Navigating the New Section 2704 Discount Valuation and Transfer Regulations: What Estate Planners Must Do Now

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Navigating the New Section 2704 Discount Valuation and Transfer Regulations: What Estate Planners Must Do Now TUESDAY, OCTOBER 11, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Susan Peckett Witkin, Partner, Blank Rome, New York James G. Blase, Principal, Blase & Associates, Des Peres, Mo. Edwin P. Morrow, III, Esq., Director, Wealth Transfer Planning and Tax Strategies, Key Private Bank Family Wealth Advisory Services, Dayton, Ohio The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Proposed Regulations Threaten to Create Higher Valuations for Family Businesses Understanding the Impact, The Proactive Planning Opportunities, the Traps and Uncertainties of Proposed Section 2704 Regulations October 11, 2016 Strafford Webinar CLE/CPE

6 Speakers for Today s CLE/CPE Susan Witkin, J.D., LL. M. Partner, Blank Rome, LLP Tax, Benefits and Private Client Group- New York office Edwin P. Morrow III, J.D., LL.M. Director, Wealth Transfer Planning and Tax Strategies Key Private Bank Family Wealth Advisory Services James G. Blase, CPA, JD, LLM Principal Blase and Associates, LLC 6

7 Topics Discussed Agenda History and Principles of Valuation for Gift, Estate and GST Tax Purposes and How Newly Proposed Regulations May Change This Explaining 2701, 2704(a) and 2704(b) Proposed Changes; Three Year Rule; Disregarded Restrictions Effect of 2704 on Income Tax Basis and The Likely Effective Date of Proposed Regulations Are They Within Treasury s Authority to Promulgate? Planning Opportunities Pre-Finalization and Effect on Wealth Transfer Planning Assuming They Are Finalized Effect on Trusts, Buy-Sell Agreements, Buy-Outs Panel Discussion 7

8 A Brief History of (not Time, but) Code Section 2704 and existing regulations October 11, 2016 Susan Peckett Witkin Partner, Blank Rome LLP

9 Susan Peckett Witkin Partner, Blank Rome LLP New York, NY Susan Peckett Witkin concentrates her practice in the areas of trusts and estates and tax law. She advises clients on a wide variety of estate planning, estate and trust administration and estate and trust litigation matters, and represents both beneficiaries and fiduciaries. Ms. Witkin provides tax and related advice to individuals, fiduciaries and privately held companies in areas such as intergenerational transfer tax planning, business succession, insurance, entity formation and management, charitable giving arrangements, estate and tax planning for foreign individuals and trusts and multinational families, tax controversies and FBAR and FATCA compliance, distribution planning for IRAs and qualified plans, income tax planning and trust company formation, and provides counsel regarding the duties and responsibilities of trustees, executors, guardians and other fiduciaries in various situations. She is frequently involved in the negotiation and preparation of preand post-nuptial agreements and the tax and property issues relevant to divorces and separations. Ms. Witkin is an adjunct professor of law at New York University School of Law and previously taught as an adjunct professor of law at St. John s University School of Law. Ms. Witkin has written and co-authored articles for various publications, including the New York Law Journal, and was one of the principal authors of the April 2012 report of the New York State Bar Association s Tax and Trusts and Estates Law Sections titled Report on Notice : Request for Comments Regarding the Income, Gift, Estate and Generation-Skipping Transfer Tax Consequence of Trust Decanting, providing the Internal Revenue Service with a response to its requests for comments on various tax issues implicated in the decanting of trusts. She has been a lecturer and moderator in various contexts, including for the American Bar Association, the California State Bar Association and the Practicing Law Institute, and frequently presents programs to various groups, including attorneys, accountants, clients and their advisors, women entrepreneurs, and entrepreneurs in the healthy living space. She served for many years as a chair of various committees of the American Bar Association's Section of Real Property, Probate and Trust Law (now the Section of Real Property, Trusts and Estates Law). She is currently an active member of the New York City Bar Association's Animal Law Committee, focusing on legal issues of animal welfare and management, rights of individuals to have support animals in various settings, and the ethical treatment of animals in agriculture, among others. She is heavily involved in various projects for the Committee that promote the welfare of animals particularly in the farm industry (including, most recently, the Committee s submission of extensive comments to the USDA s proposed organic farming regulations), animal rescue operations, and proposals relating to endangered animals. She represents Ruff House Rescue, Inc., a dog rescue non-profit organization, as a pro bono client. Ms. Witkin also serves as a member of The New York City Planned Giving Advisory Council of the American Cancer Society. 9

