Valuation Discounts. For business owners who intend to make lifetime transfers of part of their closely-held entity interests to their descendants, there is a vanishing opportunity for discount planning over the next few months. The IRS, in Prop. Treas. Reg. §25.2704 issued August 2, 2016, is implementing further restrictions that may virtually eliminate valuation discounts for transfers between family members. The new rules are intended primarily to significantly reduce or eliminate discounts for lack of marketability or lack of control, typically achieved by putting transfer or liquidation restrictions in the entity documents. The new regulations would expand the list of restrictions that will be ignored when valuing the transfer of business interests among family members. A hearing has been scheduled for December 1, and Treasury has confirmed that the final regulations won’t be effective until at least 30 days after they become final, which could be as early as January 1, 2017.
Good News. For clients with estates below the federal estate tax exemption threshold (currently $5.45 million per person, indexed for inflation and portable from one spouse to the other at the first death), valuation discounts may in any case be a detriment, since the discount results in a lower income tax basis to the recipient. Income tax basis may be a bigger concern for tax planning purposes, since the top federal income tax rate is currently 39.6%, while the estate tax is 40%, but only for the excess over the exemption ($5.45 million/$10.9 million/couple-Federal, $1.6 million/person-MN). In addition, this also will mean that full value can be given when valuing assets for purposes of the marital or charitable estate tax deductions. Where discounts do result in estate tax reduction (for estates in excess of the exemptions), the rules may provide more clarity, and hopefully it revised, will provide some relief for operating businesses. There is much uncertainty and controversy swirling around these proposed rules, and there is certain to be some modifications and changes before the rules become final (which could be well beyond January 1, 2017).
Background. For many years entity documents have been drafted with restrictions on voting or liquidation rights that would typically reduce the value of a gift to the donee. In October, 1990, Congress enacted Chapter 14 of the Internal Revenue Code, which included Section 2704 allowing the Internal Revenue Service to disregard certain restrictions when valuing transfers of interests in family entities for estate, gift and generation-skipping tax purposes. The IRS could ignore “applicable restrictions,” which generally were defined as restrictions in the document that were more restrictive then the default rules under the applicable state law. Most states then enacted default rules that were fairly restrictive, which in turn allowed entity documents to include substantive restrictions that would be recognized for valuation purposes even if the “family” could later collectively remove the restrictions on its own. The Treasury has been discussing further proposed regulations for many years, but did not do so until now.
Applicable Restrictions. The first significant change, in the §2704(b) Regulations, is that restrictions will only be honored for valuation purposes where the state law is mandatory. In other words, if the family members (including attribution) can change or draft away the restrictions, they will be ignored for valuation purposes.
Disregarded Restrictions. The second and perhaps most significant change, in new Prop. Reg. §25.2704-3, is a new concept of “disregarded restrictions,” which generally ignores the restrictions by assuming that each owner has a 6-month put right. The regulations define this put right as establishing a “minimum value,” which essentially is the net value of the entity multiplied by the interest’s pro rata share of the entity. You will determine the value of the entity, and apply the percentage of ownership interest being transferred between family members. Appraisers will continue to use the same techniques for valuing entities, but there will be very little opportunity to apply discounts to that value when appraising the underlying transfers of ownership.
Non-family Members. For purposes of determining whether a “family” has the control to modify the restrictions, the interests of non-family members will be given substance if (1) non-family members own their interests for more than 3 years prior to the transferor’s death; (2) the non-family member owns more than 10% of the entity; (3) the value held by all non-family members combined is more than 20%; and (4) the non-family member lacks a right to receive the interest’s minimum value with no more than six month’s notice of liquidation or redemption. As drafted, the Regs use this non-family member distinction for “disregarded restrictions,” but not “applicable restrictions.”
Operating Business. If the entity is an operating business, which is defined as an entity with at least 60% of the total value of its assets being non-passive assets used in the business, certain valuation principles reflecting similar public market valuations under §2031 (estate tax) and §2512 (gift tax) would apply when valuing the entity.
3-Year Rule. The new regulations would ignore any loss of liquidation or voting rights that occurred within 3 years of the transferor’s death. As an example, a 100% owner transfers 51% of the entity to children (creating minority interests for all family members), and under the old rules claim additional valuation discounts for the 49% non-controlling interest owned at death. Under the new rules, the valuation discounts would be ignored if the transferor died within three years of the transfer (i.e. the 49% interest would be valued as if it was still a controlling interest).
Commercially Reasonable Restrictions. A commercially reasonable restriction, imposed by unrelated persons (e.g. bank, venture capital) providing capital to the entity for its trade or business operations, are not applicable or disregarded restrictions. In addition, a liquidation restriction will be recognized for valuation purposes if: (1) every owner has an enforceable “put right” to sell the interest to the entity or other owners; (2) the payment must be made within six months of exercise; and (3) payment is in the form of a note that meets specific characteristics outlined in the regulation. As the rules are currently drafted, the recommendation might be to consider incorporating a put right into entity documents that would be exercisable by all equity interest holders. This would allow the restrictions to be considered in the valuation process and possibly result in a value that is less than the minimum value (essentially resulting in a valuation discount).
Recommendations. For clients planning to make any transfers by gift in investment or business entities they own, planning should be started immediately and they should consider making transfers prior to the effective date of the new rules. This could be as early as January 1, 2017, although there is much speculation that the final rules could take much longer after the comments are received between now and the hearing on December 1. Despite the new rules, however clients also need to make sure that the transfers fit consistently with their financial, retirement and estate planning goals. In addition to direct transfers, we can still consider the traditional planning which included gifts in trust, installment sales to grantor trusts, GRATS (“grantor retained annuity trusts”) and CLATS (“charitable lead annuity trusts”).