Treasury Department Proposes New Rules for Family Controlled Business Valuations
Personal & Succession Planning Update
Date: August 10, 2016
The Treasury Department issued proposed regulations to Section 2704 of the Internal Revenue Code on August 4, 2016 that will likely increase the value of intra-family transfers of equity interests in a family controlled business entity for gift, estate, and generation-skipping transfer (GST) tax purposes, and also increase the number of valuation disputes between taxpayers and the government. The proposed regulations are controversial and, if adopted, could have a significant impact on the business succession plans of many family controlled business entities. The Treasury Department requests written comments in response to the proposed regulations by November 2, 2016. A public hearing will be held on December 1, 2016.
The Treasury proposes that the rules described below will be effective for an intra-family transfer of an equity interest in a family controlled business entity that occurs after the date the regulations are published as final regulations in the Federal Register; however, some of the rules that disregard for valuation purposes a restriction that does not comply with minimum value or payment assumptions discussed below will not be effective until 30 days after the date final regulations are published.
Watchful Waiting or Action?
We expect the Treasury will receive sharp criticism to these proposed regulations, including comments that the Treasury does not have the legal authority to issue these rules. Clients need to be mindful, however, that any legal challenge to Treasury’s authority to issue these rules will take years to resolve through the judicial process.
We encourage families to meet with their advisers now to discuss how these rules might impact their business succession plans and if it is prudent to engage in intra-family transactions before these rules become final.
Congress enacted Section 2704 in 1990 as part of an integrated suite of statutes that provide special rules to determine the gift, estate, and GST tax value of an intra-family transfer of an equity interest in a family controlled corporation or partnership. Section 2704 deals with the valuation effect of a lapse of a voting or liquidation right. The statute provides that if there is a lapse of either right in connection with an intra-family transfer of an equity interest in a family controlled corporation or partnership, then the lapse is treated as a transfer of the excess of the fair market value of all equity interests held by the transferor, determined as if all voting and liquidation rights were non-lapsing, over the fair market value of such interests after the lapse. However, the statute acknowledges that a restriction that effectively limits the ability of a corporation or partnership to liquidate must be respected in determining the value of an equity interest in such entity if such restriction is imposed, or required to be imposed, by any federal or state law. Thus, if federal or state law provides that an individual equity owner does not have the right to liquidate the entity, then the statute will not generally apply to an intra-family transfer of an equity interest in such entity even if the equity owner has control of the entity.
Over the years, state legislation and court decisions have eroded the impact of Section 2704. State legislatures have revised statutes governing limited partnerships and limited liability companies to provide that the liquidation of the entity is required only with the unanimous vote of all owners (unless otherwise provided in the governing documents of the entity), and also eliminated statutory default rules that allowed an equity owner to withdraw from the entity and liquidate his or her equity interest. Accordingly, under state law, neither a controlling nor minority owner would have a liquidation right that would be subject to the statute. In addition, courts have limited the application of Section 2704 to a restriction concerning the liquidation of a corporation or partnership, and not to a restriction on the ability to liquidate an interest in the entity. Courts have also concluded that a lapse of a voting or liquidation right does not occur as a result of an intra-family transfer of an equity interest in a partnership or limited liability company where the transferee is not admitted as a partner or a member of the entity, even though the value of such equity interest may be determined based on the “assignee” not having voting or liquidation rights that might otherwise be available to a partner or member of such entity.
The Treasury believes these changes to state law and judicial developments have circumvented the Congressional intent behind Section 2704, and that Treasury needs to change the regulations under Section 2704 to reflect these developments to be able to enforce the Congressional intent behind Section 2704.
New Rules for Intra-Family Transfers of Equity Interests in a Family Controlled Business Entity
First, it is important to note that the proposed regulations apply only to determine the gift, estate, and GST tax value of an intra-family transfer of an equity interest in a family controlled business entity. Non-familial transfers, including a transfer to charity, are not subject to these valuation rules. Transfers that are made to both family and charity (e.g., “I bequeath at my death one-third of my controlling equity interest in my family controlled business entity to charity and the remainder to my family”) will be subject to two different valuation standards. The proposed regulations reconcile the different valuation standards in a manner that is favorable to taxpayers. Nevertheless, a family member who wants to transfer equity interests in a family controlled business entity to charity as part of an estate plan will want to pay attention to the valuation dynamics that result from these differing valuation standards, and pay special attention to valuation considerations when dividing a controlling interest in an entity between family and charity (e.g., in the above example, my controlling interest would be valued in my estate for federal estate tax purposes on a control basis, but the minority passing to charity would be valued for charitable estate tax deduction purposes taking into account minority interest and marketability discounts associated with such minority interest and, accordingly, the resulting charitable deduction in my estate will be less than the corresponding value of such equity interest included in my estate for estate tax purposes).
