In August 2016, the U.S. Department of Treasury (Treasury) issued proposed regulations under Chapter 14 of the Internal Revenue Code, Sections 2701 through 2704. These regulations were largely intended to eliminate a common wealth transfer technique used to lower the taxable value of transferred interest in family-owned entities for estate, gift and generation-skipping transfer tax purposes. As reported in BKD’s October 2017 article “Eight Tax Regulations Recommended for Withdrawal or Revision,” these highly controversial regulations were identified for withdrawal in response to President Donald Trump’s Executive Order 13789, which formally occurred on October 20, 2017. Here’s what you need to know about this withdrawn guidance and what it might mean going forward.
The Proposed Regulations
Treasury offered three central justifications for issuing the proposed regulations:
- To reinvigorate the regulations to effectively implement the legislative intent of the statute (Treasury and the IRS believe the statute has been eroded by case law and various state law changes.)
- To align the regulations with case law1
- Informally, to update the guidance in light of the current, higher-lifetime exemption ($5,490,000 for 2017)
The proposed regulations took aim at the use of valuation discounts on interests in family-owned entities and refined the family attribution rules under the statute. Had the proposed guidance gone into effect, valuation discounts associated with closely held business interests would’ve been effectively eliminated. Consider the following examples:
- Current Tax Law
- Partnership A has an enterprise value of $1,000. While a 1 percent interest would be worth $10 on an enterprise value basis, generally accepted estate and gift tax valuation principles tell us the purchaser of a 1 percent interest would likely demand a discount for lack of marketability as well as a minority discount. Accordingly, a purchaser only may be willing to pay $6 (or $7) for the interest, reflecting a minority and marketability discount.
- Proposed Regulations
- Same as above except the 1 percent interest would be valued at $10 for transfer tax purposes due to the elimination of the minority and marketability discounts.
For more on the proposed regulations, see our 2016 Year-End Tax Advisor article.
Proposed Regulations Withdrawn
Response to the proposed regulations was swift and generally negative from both the courts and estate planning community. In an unrelated case, a federal district court flatly rejected the “reinvigoration” approach discussed above. Comments from the estate planning community were equally harsh. Through more than 10,000 comments, commentators and practitioners argued the proposed regulations were inconsistent with the original legislative intent, would result in estate and gift tax valuations higher than economic reality and significantly disrupt the orderly transfer of closely held businesses between family members.
After considering comments to the proposed regulations and other legislative reviews ordered by the Trump Administration, Treasury withdrew the proposed regulations on October 20. This means the regulation project is terminated. To restart the process, Treasury would have to publish new proposed regulations and begin the notice-and-comment process anew.
While Treasury hasn’t revealed new plans to address these issues, this is by no means an indication Treasury’s position regarding valuation discounts has changed. Treasury may continue to pursue an attempt to curtail perceived abuse of valuation discussions through legislation and court challenges, though legislation seems unlikely given the current political environment. Treasury may look to find cases in which it can argue the positions outlined in the proposed regulations and take a more aggressive posture toward reviewing and challenging the structuring and administration of certain estate planning techniques. It’s important to carefully and completely document estate planning technique structuring; it’s equally important to diligently document these techniques’ implementation and administration.
The proposed regulations’ withdrawal is neither a reason to accelerate nor delay estate planning. We continue to advocate that business owners and families should focus estate planning on orderly planning steps appropriate for the family and business. Contact Karen, Jeff or your trusted BKD advisor to discuss potential planning opportunities.
1The cited case law dated back more than 25 years and predated the original §2704 legislation. As was pointed out in several comments to the proposed regulations, it wasn’t feasible for Treasury to argue that those cases weren’t considered when the existing code was passed and corresponding regulations promulgated.