by Jeramie J. Fortenberry, JD, LLM (Taxation)
WealthCounsel, Executive Editor and Legal Education Faculty
On December 1, 2016, representatives of the Treasury and the Internal Revenue Service (IRS) held a hearing to discuss the proposed regulations on valuation discounts for family-owned businesses under Internal Revenue Code (Code) § 2704 (Proposed Regulations). The Proposed Regulations were released on August 2, 2016. This article summarizes that hearing in light of the Proposed Regulations and concludes with a few practical takeaways.
Background of the Proposed Regulations
The Proposed Regulations made several significant changes that were targeted at curbing the use of minority discounts to transfer family-controlled business interests at a lower estate tax value. The most controversial change is Treasury’s creation of new disregarded restrictions that will be ignored for valuation purposes unless they are required by non-waivable provisions of state law (Disregarded Restrictions). Section 25.2704-3(b)(1) of the Proposed Regulations creates four categories of Disregarded Restrictions:
- Provisions that limit or permit the limitation of the holder’s ability to compel liquidation or redemption of the interest.
- Provisions that limit or permit the limitation of the amount the interest holder may receive on liquidation or redemption of the interest to an amount that is less than minimum value.
- Provisions that defer or permit the deferral of the payment of the full liquidation or redemption proceeds for more than six months after the date the holder gives notice to the entity of the holder’s intent to have the holder’s interest liquidated or redeemed.
- Provisions that authorize or permit the payment of any portion of the full liquidation or redemption proceeds in any manner other than in cash or property.
Many commentators read these new categories of Disregarded Restrictions as treating all family owned interests as though the owner could require the entity to redeem the interest for cash or equivalent property within a six-month period at a value equal to the interest’s pro rata share of the entity’s assets. By disregarding all non-mandatory restrictions to the contrary, the Proposed Regulations can be interpreted to create a deemed mandatory put right for all interests in family controlled businesses.
The Proposed Regulations also apply a three-year rule to transfers of family-controlled business interests that are subject to lapsing liquidation rights. If a taxpayer transfers an interest with a lapsing liquidation right within three years of the taxpayer’s death, the liquidation rights are considered to lapse at the taxpayer’s death and the value of the lapsed rights are included in the taxpayer’s gross estate.
Many commentators are concerned that the new three-year rule could trigger a retroactive application of the Proposed Regulations. Because the Proposed Regulations treat the lapse of a liquidation or voting right as occurring on the transferor’s death, the Proposed Regulations could affect valuation of interests that are transferred before the effective date of the Proposed Regulations. For example, assume a taxpayer transfers an interest that causes a lapse of voting or liquidation rights on November 2016, the Proposed Regulations are finalized in March 2017, and the taxpayer dies in October 2017. Under the Proposed Regulations, the lapse is treated as occurring in October 2017 (after the Proposed Regulations are final) even though the transfer occurred in November 2016 (before the Proposed Regulations were final).
The Proposed Regulations were published on August 4 and followed by a 90-day comment period. After the 90-day comment period, a hearing was held on December 1. This public hearing was a precursor to the Treasury’s adoption of the Proposed Regulations as final. Because it was a last chance for practitioners to comment on controversial and perhaps overbroad regulations, the estate planning community anxiously awaited the December 1 hearing in hopes that some of the open issues would be clarified.
Comments and Responses at December 1 Hearing
The December 1 hearing lasted almost six hours. Although several IRS representatives were on the panel, most of the official discussion came from Catherine Hughes, Attorney-Advisor in the Treasury Department’s Office of Tax Policy. Ms. Hughes has made unofficial comments about the Proposed Regulations at the recent Notre Dame Tax and Estate Planning Institute, and many hoped that she would state the Treasury’s official position on key issues or at least indicate the next steps that Treasury intends to take to address practitioners’ concerns.
At the hearing, Ms. Hughes made a few comments that, although not authoritative, may provide some indication of the Treasury’s intent in adopting the Proposed Regulations. First, in response to practitioner concerns about the deemed put right that is arguably created by the new category of Disregarded Restrictions, Ms. Hughes stated unequivocally that it was not the Treasury’s intent to create a deemed put right. This statement echoes her prior statements at private events, but does little to clarify how the Proposed Regulations should be interpreted if they do not create a deemed put right. A plain reading of the Proposed Regulations could support a Tax Court determination of a deemed put right, notwithstanding Ms. Hughes’s statements to the contrary.
Second, Ms. Hughes stated that the Proposed Regulations would be clarified to address the ambiguity around the retroactive application of the three-year rule for transfers of business interests that are subject to lapsing liquidation rights. Ms. Hughes stated that the three-year rule would not cause retroactive application of the new Proposed Regulations to these transfers.
Beyond these two minor clarifications, though, neither the IRS nor the Treasury provided any meaningful feedback. They left unaddressed many concerns regarding the Treasury’s novel redefinition of fair market value and the control and family attribution rules. They also failed to give any response to commentators’ requests to exempt operating businesses from the application of the Proposed Regulations. And, although all but one of the 37 commentators requested that the Proposed Regulations be withdrawn and reconsidered, the IRS did not indicate their intentions regarding when—or even whether—the Proposed Regulations would be finalized. The lack of clarification on these important open issues provided little reassurance to planners concerned about the application of the Proposed Regulations.
The Future of the Proposed Regulations
Although Ms. Hughes provided verbal assurance that Treasury did not intend to create a deemed put right, her comments did little to identify what, exactly, the Treasury did intend when it created the new category of Disregarded Restrictions. And, as one commentator noted, the issue is not only what the Treasury may have intended, but also how a court may read the plain language of the Proposed Regulations. Although there is now at least some indication that the Treasury is willing to amend the Proposed Regulations to address the retroactive application of the three-year rule for transfers of interests with lapsing liquidation rights, we do not know how or whether the Treasury intends to clarify the remaining open issues.
The Proposed Regulations are also overshadowed by the recent election of Donald J. Trump as President of the United States and the Republican majority in both houses of Congress. Both President-elect Trump and Republicans in the House of Representatives have pledged to repeal the current Federal estate tax. If the estate tax is repealed, the Proposed Regulations would presumably become irrelevant. Given the open issues that the IRS and Treasury have not addressed and the possibility of estate tax repeal in the early months of the Trump presidency, the future of the Proposed Regulations is uncertain.
Reprinted courtesy of WealthCounsel, a community of over 4,000 trusts and estates attorneys with a common goal to practice excellence.
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