10 A refresher on Chapter 14 (relating to Code section 2704) Let s all remember: essentially all transfer tax valuations harken back to seminal rules of Rev. Rul , C.B. 237 Basically, fair market value is the price that a hypothetical willing buyer would pay a hypothetical willing seller, neither being under any compulsion to buy or sell The gift tax regulations provide substantially the same rule at Reg Fast forward to the late 1980s: Code 2036(c) and Estate of Harrison v. Commissioner, T.C. Memo , 52 TCM (c) related to estate freezes and attempts to retain an income or other rights interest in an entity while transferring a disproportionately large share of the potential appreciation. Quickly recognized as being unworkable, and was repealed as part of PL , the Omnibus Budget Reconciliation Act of 1990, which enacted Chapter

11 A refresher on Chapter 14 (relating to Code section 2704) Estate of Harrison was particularly irksome to the Service: This case involved a partnership that parent and two children controlled as the GPs. The parent also held all of the LP interests. The GPs could each liquidate at any time. At death, parent s GP interest essentially became a LP interest, because the estate of a deceased GP could not exercise the liquidation right. The liquidation right lapsed. The value of parent s LP interest was considerably less when held without the right to liquidate the partnership. These types of lapsing rights were addressed by 2704(a) Note that partnerships and corporations only were addressed-llcs not mentioned 11

12 Code 2704(a) Provides that where a voting or liquidation right lapses and the family controls the partnership or corporation both before and after the lapse, the lapse is a deemed transfer that is taxable As a gift if the lapse occurs during life As taxable in the estate if it occurs at death The amount of the transfer (Code 2704(a)(2)) is the excess of (i) the value of all interests in the entity held by the transferor (or decedent) immediately before the lapse (determined as if voting and liquidation rights inherent in the interest were non-lapsing) over (ii) the value of such interests after the lapse 12

13 Restrictions on ability of corporation or partnership to liquidate-code 2704(b) In addition to lapsing rights, of concern to Treasury were restrictions placed on the ability of the entity to liquidate that could be removed by the transferor and her family Many donors and decedents had interests in entities that were governed by shareholders and partnership agreements that precluded liquidation of the entity in the absence of consent of all shareholders or partners Such restrictions were taken into account in the willing buyer/willing seller regime but were viewed as artificially depressing value for gift and estate tax valuation purposes because the transferor or her family could nullify its effect Code 2704(b) requires valuation of an interest for transfer tax purposes to ignore a restriction labelled as an applicable restriction - -that effectively limits the ability of a corporation or partnership to liquidate (such as requiring consent of all partners or all shareholders) where the transfer is among family members, where the transferor and her family control the entity before the transfer, and where the transferor or any member of the transferor s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. 13

14 Family members and control Family members include, with respect to an individual: her spouse her ancestors and lineal descendants The ancestors and lineal descendants of her spouse her siblings; and the spouse of any such ancestor, descendant or sibling Pretty comprehensive and captures siblings, who are notorious for not cooperating in matters of the family business in many situations to frequently devolve into liquidation Control has the same meaning as in Code 2701(b)(2) Corporation: 50% by vote or value of the stock Partnerships: For a limited partnership, a GP interest, or In all types of partnerships, the holding of at least 50% of the capital or profits interest 14

15 Note the elements of 2704(b): family control before the transfer and the existence of an applicable restriction If there is a restriction on the entity s ability to liquidate, it is disregarded only if it is an applicable restriction To be an applicable restriction, it has to satisfy both of these elements: It restricts the ability of the entity to liquidate, and It lapses or can be removed by the transferor or a member of her family or any combination of one or more of the transferor and her family members after the transfer is made 15

16 This looked like an attempt at family attribution and an end to certain discounts As we all know, a minority discount reflects the shareholder s or partner s (or LLC member s) inability to direct the management of the entity, to compel the payment of dividends or distributions or to compel a liquidation and thus receive a pro rata share of the entity s net asset value Lack of marketability discounts reflect the relative difficulty the holder of an entity interest would have finding a buyer for such interest (i.e., not many people want to buy into a closely-held business) 16

17 Family attribution Family attribution had generally been discredited by numerous decisions at the time. E.g., Estate of Bright, 658 F 2d 999 (5 th Cir. 1981) and Estate of Andrews, 79 TC 938 (1982),which held that the hypothetical willing buyer/willing seller construct required the valuation to ignore that the most probable purchaser would be other family members who owned the other interests in a family business, where a decedent held only a minority interest There is an attribution rule in Code 2704(c)(3) which invokes 2701(e)(3) for purposes of determining the interests held by an individual but that deals with attribution for ownership indirectly held through other entities, including trusts 2704(b) did not cause a transferor to be deemed to hold interests held by family members for purposes of valuing the entity Rev. Rul , valuing family owned stock as if held by one person, eliminating minority and lack of marketability discounts was revoked in Rev. Rul

