Forthcoming Treasury Regulations Could Limit Valuation Discounts on Interests in Family Entities
“You may never get a chance for a discount again!”
“Discounts will be severely restricted or eliminated.”
It may sound like a bad 2 a.m. infomercial, but these statements and others have been made recently regarding estate planning and valuation discounts.
The Treasury Department (Treasury) has indicated that proposed regulations are forthcoming that are intended to place new limits on valuation discounts associated with interests in family entities, including family limited partnerships (FLP) and limited liability companies (LLC). There’s wide speculation as to whether the new regulations will be narrowly focused on specific issues or broader in scope, effectively eliminating valuation discounts.
Corporations, partnerships, limited partnerships and LLCs are common ownership structures for family businesses. Limited partnerships and LLCs also have become common ownership structures for the pooling and management of family assets, i.e., real estate, private equity investments and marketable securities.
The transfer of those FLP and LLC interests among family members is subject to gift and estate tax based on the interest’s fair market value, which is defined as the price at which an interest would change hands between willing buyer and willing seller, assuming neither is under any compulsion to buy or sell and both have reasonable knowledge of relevant facts.
Fair market value is an issue of fact. A buyer typically will pay less for an interest if the buyer won’t control investments or distributions, i.e., lack of control or minority discount. Likewise, a buyer will pay less for an interest that cannot be readily sold, i.e., lack of marketability discount. Both minority and marketability discounts have been accepted in valuations by Treasury and courts.
Chapter 14 of the Internal Revenue Code (IRC) was enacted to prevent perceived excesses and abuses of the marketability discount. These provisions were intended to disregard techniques and provisions designed to suppress the value of a transferred interest by enhancing the marketability discount without reducing the economic benefit to the recipient.
More specifically, IRC Section 2704(b) provides that certain “applicable restrictions” are to be ignored in valuing interests. Regulations issued after Chapter 14 was enacted defined applicable restrictions as those more restrictive than applicable state law. Many states responded by amending their respective state business entity laws to allow liquidation rights and withdrawal rights to be defined in business organization documents. State legislation has effectively defeated the applicable restrictions limitations.
In addition to state legislation, Treasury positions regarding the application of Section 2704(b) to marketability discounts have been rejected by the courts in a number of cases.
From 2009 through 2013, the Obama Administration included proposals for legislative changes to IRC Section 2704. The 2013 proposal included five specific items:
- Additional “disregarded restrictions”
- Elimination of discount for assignee interests
- Elimination of third-party exception for restriction removal
- Safe harbor provisions
- Consistent valuation treatment with marital and charitable deductions
Most of the concern is related to the first item: additional disregarded restrictions. It wasn’t clear from the legislative proposal whether the restrictions would be a clarification of those under IRC Section 2704 or whether the legislation was intended to create new categories of restrictions for “family controlled entities.”
The proposed legislation was removed from the administration’s legislative agenda in 2014, signaling that Treasury intended to proceed with issuing new regulations.
Catherine Hughes, an estate and gift tax attorney advisor with the Treasury’s Office of Tax Policy, told members of the American Bar Association (ABA) in May that Treasury hopes to issue new regulations under Section 2704(b) prior to this fall’s tax section meeting of the ABA, scheduled for September 17 through 19.
Some estate planners have expressed concern the new regulations significantly restrict or even eliminate the use of valuation discounts by family-controlled entities like FLPs. Others note that the legislative history of Chapter 14 emphatically states Chapter 14 never was intended to affect minority discounts or other discounts. As a result, any new regulations should be limited to the marketability discounts. Many expect the restrictions to focus on use of FLPs holding marketable securities.
Treasury regulations typically are issued in a three-step process. First, proposed regulations are published for notice and comment. Treasury then accepts written comments and conducts a public hearing regarding the proposed regulations, after which final regulations are issued. In general, the regulations only become effective after final regulations are published.
There are, however, limited circumstances under which final regulations can have an effective date retroactive to the date proposed regulations are first published. In the past 10 years, Treasury has attempted to apply a retroactive effective date twice. In one case, the position was later abandoned. In the other case, no final regulations have been issued. Hughes indicated the effective date for the new regulations is still under consideration.
Regardless of which position Treasury takes, the new regulations likely will apply to transactions, e.g., gifts or sales, after the effective date. Many commentators have stressed any “grandfathering” rule will not be applied on an entity basis, i.e., the “grandfathering” rule will not be applied on the basis of a limited partnership or LLC formed prior to the effective date of the regulations. Accordingly, any transactions involving transfers of interests in such a limited partnership or LLC after the effective date will be subject to the new regulations.
What Happens Next?
It’s difficult to predict the breadth of the proposed regulations. IRC Section 2704(b) is a fairly narrow provision, focusing on aspects of the marketability discount. Nevertheless, part of this section could be read to support broader regulations. In addition, the current presidential administration has shown a proclivity for issuing new regulations covering a wide range of issues in lieu of pursuing legislation through Congress. Likewise, proposed regulations generally aren’t effective until issued as final regulations after notice and comment, which generally takes more than a year. Nevertheless, Treasury could attempt to apply the new regulations as of the date the proposed regulations are published.
Given the uncertainty regarding the scope of the proposed regulations and effective date, it’s strongly recommended that planning for transfers of interests in FLPs and other family-controlled entities be completed as soon as possible ahead of the issuance of proposed regulations.
To learn more about how these potential regulations may affect your tax situation or to discuss planning opportunities, contact your BKD advisor.