On August 2, 2016, the IRS released proposed regulations that would significantly strengthen its goal of reducing valuation discounts for transfers of minority interests among family members in closely held businesses.
Comments to the much-anticipated Section 2704 proposed regulations must be submitted to the Treasury Department by the end of October. A public hearing is scheduled for December 1, 2016. If adopted, the new regulations won’t be effective until the publication of a Treasury Decision formally adopting the final regulations.
Background
Many families use transfers of minority interests as an effective tool to pass ownership (and wealth) from one generation to the next while reducing transfer taxes through the use of valuation discounts. The new regulations, if passed in their current form, would severely impact this strategy.
Overview of Proposed Regulations
Following are selected highlights of the proposed regulations. There are many more important changes that aren’t discussed below that should be reviewed and discussed with your tax advisor.
Transfers Made Within Three Years of Death
Transfers made before three years of death would still be valued to reflect a lack of liquidation and voting rights. However, transfers made within three years of death would be considered deathbed transfers.
For valuation purposes, this means that any equity interests held by a decedent at death would be combined with all other interests the decedent transferred within three years of death. The total sum of the interests would be tested to assess whether the decedent had the ability to control the entity (defined below) or had liquidation rights during the three-year period. If so, the values of the prior transfers plus any interest held at death would be determined for federal estate tax purposes as if the previously transferred voting or liquidation rights was retained.
Clarification of the Definition of “Control”
Control is defined as a family (either through direct or indirect ownership interests) having:
- At least 50 percent by vote or value of the stock of a corporation or capital or profit interest of a partnership or limited liability company (LLC)
- Any general partner interest
- The ability to liquidate the business entity
Treatment of Lapses in Voting and Liquidation Rights
The proposed regulations address how these restrictions would be considered for valuation purposes when transferring interests in business entities. If these restrictions are disregarded, as is proposed under the regulations, the interest will be more highly valued as if the holder of the interest had a “put” right, or unrestricted option, to sell the interest back to the business.
Entities Subject to Rules
All types of business entities—partnerships, LLCs, and corporations—are included.
Disregarded Restrictions
For valuation purposes, the regulations target any restrictions that limit either the ability to liquidate an entity (in whole or in part) or an interest holder’s ability to redeem or liquidate interest in an entity. Many states passed laws restricting withdrawal rights from a partnership or LLC. Under the proposed regulations, the defaulting state laws aren’t considered mandatory restrictions and are disregarded.
Next Steps
Assess how the proposed regulations could impact your business succession and wealth transfer strategies by talking with legal and tax advisors. Clients who are contemplating making transfers may wish to complete their plans prior to the new regulations becoming final.
On a cautionary note, please be sure that any transfers fairly consider the impact of:
- State transfer taxes, if any
- Lost step-up in asset basis
This is especially true for large holdings of real estate or fully depreciated assets that are owned either outright or are in LLCs or partnerships.
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If you’d like to better understand how this might impact your business, contact your Moss Adams professional.