18 Discounts The Conference Report to Chapter 14 (H.R. Conf. Rep (1990)) is instructive The government acknowledged that Code 2704(b) was not intended to affect minority and lack of marketability discounts The conference agreement modifies the provision in the Senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation. These rules are intended to prevent results similar to that of Estate of Harrison v. Commissioner, 52 T.CM. (CCH) 1306 (1987). These rules do not affect minority or other discounts available under present law. 18

19 Discounts Further support that discounts are not affected by 2704(b) in the Conference Report (Example 8): Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. Under the conference agreement, the value of Mother s partnership interest in her estate would be valued without regard to the restriction. Such value would be adjusted to reflect any appropriate fragmentation discount. 19

20 Section 2704(b) also contained some important exceptions and also a broad grant of regulatory authority Code 2704(b)(3) provides that a commercially reasonable restriction that arises as part of any financing by the entity with a person who is NOT related to the transferor, the transferee or a family member of either is not an applicable restriction That same section provides that any restriction imposed, or required to be imposed by any Federal or State law is not an applicable restriction Code 2704(b)(4) is highly significant: It provides that the Secretary of the Treasury may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or a partnership to a member of the transferor s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this Subtitle but does not ultimately reduce the value of such interest to the transferee. 20

21 What about the broad regulatory authority granted in Code 2704? IRS proposed regulations in 1991 Final regs were issued in 1992 The disappearance of value where value is rearranged within the family (with no loss of value to the family as a whole) was the target, but within the parameters of the statute as written and the legislative intent described above. Clearly, minority and lack of marketability discounts were not the target 21

22 Reg deals with lapses; Reg deals with transfers subject to applicable restrictions Lapses of voting and liquidation rights: Reg (a) makes it clear that if a lapse that is reached by Code 2704 occurs during life, the value lost as a result of the lapse is a gift and if the lapse occurs upon death (like in Harrison), the lapse is deemed a separate transfer that occurs at death and is includible in the gross estate. Notably, Reg (c) states that a transfer of an interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated. 22

23 This is not specified in 2704, but the regulations were clearly aimed at Harrison shenanigans where rights embedded in the donor s/decedent s entity interest lapse not where a liquidation right incident to the amount of voting stock held by parent vanished by making a transfer that brings parent down below voting control. It could be argued that this is a helpful, but not mandatory construction of 2704, although given the legislative history, a different construction would have been vociferously challenged as contrary to legislative intent Example 4 of (f) illustrates this exception: If Parent has 84% of the vote and gives half away in equal shares to each of Parent s children, the reduction from majority controlling shareholder to minority shareholder (with a resulting loss in the value of those shares, no longer a control block) is not a lapse of a voting or liquidation right contemplated by 2704 because the voting rights (in the hands of the transferees) have not been eliminated. 23

24 Current regulations sanctioned reduction in values that were thought to be abusive Key example is a majority owner who gives away just enough to no longer give her voting control and the right to unilaterally liquidate the entity by making transfers made close to death: example: 60% owner gives away 11% several months before her death. She no longer has voting control, and the stock included in her estate will receive minority discount valuation. This gift clearly caused a lapse of a liquidation right. BUT The current regulations say that no lapse of a voting or liquidation right occurs if the interest given (here stock) has all the rights in the hands of the donee that it had in the donor s hands. Since the voting stock did not become non-voting upon the gift, no taxable lapse occurred at the time of the gift 24

25 What about the shares the transferor retained? The donor is now put in a lower valuation position with respect to the stock she retains. Under current law, if donor dies owning those shares (and death follows the gift closely in this example) the transferor s shares can claim a minority discount on the estate tax return. But shouldn t this be the case? Unless there is agreement with the donee that the donor would remain in de factor control (which brings up other estate tax inclusion rules), the donor s property has become less valuable. As we will see the Proposed Regulations seek to address this situation 25

26 Estate of Murphy v. Commissioner, T.C. Memo , 60 TCM 645 (1990) disallowed the minority discount in such a situation. As we will see, the Proposed Regs do not remove this example or this exception to the reach of 2704(a) but they limit it (and change this example and one other) to avoid so- called death bed transfers that reduce voting control The Proposed Regs in essence say, this type of loss of value will be respected if the transfer occurs more than 3 years before Parent s death. 26

