In early August 2016, the IRS released proposed regulations regarding the valuation of interests in family-controlled entities. Specifically, the Proposed “2704” Regulations focus on the elimination of most discounts when ownership interests are transferred between family members. Aside from that, let’s not forget that it’s an election year! Leading Democrats, including Secretary Clinton, believe the federal estate tax exemption should decrease from $5.45 million (as of 2016) to $3.5 million, and support federal estate tax rates increasing from 40% to 45%.  If combined, how many (millions?) more estates will need a new strategy to soften the tax bite. Talk about an imperfect storm!

By way of background, valuations of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes can currently be discounted for minority ownership, lack of marketability, and lack of control. This allows a taxpayer to transfer family owned entities to the next generation at a discount from what the underlying value is. The new rules would eliminate the lack of control discount and suppress the lack of marketability discounts that are typically available.

The main points of the proposed regulations are as follows:

  • Transfers within three years rule (“deemed death bed planning”) – The proposed regulations have added a bright line test for lapsing rights. If transfers within three years of death result in a lapse of a liquidation right for the transferor, the transferred shares will be included in the transferor’s gross estate for Federal estate tax purposes. Per the IRS, this bright line test will avoid the fact-intensive inquiry which both the IRS and the taxpayer must go through to determine a donor’s subjective motive.

We personally believe that this is a gross over-reach by the IRS.  Three years is a long time, and a company’s strategic plan may be updated several times within that time-frame.

  • Disregarded restrictions – This is the most far reaching aspect of the proposed regulations, which essentially values transfers of interests in family-controlled companies as if the holder has a put right to sell the interest within six months. They will allow the holder to be paid by a note as long as the note is at market rates (no AFR) and the term is no longer than six months.

How many companies operate in such a manner where all shareholders can (in theory) take their share at any time? Is every company now required to keep cash on hand or maintain enough unused credit to fund the liquidation events when requested?  Don’t get overly excited my banker friends – I sense a strong challenge coming from this section…

  • Definition of family control – The regulations have tightened the definition of family control of an entity. The IRS concluded that the grant of an insubstantial interest in the entity to a nonfamily member should not preclude the application of 2704(b), because such nonfamily member interest generally does not constrain the family’s ability to remove a restriction on the liquidation of an individual interest. The IRS concluded that the presence of a nonfamily-member interest should only be recognized where the interest is economically substantial and longstanding, thus likely to have a more substantive effect.

In essence, no inviting the neighbors to join the family business to circumvent the rules.

To date, the regulations are proposed, and are not effective until made final and promulgated.  Let’s not forget that most proposed regulations, even non-controversial ones, are generally not finalized for two or more years.  Controversy is prevalent in these proposed regulations, and the IRS will no doubt receive many comments at its hearing on December 1, 2016.  If adopted in their current form, they only apply to transfers made at least 30 days after the restrictions become final (December 30, 2016 would be the earliest “worst case scenario” possibility). Even if the proposed regulations become final in their current form, there are several strategies still available to minimize transfer tax, like freezing the value of appreciating assets through a Grantor Retained Annuity Trust (GRAT). We encourage you to discuss with your team of advisors, which should include your estate attorney, CPA and valuation experts.

If you have questions regarding this legislation, and wish to speak with a member of the Barnes Dennig consulting team, please fill out a brief form here or call 513.241.8313.