New Treasury Regulations Effect Transfers of Family Businesses

On August 2, 2016, the Treasury Department issued proposed regulations for Section 2704 of the Internal Revenue Code (the “Code”). 

Background. One of the tried and true estate planning strategies associated with transferring a family business down generational lines has been a transaction that includes the formation of an entity by senior members of the family, followed by gifts and/or sales of minority (non-controlling) interests in that entity either outright and/or to trusts for the benefit of a second or third generation of persons who are believed to have the ability and desire to continue the business after the senior member either retires or dies. The key component of such plans requires the inclusion of various restrictions into the governing document (shareholders, partnership or operating agreement) of the entity. 

Current Law. Section 2704 of the Code was enacted in 1990 in response to what Congress believed were transactions similar to that described above, which were being carried out not for the purpose of transferring the business from one generation, but instead, primarily used to minimize the value of the interests in family-controlled entities for gift and estate tax purposes. In other words, they believed the values being assigned to these business interests were being substantively depressed (but without real substance) by certain restrictions included in the governing document. Accordingly, the 1990 statute included a blanket mandate that certain restrictions must be “disregarded” in valuing interest in family and other closely held businesses. 

Those restrictions to be disregarded included: (i) any that limit the ability of the entity to liquidate, and (ii) any that fall away (“lapse”) following a transfer, or that the transferor or the transferor's family can remove.  

Despite the limitations presented by Section 2704, many estate planners, including this one, have been able to accomplish tax efficient freeze transactions for family-controlled entities through the creation of various classes of equity interest in the entity, and construct a transfer of those equity interests down generational lines.

Targeted Goal. In any transaction, the transferred interests are usually "minority" interests, so they have no ability to control the operation of the business; and because these transferred interests are of a closely held family business, there is normally no ready market into which they can be sold. As a consequence of both attributes (i.e., lack of control and lack of marketability), the value of the transferred interests are worth less than what would be the same percentage of the entity represented by the transferred interest of the fair market value of the assets owned by that entity. That is, the value of the transferred interest is entitled to be reduced ("discounted"), resulting in an opportunity to transfer more value with the same percentage interest to be transferred. These discounts can range from 15% to sometimes as high as 50%. And the result is that wealth transfer taxes at the time of death, or when gifting assets during one’s lifetime, are significantly reduced.

Example: Assume an entity owned 100% by a senior family member has assets with a fair market value of $50 million. This senior family member decides to make a gift to his children consisting of a percentage of his equity in the business equal to $10 million. Absent anything else that can be relied upon in valuing the interest he desires to gift, he would need to make a gift of 20% of his equity in the company [10 ÷ 50]. But if that 20% equity interest could be valued taking into account a discount based on lack of control and lack of marketability, and that discount is determined by appraisal to be 40%, then either (i) the value of the gift is really 12% of the underlying assets [.20 x (1 - .40)], or $6.0 million; or (ii) the interest of that entity that can be gifted that is still worth $10 million can be increased to 33.33% [33.33 x (1 - .40) = 20]. With the current highest marginal estate tax rate of 40%, this could reduce the estate (or gift) tax by $2.66 million.    

Proposed Regulations. The stated purpose of the proposed regulations is to prevent the undervaluation of interests in closely held corporations and partnerships that are transferred between certain members of the same family. It does this by: (i) imposing additional categories of restrictions that must be ignored (disregarded); and (ii) severely limiting those transactions in which valuation discounts may be achieved. The specific provisions of the proposed regulations are very technical, and therefore beyond the scope of an article for the purpose of this particular newsletter. But we are well versed in all of them and are prepared to discuss them in greater detail with any of our clients who would like to do so.     

Timeline to Adoption. The proposed regulations have been, and continue to be subject to public comment for 90 days. A public hearing was scheduled to take place on December 1, 2016. But this was scheduled before the recent elections. It is not certain any hearings will now commence on this date. After the hearing, the proposed regulations could be further revised, or they could be published as final. Significant commentary has already been, and it is anticipated more will be submitted. This is likely to postpone publication of the final regulations. The effective date for adoption will be 30 days after the regulations are published as final.

Congress Has Already Taken Notice. Not one, but two bills have already been introduced in Congress that might stop the implementation of these proposed regulations. One, The Protect Family Farms and Business Bill, was introduced by Rep. Warren Davidson, R-Ohio, on September 21st. Also addressing the proposed Code Section 2704 regulations is a bill [HR 6042] introduced by Rep. Jim Sensenbrenner, R-Wis., on September 15th. No comment is offered here on the likelihood of either one of these bills making it into law. 

Conclusion.  At this time, it is difficult to offer an opinion on the full impact of the Section 2704 proposed regulations if they are published as final without further changes. Taking them at face value, the strategies that have been commonly used to minimize the transfer tax consequences of making transfers of family-owned and other closely held businesses will need to be reconsidered. 

We will keep an eye on all new developments. In the meantime, any client who is interested in moving forward with a transfer of interest in a family-owned business should consider acting sooner (very soon) as opposed to later. The limited good news is that the proposed regulations will only apply to transfers on or after the date that the final regulations are published in the Federal Register.