27 Significant limitation on the definition of an applicable restriction in Given the ostensibly broad read and reach of Code 2704(b), as well as the legislative history, the government agreed to a compromise interpretation that would not eliminate discounts or reimpose family attribution The regulations at (b) preclude the application of 2704(b) in certain circumstances by carving out from the definition of applicable restriction a restriction on liquidation that is no more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction. 27

28 Developments that lead to the Proposed Regs Kerr v. Commissioner, 133 T.C. 449 (1999), aff d 292 F.3 rd 490 (5 th Cir. 2002), essentially provided that Code 2704(b) did not apply to a restriction on the right to liquidate an interest in the entity, holding instead (after reviewing the legislative history and the plain wording of the statute and regulations) that 2704(b) applies only to restrictions on the ability to liquidate the entire entity. The carve out just described (i.e., only being more restrictive than state law gets you into trouble under 2704(b)), together with significant changes in state laws governing partnerships and LLCs together rendered 2704(b) fairly ineffectual. Default state law, which in effect provides the baseline for valuation purposes, has evolved since Default rules preclude a limited partner or member of an LLC from withdrawing or transferring his interest except as set forth in the governing agreement, so the default rule is that an interest cannot be liquidated In statutes that permit transfers in the absence of a governing agreement provision, the transferee (In the absence of the consents required by the agreement) only receives an assignee interest, with no right to vote or participate This addressed the issue of permitting transfers as a default but not forcing the remaining members or partners to accept the transferee as a fellow partner or member Many statutes provide a requirement that all members/partners consent to a liquidation of the entity 28

29 Other areas of concern for Treasury Taxpayers use of nominal interests in non-family members, including charity, to avoid the application of Code 2704(b), by ensuring that the family could not remove the restriction The promulgation of check- the- box regulations and the proliferation of LLCs that are taxable as partnerships require updates to the regulations 29

30 Highlights of the Proposed Regulations and the Heated Debate Over How Broad (or Narrow) They Are Ed Morrow Director, Family Wealth Consulting Group Key Private Bank

31 The Newly Proposed Treasury Regulations Section (expansion and clarification of definition of controlled entity, not the most groundbreaking change) Section (lapse of certain rights, includes 3 yr rule) Section (transfers subject to applicable restrictions) Section (transfers subject to disregarded restrictions the most controversial and confusing) all the others are amendments, this one is completely new Section (effective date) These are uploaded as downloadable handout pages 1-22 of pdf are the preamble, pages are the proposed changes. I highlighted portions that will be discussed today and will reference page numbers of these (more readable than slides). 31

32 Who Wins and Who Loses if Proposed Regulations Become Law Who is potentially negatively impacted? Anyone with a taxable estate ($5.45 /$10.9 million married, increasing to $5.49/$10.98 million in 2017), who owns a business entity or arrangement, which the family could control if aggregated together (control meaning 50% or more). Who Wins? Potentially, anyone with a non-taxable estate with affected business entities (since they may benefit from higher valuations, which would increase basis - but this is very uncertain, especially for non taxable estates see Morrow article). Indirectly: valuation, law and accounting firms, maybe even life insurers to cover a three year lookback! Who is unaffected? Those who do not own closely held business interests nor would ever establish one, or those families with non-controlling (<50%) interests in a closely held business (aggregated). 32

33 Prop. Reg : Clarifying Application to Various Entities Addresses what constitutes control of an LLC or other entity or arrangement that is not a corporation, partnership, or limited partnership and clarifies what entities the regulations apply to. 33

34 Prop. Reg : New Assignee and Three Year Rule Prop. Reg Lapse of Certain Rights (Page discussion in preamble at p. 3-5, page of the pdf file containing regs, page for Examples) first clarifies the scope of affected entities and application to assignees (e.g. if I transfer LLC interest but donee is mere assignee, it s a lapse), but (c) is the most far reaching it is essentially correcting the result in the Murphy case, and superseding Rev. Rul (where IRS permitted non-aggregated minority interest discounts where donor gifted 5 20% shares of business) for transfers within 3 years. When the dust settles and we have final regulations, this is likely to be the most far-reaching, and potentially most devastating. 34

35 Three Year Rule Prop. Treas. Reg (c) The proposed regulations would create a valuation penalty for transfers occurring within three years before the transferor s death if the entity is controlled by the transferor and members of the transferor s family immediately before and after the lapse. They apply to transfers of property*** occurring on or after [date regulations are final] Is the transfer the original transfer or the deemed lapse/gift at death? E.g. if owner gifts shares in 2016 but dies in 2018, assuming this is after similar regs are made final, when is the transfer? 35

