When I was a kid, I always liked to eat the icing on the cake first – and probably most of you did as well. If the proposed IRS 2704 regulations are adopted in their current form, they will have the effect of virtually eliminating all the “icing on the cake” of a common estate planning technique used by most advisers and families of interests in family controlled entities, and leaving only the sponge. The minority or lack of control valuation discounts for transfer tax purposes in the context of family-controlled entities will effectively be eliminated, thereby reducing the effectiveness of traditional estate freeze techniques utilized under current law.
If the IRS proposed regulations are made final in their current form, the result will bring sweeping changes to the current estate planning options available to taxpayers.
In the next 90 days, it is important for clients to take a step back and analyze both their short-term and long-term planning goals before the regulations become final in 2017. The changes apply specifically to intra-family transfers of interests in family controlled entities. Essentially, the discounting game will be over, unless challenges to the regulations are successful. Previously, guidance determining discounts was developed on a case-by-case basis in court by judges but the proposed regulations will provide clarity to an issue where previous guidance was uncertain.
6 Highlights of the proposed regs Section 2704 to intra-family transfers of interests in family-controlled entities. These Proposed Regulations would:
- Start off by clarifying what entities are affected. In particular, LLCs are a relatively recent creation and these proposed regulations are updating certain provisions of the Code which only refer to Partnerships and more traditional entities. The IRS wants to cover any entity that may exist that is giving rise to these deductions in intra-family situations.
- Claw back into an estate and tax all transfers within 3 years of death as if they were made “on the deathbed” so that the full value of the asset (ablest any discount) is added back into the estate for tax purposes.
- Eliminate any minority discounts where you are not a full owner.
- Define what constitutes “control” of an LLC or other entity that is not a corporation, partnership, or limited partnership to holding at least 50% of the equity in the entity or holding an equity interest, such as a GP position, with the power to cause full or partial liquidation of the entity.
- Prevent a workaround that many practitioners have used in recent years of having a non-family member (often a charity) hold certain voting or liquidation rights. The proposed regulations would close this loophole and would disregard rights held by these entities unless the nonfamily member has held an interest for more than three years, owns a substantial interest in the entity, and has a put right to be redeemed for cash or property within six months’ notice.
- Ignore any applicable state and federal law exceptions when determining the fair market value of the transferred interest.
Proposed regulations under 2704 looks at family held enterprises and does not exempt operating businesses even if you own the business with distant relatives or strangers. The consequences are significant! For example, let’s say I own 60% of the voting stock in our family held enterprise. I gift 15% of my voting stock to my two children, 50% equally to each of them. The current regulation values their 15% interest as a minority interest valued with a minority discount. Likewise, my remaining shares (45%) is now considered a minority interest and would be valued with a minority discount. These newly proposed regulations would now require the donor (me) to survive 3 years after the gift is made, but if death occurs within 3 years, then the value of a lapse right that gave rise to the discount will have to be included in my estate for estate tax purposes. This is an outrageous effect considering the asset is gone from my estate and will be valued by the IRS as of my date of death, not the earlier date of the transfer value.
If these regulations are enacted, this will be the biggest change in estate tax planning in the last 25 years. We expect that there will be significant comments to the proposed regulations at the public hearing scheduled for December 1, 2016 with the earliest final regulations finalized sometime in 2017. And, although there are strategies for estate planning post adoption of proposed Section 2704, there are still several techniques for estate and gift tax reduction strategies that families can do in the next 90 days.
There are complex nuances in these proposed regulations and specific family issues should be evaluated quickly. We encourage families who are considering transferring interests in family-controlled entities to review their estate and transfer tax planning as soon as possible to secure the discounts available before the effective date of these Proposed Regulations. Furthermore, there is a need to look at insurance coverage or liquid assets and whether, with a loss of a discount, these are sufficient to pay taxes due on assets. More on this and embracing gifting and other techniques in anticipation for the loss of redemption.
Part II of this series will follow soon – Planning strategies for proposed IRS 2704 regs