entities, it is assumed that families place artificial restrictions on equity interests for the purpose of depressing the value, without affecting the value of the underlying assets. The impact of discounts is significant, with combined discounts for lack of marketability and lack of control often in the range of 25 percent to 50 percent off of the net value of the underlying assets.

What Do the Proposed Regulations Say?

On its face, the wording of the proposed regulations may obscure their plain impact. The Treasury Department’s summary indicates that the regulations “concern the treatment of lapsing rights and restrictions on liquidation” so as to prevent undervaluation of transferred interests. Although perhaps not obvious, the practical effect is to significantly curtail valuation discounts with respect to family held entities where those discounts rely on the normal inability of the owner of an interest in a private entity to quickly convert the interest to cash.

The regulations fall under section 2704 of the Internal Revenue Code. This section attempts to curb perceived valuation abuses associated with lapsing voting and liquidation rights. Even under current law, a transfer that results in a lapse of a voting or liquidation right is treated as a gift if it occurs during life, or is included in the gross estate if it occurs at death. Nonetheless, current law provides a number of exceptions that make planning with valuation discounts possible. The proposed regulations would eliminate almost all of these exceptions.

Briefly, each of the major categories of the proposed regulations is described below:

Applicable Restrictions Redefined. As noted above, present law targets valuation abuses with respect to liquidation rights. Thus in valuing a transfer of an interest in a controlled entity, “applicable restrictions” are disregarded. “Applicable restrictions” are restrictions on the entity’s ability to liquidate, which restrictions either lapse or can be removed by the transferor’s family. They do not, however, include restrictions imposed or required by state law. 

Under current regulations, applicable restrictions are those that are more restrictive than state law. The proposed regulations expand the definition of an applicable restriction, such that even state law defaults would be “applicable restrictions” – unless the law provided that they could not be modified, which is rare in practice.

Disregarded Restrictions. Perhaps the most noteworthy section of the proposed regulations is the introduction of a class of “disregarded restrictions.” Like applicable restrictions, disregarded restrictions would be ignored in valuing an interest in an entity for estate and gift tax purposes. A disregarded restriction includes:

1. Any restriction or limitation on the ability of the holder to liquidate or have his or her interest redeemed;

2. Any restriction limiting the amount received by the holder to less than a minimum value, defined as a pro rata share of the entity value reduced by certain outstanding obligations;

3. Any provision permitting deferral of redemption proceeds for more than six months; and

4. Any provision that permits repayment in anything other than cash or property. Notably, a promissory note is not considered “property” unless the entity is engaged in an active trade or business, the proceeds are not attributable to passive assets, the note is adequately secured and the note is issued at a market interest rate.   

The Three Year Rule. This rule is intended to capture deathbed transfers. If a transfer made within three years of death results in the lapse of a voting or liquidation right, the transferor’s gross estate will be increased by the value of that lost liquidation right. This would occur, for example, if parent held 60 percent of the vote, transferred 10 percent to each of her two children (leaving her 40 percent), and subsequently passed away. Under the proposed regulations, if she passes away within three years after making the transfer (and indeed, if she made the transfer last month and dies one year from now after the regulations are enacted), that “lost value” attributable to her liquidation power will be added to her taxable estate. This effectively creates a phantom asset in the estate – it will be taxed, but the tax must be paid from other assets of the estate.

Who is Affected?

Anyone with an interest in a family controlled entity may be affected. Roughly speaking, an entity is controlled if family members collectively own greater than 50 percent of the entity. In a complex set of rules, interests held in trust are attributed to the grantors and beneficiaries of the trust.

For purposes of determining control, the proposed regulations would ignore interests held by nonfamily unless:

1. The interest has been held by the nonfamily member for at least three years; 

2. The interest is at least a 10 percent equity interest;

3. Nonfamily members in the aggregate hold at least 20 percent of the equity of the entity; and

4. Each nonfamily has the right to put his or her interests to the company and receive a share of the underlying value. 

The stated purpose of this provision is to limit taxpayers’ ability to give “insignificant” interests to nonfamily members in order to escape being subject to the rules.

When Would the Regulations Take Effect?

At this point, the regulations are in proposed format. The Internal Revenue Service has requested comments by November 2, and will hold a hearing on December 1. Thus, even though exact timing is uncertain, the regulations could not take effect before December of this year. 

More likely, the comments submitted to the IRS will result in modifications and clarifications to the proposed regulations, which can take time. The IRS has indicated, however, that this is a high priority. Thus, it is possible that regulations would be finalized and effective in early 2017.

For the most part, the regulations would apply to transfers that take place after the effective date of the final regulations. However, the proposed regulations would allow a 30 day grace period for transfers of interests subject to “disregarded restrictions.” 

Even after the regulations are finalized, they likely will be subject to challenges in court. In addition to challenges to the scope of the IRS' regulatory authority under the statute, there will probably be litigation over what the appropriate level discount for lack of marketability is under these regulations. If the entity in question holds primarily non-marketable assets, such as real estate, can the valuation take into account that the property that hypothetically would be received by a liquidating owner is not liquid? What if the entity consists of both marketable and non-marketable assets? 

Is Current Action Recommended?

Yes. Anyone considering a transfer of interests in a family controlled entity – whether an operating company or an investment company - might wish to do so now. For this purpose, “transfers” includes gifts, sales to grantor trusts and any other change in ownership. Even though proposed regulations indicate a 30 day grace period for transfers subject to disregarded restrictions, the provisions concerning applicable restrictions would take effect immediately. Notably, the estate tax inclusion associated with deathbed transfers would apply for those who die after the regulations are enacted – even if they had given away their interests before the regulations came out.