36 Three Year Rule Prop. Treas. Reg (c) This could affect transfers made pre-final regulation if the transferor dies within three years. Treasury will very likely clarify this and may ultimately resolve the uncertainty with a more taxpayer-favorable interpretation. Nonetheless, we have to warn clients of clawback possibility, even if regs take 2 years to finalize. WORSE: it may lead to phantom inclusion that does NOT qualify for the marital deduction (there is a marital deduction valuation symmetry in proposed 2704(b) regulations (see highlighted portion of preamble on page 20 of pdf and (g) Ex 4, but this is not mentioned anywhere in

37 Three Year Rule Prop. Treas. Reg (c) Calculating the value of the lapse under the three year rule is uncertain. The regulations state that the value is calculated by comparing the value of the interests before and after the lapse (see current Reg (d)). But, is this at the time of the gift, or at the time of death when the deemed lapse occurs? I believe the latter. 37

38 Three Year Rule Prop. Treas. Reg (c) Practical example of what would change: Dad Donor owns 100% of DonorCo, worth $10 million. He gifts three 20% full membership/voting shares to his children. Let s assume for now that 2704(b) does not apply at 30% discount this is a $4.2 million gift. If Dad Donor dies two years later, the proposed regulation would cause a taxable lapse of Dad s previously held right to redeem/liquidate DonorCo, the value of which would be added to Dad Donor s estate. Let s say in 2 years DonorCo is now worth $11 million. So, Dad Donor s 40% share that might have been $3.08 million discounted will now have 2704(a) additional inclusion of $1.32 million for a total of $4.4 million. However, if Dad Donor leaves this to his wife, the marital deduction may only be $3.08 million. Basis to wife? 38

39 Three Year Rule Prop. Treas. Reg (c) But wait, there s more it s not just the value of the retained portion of the stock that is increased! What about the value of the three gifts of 20% of DonorCo two years earlier? The value of the inclusion would be calculated by comparing the value at the time of death with or without the lapsed control. This may cause more inclusion than the prior discount! For example, in our previous slide, gifts were 3x$1.4 million=$4.2 million. But the proposed 2704(a) inclusion would likely be based on the value 2 years after the gift, at death -10% higher. Not $6 million minus $4.2 million (the $1.8 million discount valued two years earlier at time of gift), but $6.6 million minus $4.62 million (amounts two years later at death)=$1.98 million. In other words, you don t get the two years growth removed from the estate either (at least, not all of it)! 39

40 Effect of 2704 Application on Income Tax Cost Basis It is unclear whether any increased valuation resulting from 2704 or the proposed regulations leads to an increased income tax basis pursuant to 1014, because the statute and regs specifically limit application for purposes of this subtitle, which is estate, gift and GST tax, not income tax. See attached LISI article. Estates that are required to file estate tax returns pursuant to Section 6018 (which would be most of the people we are trying to actively do estate tax planning for) have a good argument that basis should symmetrically follow estate tax valuations. However, even this is uncertain for phantom inclusions (e.g., in our prior example, the amount added to the three 20% gifts, not the 40% retained, which is clearer) the basis could be reduced by depreciation taken post-transfer per 1014(b)(9) 40

41 Prop. Treas. Reg and Applicable Restrictions: Attacking State Laws Causing Higher Discounts by Prohibiting Withdrawal Section (b) provides, in part, that an applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction. This regulation amends to refine the definition of the term applicable restriction by eliminating the comparison to the liquidation limitations of state law (sorry Nevada!), if there are comparable state law alternatives that would not have such limitations see highlighted portion on page 33 of pdf. 41

42 Prop Reg : Disregarded Restrictions In explaining the three year rule, we assumed that the traditional discounts were still in place. In explaining the three year rule, the regulations do not mention any application of 2704(b) or proposed in the examples to such transfers in the first place. Back to our earlier example, if I gift three 20% interests and retain 40%, are these three gifts entitled to the same discounts as previously in most cases, or do the proposed regulations only apply to a narrow subset of restrictions and less common situations? This is the big debate. If discounts are mostly removed by 2704(b) anyway, then the proposed three year rule is close to meaningless. I will refer to the two interpretations as weak (not having much valuation effect at all) or strong (profound effect). 42

43 Disregarded Restrictions in the Debate Does this, as some argue, create a minimum value, a put right? This strong interpretation would effectively eliminate most of a discount for lack of marketability or lack of control, because someone would be deemed to have access to the underlying assets for valuation (with a mere 6 month delay). This interpretation has caused the huge uproar in the business owner community, and has been widely disseminated by many noted experts. Or, is just an awkwardly worded and confusing provision that has very little effect on traditional discounts at all? Informal comments by Treasury officials are indicating this is the more likely interpretation that should be clarified upon finalization. If this weak version holds, is a big yawn. 43