The heart of the new rules is that any restriction that is contained in the governing documents of a family controlled entity to liquidate the entity, or a family member’s right to liquidate an equity interest in such entity, must be disregarded in determining the value of such equity interest if the family can remove the restriction by agreement. Treasury intends that this rule will result in the equity interest transferred by a family member to reflect a “minimum value” that corresponds to the subject equity interest’s share of the net fair market value of the property held by the entity on the assumption that payment for such interest would occur within six months in cash. However, the proposed regulations acknowledge that such valuation will still take into account all relevant factors affecting value, including rights under the governing documents and local law. It is important to note, the proposed minimum value rule does not create a liquidation right at minimum value; only that restrictions that provide for the holder of the equity interest to receive less will not be taken into account for purposes of determining the gift, estate, and GST tax value of such equity interest.
The proposed regulations go on to reverse court decisions that treat a transfer of an equity interest to an “assignee” as not constituting a lapse of a voting or liquidation right.
The Treasury further proposes new rules that will treat a donor who controls a family controlled business entity and who makes an intra-family gift or sale of a minority equity interest in such entity to a family member within three years of death (so that the transferred equity interest is valued taking into account minority interest and marketability discounts that may be associated with a minority interest) as making a transfer of such equity interest at death that is subject to a lapse of a liquidation right. A transfer that occurs more than three years before death will not be subject to this look back rule.
As mentioned above, the proposed regulations generally disregard any payment arrangement for an equity interest that is not a six-month cash equivalent, but the proposed regulations provide an exception for an installment payment arrangement if at least 60 percent of the value of such entity consists of interests in an active trade or business and such installment arrangement is adequately secured, requires periodic payments on a non-deferred basis, bears a market rate of interest, and has a fair market value on the date of liquidation or redemption that is equal to the liquidation proceeds that are attributable to assets used in the trade or business.
What Is a Family Controlled Entity?
The proposed regulations apply to any family controlled entity that, under state law, is a:
- corporation (including an S corporation);
- limited liability company (including a limited liability company that is disregarded or treated as a partnership for federal tax purposes); or
- any other arrangement that is classified as a business entity under Treasury regulations.
An entity is “family controlled”
- in the case of a corporation, if family members hold at least 50 percent (by vote or value) of the stock of the corporation;
- in the case of a partnership (including a limited liability company that is treated as a partnership for federal tax purposes), if family members hold at least 50 percent of either the capital or profits interest in the entity; and
- in the case of either type of entity or other business entity, if any family member holds any equity interest with the ability to cause the full or partial liquidation of such entity.
But, “control” is determined by excluding any equity interest that is held by a non-family member, unless:
- such interest has been held by such non-family member for at least three years;
- such interest constitutes at least 10 percent of the value of all equity interests in the entity;
- the total equity interest held by non-family members in the entity is at least 20 percent of the value of all equity interests in the entity; and
- each non-family member, as an owner, has a put right at least equal to the “minimum value” of such equity interest on the date of liquidation or redemption.
“Family members” include:
- an individual’s spouse, an individual’s ancestors, the lineal descendants of such individual and of his or her spouse, the brothers and sisters of such individual, and the spouse of any such lineal descendant, brother and sister; and
- attribution rules apply to count a beneficial interest that is held by a family member indirectly through a corporation, partnership, trust, or other entity.
Liquidation Restrictions That Can Be Counted
The proposed regulations do permit the valuation of a familial transfer of an equity interest in a family controlled entity to take into account any commercially reasonable restriction on liquidation that is imposed by an unrelated person providing capital to the entity for the entity’s trade or business operations, whether in the form of debt or equity. Consequently, a family controlled entity that is leveraged may have more favorable valuation characteristics under the proposed regulations than one that is not leveraged. The proposed regulations further permit the valuation of an equity interest in a family controlled entity to take into account a restriction on liquidation that is imposed by federal or state law if the family cannot override that restriction by agreement or choose an alternative statutory scheme to apply to the entity that does not require such restriction.
Final Note on Valuation
As a final note, the proposed regulations do not offer specific guidance on how to determine the “minimum value” of a family controlled business entity or the effect to be given to provisions of governing documents or law that are not required to be disregarded in determining the value of an equity interest that is the subject of an intra-family transfer. We expect that this ambiguity will lead to an increase in the number of valuation disputes between taxpayers and the government and heighten the importance of well documented appraisals in defending government challenges to valuations.
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