44 Disregarded Restrictions in the Debate Prop. Reg The term disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity that is described in any one or more of paragraphs b)(1)(i) through (iv) of this section, if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor s family (subject to paragraph (b)(4) of this section), either alone or collectively. If you stop reading here, you see why the effect may be mild if you don t restrict someone from selling their interest, no big deal, this is not triggered, keep your discounts. What has unfortunately led to the confusion is how Treasury described the restrictions in paragraphs i-iv. See p. 16 of pdf for preamble s discussion, p. 36 for reg s definition. 44

45 Disregarded Restrictions in the Debate (i-iv), on page of the uploaded pdf, are too long to paste in a slide, but summarized, includes provisions that: i)limit the ability to sell (easy to understand) ii)limit the ability to sell for less than a minimum value (OK, sounds easy, just avoid adding any such restriction, but it is very convoluted the way they word it because they imply there is a minimum value of the interest based on pro rata value of the entity) iii)limit the ability to get payment for more than 6 months iv)limit the ability to get cash/property for interest (no notes) 45

46 Disregarded Restrictions in the Debate Ed s take: the restrictions that are disregarded only pertain to the ability to redeem or liquidate an interest in an entity, not the ability to liquidate the entity itself. In a typical situation, you do not limit or prevent an owner from: i) selling; ii) selling for more than $X; iii) getting paid immediately; or (iv) getting cash/property for sale. The examples in the regulations imply that the same discounts apply, except for the effect of disregarding the specific provision, valued under generally accepted valuation principles (e.g. in Ex. 1-5 on page of the attached regs, the 33% share is still valued as a 33% share, but just with the right to sell it on open market. If they had meant to force valuation based on put right, wouldn t they simply say directly that the 33% is valued at minimum value in the examples?) 46

47 Disregarded Restrictions in the Debate Here are examples of provisions that might still be disregarded for valuation, even under the weak interpretation of the regs (i.e. no big effect): prohibition on withdrawal (obvious from examples); party receives or can only receive assignee interest (also covered in ), or the right of first refusal allows the company to purchase but only pay with issuance of a note. Treasury could have avoided a lot of controversy with clearer examples! The key question: if a party cannot withdrawal and demand pro rata purchase, yet can sell interest on open market, is the inability to instantly redeem a disregarded restriction (aka strong interpretation )? 47

48 Disregarded Restrictions in the Debate Argument for the 6 month put right: What if documents are merely silent on restrictions (in some cases you may not even HAVE an operating agreement)? For instance, a document might restrict an owner from having the ability to withdrawal and be paid for the interest, or dissolve the company and receive a pro rata share, but these are usually baked into state law without needing to be drafted into an operating agreement. Are the lack of such powers disregarded restrictions? Is the fact that state law or document does not grant liquidation or dissolution rights a limitation on the ability of the holder of the interest to compel liquidation or redemption of the interest? 48

49 Disregarded Restrictions in the Debate Would Treasury go to all the trouble of the regulations to merely bite at the periphery attacking only extreme state law effects or outright prohibitions on sale or withdrawal that are not often used? Perhaps. The term disregarded restriction means a restriction that is a limitation on the ability to redeem or liquidate an interest in an entity this phrase should not be interpreted to impose a right to redeem or liquidate an interest in an entity for a minimum amount. That said, many more distinguished practitioners than I think otherwise, so I m going to warn clients anyway until clarified. 49

50 Disregarded Restrictions in if the strong interpretation applies Obviously the strong interpretation of would have extremely profound valuation effects! The minimum value is the net value of the entity multiplied by the interest s share of the entity. (see page 17 (preamble), page 36 of handout). The put right is a right, enforceable under applicable local law, to receive from the entity or from one or more other holders, on liquidation or redemption of the holder s interest, within six months after the date the holder gives notice of the holder s intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption (page 42 of handout) 50

51 Contrasting Effect - Related and Unrelated Parties Example: Francis, Tim and Jeff own an LLC worth $12 million. They are unrelated. Their 1/3 share should still be valued under the old fair market value principles for gift/estate tax perhaps a 20-40% discount- perhaps $ 3 million value. However, if a funded buy-sell agreement formula mandates the buyout of a deceased owner for a pro rata value of $4 million (not uncommon for unrelated parties), it would be valued at $4 million regardless. Beware: if Jeff retires or dies and Francis and Tim buy him out (regardless of whether it is for $3 million or $4 million), 2704 may now be triggered because they own 50% (again, the remaining discount after application is unclear, but the three year rule application could still be quite impactful) 51

52 Contrasting Discount - Related and Unrelated Parties Contrast, if Francis, Tim and Jeff in our prior hypothetical were brothers, each of their interests may be valued closer to $4 million for estate tax purposes under the proposed regulations, even if there is no buy sell agreement, even if they hate each other and always litigate, even if the widow/estate of owner is later bought out for $3 million! (again, this effect is debated) In most families, siblings control each other as much as we control the wind, moon and tides, yet the IRS may attribute collusion regardless. Similarly, 50% ownership of a company is hardly control, yet the regulations force higher valuation, especially if three year rule to apply (e.g. if 51% owner gifts 2% and retains 49%). 52

53 Contrasting Discount for Non-Entities, Tenancies in Common Example: Francis, Tim and Jeff are brothers and own real estate or artwork as tenants-in-common worth $12 million. Their 1/3 interest should still be valued under the old fair market value principles for gift/estate tax perhaps a 15-30% discount (less discount typically than an LLC/LP)- perhaps $ 3.2 million value, unaffected by the proposed regulations. The new regulations only affect entities. However, except for the rare case of siblings inheriting property from a parent, most people will co-own real estate through a limited liability entity for superior ease of transfer and asset protection. But, consider, what about Francis, Tim and Jeff contributing their 1/3 tenancy in common to their own three separate LLCs? Potential IRS attack: depending on the level of cooperation and coordination, the IRS might find such joint ventures/tics to be de facto partnerships for tax purposes. See Rev. Proc for discussion. While tenancy in common agreements are recommended, a restriction on partition may be disregarded. IRC

54 Effective Dates Some of the regulations become effective upon immediately after the regulations are published as final, but the most substantial and farreaching rules will not take effect until 30 days after that. Prop. Reg (page of pdf). They could be made final in December, January, or likely months later (it could take years). The important point is that we have time to plan. There is a strong possibility that regulations may be modified or even overturned (more likely if the strong 6 month put right interpretation applies), but it may take years safest to plan for the worst. 54

55 Proposed 2704 Regulations Exceed IRS Authority James G. Blase, CPA, JD, LLM Blase & Associates, LLC St. Louis, MO

56 Proposed Section 2704 Regulations Exceed IRS Authority Note bills in both House and Senate along the same lines. 56

57 And/or Change The IRS has attempted to add regulations that change the law so that no longer must the control of the entity immediately before the lapse or transfer be in the hands of the transferor and members of their family, as required by both Internal Revenue Code Section 2704(a) and 2704(b), but instead control immediately before the transfer need only be in the transferor and/or members of the transferor s family. 57

58 And/or Change The Conference Committee Report that accompanied the passage of IRC Section 2704 in 1990 was very specific in including the requirement that control of the corporation or partnership immediately before the lapse or transfer be in the transferor and family members, and included this concurrent arrangement in all three of its examples illustrating the application of IRC Section 2704(a) and 2704(b). 58

59 And/or Change The Internal Revenue Service has clearly exceeded its regulatory authority by changing the Congressionally-imposed and to an IRS-imposed and/or. Congress gave the IRS authority to disregard other restrictions, which the IRS clearly has done by proposing new Treasury Regulations Section , but Congress didn t grant the IRS authority to make other unilateral changes to the IRC, which it clearly has also done by changing the key concurrent word and to the concurrent or disjunctive phrase and/or. 59

60 And/or Change Evidence that Congress knew how to employ the concurrent and disjunctive and/or concept can be found in the separate IRC Section 2704(b)(2)(B)(ii), which deals with the situation after the transfer: The transferor or any member of the transferor s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. 60

61 And/or Change The IRS itself has also demonstrated that it understands the difference between the immediately before and after sections and the use of the word and versus the phrase and/or, by choosing to employ the following language in proposed regulation Section (b)(1):... if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor s estate, and/or any member of the transferor s family, either alone or collectively. 61

62 And/or Change The preamble to the proposed regulations likewise illustrates that the IRS recognizes that Congress intended the word and to mean concurrent ownership only: The legislative history of section 2704 states that the provision is intended, in part, to prevent results similar to that in Estate of Harrison v. Commissioner, T.C. Memo In Harrison, the decedent and two of his children each held a general partner interest in a partnership immediately before the decedent s death

63 And/or Change Finally, note that the IRS current immediately before regulations do not employ the proposed and/or wording, but rather track the Code s and wording. Thus, for whatever the reasons, the decision was apparently made to change the concurrent word and to the concurrent and disjunctive phrase and/or. 63

64 And/or Change Relevance An owner owing 100% of an entity may have his or her minority, etc. discounts severely reduced when making lifetime gifts of the entity to his or her children, as the restrictions on liquidation and lack of voting control could be ignored. 64

65 And/or Change Relevance A possible planning technique around Section 2704 completely would be to transfer the 100% interest in the entity to an incomplete gift irrevocable trust where the transferor retains no interest other than the ability to allocate the entity among family members. But this technique fails when the and/or change is read into the law. 65

66 Deemed Lapse at Death If a transfer of an interest results in a lapse of a voting of liquidation right within three years of the transferor s death, the Service will deem that the lapse occurred at death. Again, there is no authority in the Internal Revenue Code which would allow the IRS to change the law in this fashion. 66

67 Deemed Lapse at Death Relevance If the deemed lapse at death is invalid, and no attempt is made by the IRS to tax resulting lapses for federal gift tax purposes, then the only valuation argument remaining on the typical minority interest lifetime transfer is the Section 2704(b) applicable restriction argument, which again fails if the and/or change fails. 67

68 Disregarded Restrictions The entire proposed regulation (PR) Section on disregarded restrictions misses a vital requirement of the enabling Internal Revenue Code Section 2704(b)(4). That section includes the prerequisite that the disregarded restriction not ultimately reduce the value of such interest to the transferee. 68

69 Disregarded Restrictions In each of the four situations described in PR subparagraphs (i) through (iv) of Section (b)(1) involving various limitations on the ability to redeem or liquidate an interest in any entity, however, the value of the interest in the transferee is ultimately reduced. Therefore, all of the disregarded restrictions listed in PR Section are invalid. 69

70 Removal of Restrictions The PRs incorrectly extend the attribution rules (including the trust attribution rules) referenced at Section 2704(c)(3) to the requirement that the restrictions must be removable after the transfer by the transferor and/or members of the transferor s family. 70

71 Removal of Restrictions Section 2704(c)(3) provides that [t]he [attribution] rule of section 2701(e)(3) shall apply for purposes of determining the interests held by any individual. The interests held by any individual language is referenced in the IRC Sections 2704(a)(1)(B) and (b)(1)(b) prerequisites that the transferor and members of the transferor s family hold control of the entity, and in the Section 2704(a)(2) determination of the value of the lapsed voting or liquidation right. 71

72 Removal of Restrictions This same held language isn t employed as part of the Section 2704(b)(2)(B)(ii) requirement that [t]he transferor or any member of the transferor s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. 72

73 Removal of Restrictions Thus, for example, if the limited entity interest is transferred, either during lifetime or at death, to an irrevocable trust that includes an independent trustee or cotrustee, how can it be said that: [t]he transferor or any member of the transferor s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. 73

74 Removal of Restrictions To remove the restriction, the family members would need the consent of the independent trustee or cotrustee. There s nothing in the IRC that authorizes a deemed or attributed consent concept in the right to remove the restriction context. 74

75 Disregarded Restrictions Held by Non-Family Members Although the IRS arguably has the authority to disregard de minimis or nominal ownership interests generally, the question is whether the proposed regulations have exceeded this authority. The three-year, 10 percent, 20 percent and put right requirements add up to a very significant interest indeed, far exceeding what s generally thought to be a de minimis or nominal interest. 75

76 Planning Opportunities and Strategies Ed Morrow Director, Family Wealth Consulting Group Key Private Bank Topic Presented by Entire Panel

77 Planning Opportunities that Will Remain Effective Short Term GRATs often use non-family entities for funding anyway (because distributing in kind with a discount going out as necessary for 2-3 year GRAT removes most benefit of discount anyway) - these will not be affected Even if the proposed regulations are made final (and the more stringent deemed 6 month put interpretation valid), many gifting strategies will still be highly effective and continue to be used, especially over the longer term, because grantor trust status permits tax-free gift by paying the tax, and growth is still outside of estate. Over time, these two factors dwarf the value of the discount. Volatile assets may be well suited to GRATs, whereas more stable ones to IGTs, since GRATs do not waste any seed gift if the value of the asset decreases. GRATs can adapt to increased valuation uncertainty! 77

78 Old Buy-Sell Agreements a Ticking Time Bomb? If the estate tax value increases due to 2704, is the buy-sell agreement buyout tied to that number in any way? If it is not, should it be (if so, when)? Phantom estate value occurs if $X is in estate, but estate receives $.64X (non-family buy-sells usually do not discount). There is no obvious answer, it depends on the situation, but parties should make sure they agree on result - the three year rule may create the nastiest valuation difference The difference between estate tax value and fair market value could be significant and may lead to expensive non-tax litigation! Buy-sells where other family members are or may become owners should be reexamined. Buy-sells with non-related parties are not as likely to be affected, but verify. 78