THE RECENTLY PROPOSED SECTION 2704 REGULATIONS: WHAT'S ALL THE HOOPLA ABOUT?

Transcription

1 THE RECENTLY PROPOSED SECTION 2704 REGULATIONS: WHAT'S ALL THE HOOPLA ABOUT? By DAVID PRATT, ESQ. DANA FOLEY, ESQ. DANIEL HATTEN, ESQ. Proskauer Rose LLP DAVID PRATT, ESQ. DANA FOLEY, ESQ. DANIEL HATTEN 2255 Glades Road, 1001 Pennsylvania Ave., Eleven Times Square Suite 421A N.W. Suite 600 South Boca Raton, FL Washington, DC New York, NY P: (561) P: (202) P: (212) F: (561) F: (202) F: (212) COPYRIGHT 2016 DAVID PRATT, ESQ. ALL RIGHTS RESERVED

2 I. INTRODUCTION The long-awaited Proposed Regulations (the "Proposed Regulations") under Internal Revenue Code Section were released on August 2, 2016 and published in the Federal Register on August 4, As practitioners expected, the Proposed Regulations closely follow the Obama administration's legislative proposals, as set forth in the Greenbook. 3 If the Proposed Regulations are adopted in their current form, they will have the effect of virtually eliminating all minority or lack of control valuation discounts for transfer tax purposes in the context of family-controlled entities, therefore reducing the effectiveness of traditional estate freeze techniques utilized under current law. Yet despite the impediments presented under the Proposed Regulations, taxpayers should still be able to achieve significant transfer tax savings through tried-and-true techniques, by utilizing fractional interest discounts and other valuation methodologies. Moreover, the regulations, once finalized, may even present potential planning opportunities for clients. So, this begs the question, just what is all the hoopla about? The real transfer tax savings occur when a taxpayer transfers an asset that appreciates outside of the transferor's estate over the rest of his or her life and over the lives of future generations (when generationskipping transfer ("GST") tax planning has been properly implemented). Indeed, discounts have been viewed by many professionals as the "icing on the cake." While the benefit from discounts will undoubtedly be diminished by the Proposed Regulations, practitioners should continue advising clients to use classic estate planning techniques to remove future appreciation from their estates. II. SECTION 2704 UNDER CURRENT LAW A. Background and Intent Behind Section 2704 Section 2704, attached as Exhibit A, along with the rest of Chapter 14 of the Code, was passed to prevent the use of freeze techniques that were intended to reduce a transferor's taxable estate or gifts by discounting the transferred asset's value without actually reducing the transferee's economic benefit. 4 1 For purposes of this outline, section references shall be to sections under the Internal Revenue Code of 1986, as amended (the "Code") Fed. Reg (Aug. 4, 2016). 3 The Treasury Department's General Explanations of the Administration's Revenue Proposals for a given year are commonly referred to as "the Greenbook." These contain the current Administration's proposals for changes to the tax law in a given year. 4 See 136 CONG. REC , (October 18, 1990); see also Letter from Richard Dees to the Hon. Mark Mazur, Assistant Secretary of Tax Policy, Dept. of the Treasury, and the Hon. William J. Wilkins, Chief Counsel, IRS (Aug. 31, 2015) re: Possible New Regulations under Internal Revenue Code Section 2704(b) (available at (hereafter, "Letter from Richard Dees to the Hon. Mark Mazur"). 1

3 B. Section 2704(a) Treatment of Lapsed Voting or Liquidation Rights Section 2704(a) treats the lapse of any voting or liquidation right attached to an ownership interest in a family-controlled entity as a taxable transfer equal to the difference in value of the interest (1) calculated as though the restrictions were non-lapsing and (2) calculated after the lapse of the restriction. 5 If the lapse occurs during the transferor's life, the transfer is deemed a taxable gift, 6 and if the lapse occurs upon the transferor's death, the transfer is included in the transferor's federal gross estate. 7 Broadly, whenever a lapsed right is associated with a transferred interest, 2704(a) treats the lapsed right as a taxable transfer. Section 2704(a)(3) provides a specific grant of authority to the Treasury Secretary to apply Section 2704(a) "to rights similar to voting and liquidation rights." 8 C. Section 2704(b) Exceptions Under Section 2704(b)(1), if an interest in a corporation or partnership is transferred "to (or for the benefit of) a member of the transferor's family, and the transferor and members of the transferor's family hold, immediately before the transfer, control of the entity, then any applicable restriction shall be disregarded in determining the value of the transferred interest." 9 "Applicable restriction" is defined in Section 2704(b)(2), as any restriction which "effectively limits the ability of the corporation or partnership to liquidate" and either (i) lapses, in whole or in part after the transfer or (ii) can be removed, either in whole or in part, by "the transferor or any member of the transferor's family, either alone or collectively." 10 Critically, Section 2704(b)(3) explicitly excludes two classes of restrictions from the definition of "applicable restrictions": "(A) any commercially reasonable restriction which arise as part of any financing by the corporation or partnership with a person who is not related to the transfer or transferee, or a member of the family of either, or (B) any restriction imposed, or required to be imposed, by any Federal or State law." 11 5 IRC 2704(a). 6 IRC 2704(a)(1). 7 Id. 8 IRC 2704(a)(3). 9 IRC 2704(b)(1). 10 IRC 2704(b)(2). 11 IRC 2704(b)(3). 2

4 Section 2704(b)(4) is titled "Other Restrictions," and provides a specific grant of authority to the Treasury Secretary: "The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or 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." 12 D. Section 2704(c) Definition of "Member of the Family" and "Control" Section 2704(c)(1) defines the term "control" by cross-reference to Section 2701(b)(2). 13 In the case of a corporation, "control" means "the holding of at least 50 percent (by vote or value) of the stock of the corporation." 14 For a partnership, "control" is defined as either "(i) the holding of at least 50 percent of the capital or profits interest in the partnership, or (ii) in the case of a limited partnership, the holding of any interest as a general partner." 15 "Member of the Family" is defined under Section 2704(c)(2) as (A) an individual's spouse, (B) an ancestor or lineal descendant of such individual or (C) any brother or sister of the individual, or (D) any spouse of an individual described in (B) or (C). 16 III. CURRENT PLANNING UNDER SECTION IRC 2704(b)(4). 13 IRC 2704(c)(1). 14 IRC 2701(b)(2)(A). 15 IRC 2701(b)(2)(B). 16 IRC 2704(c)(2). The most successful estate planning techniques pass significant value from one generation to the next by freezing or establishing an appreciating asset's value and shifting the asset's growth to a younger generation. Fortunately, for taxpayers, and, unfortunately, for the Internal Revenue Service (the "IRS" or the "Service"), Section 2704, coupled with favorable state laws regarding an interest holder's right (or lack thereof) to liquidate his or her interest, has allowed taxpayers to obtain valuation discounts that are applied to gifts of interests in limited partnerships, limited liability companies ("LLCs") and corporations; and, with proper planning interests in these types of entities may be discounted at death Under current law, if certain rights are transferred within three years of the decedent's death, the value of the transferred property will be brought back into the decedent's gross estate. IRC 2035, This can lead to "phantom" inclusion, which may not be eligible for the marital deduction, charitable deduction or the currently available discounts. See Quigley, Christine, Transfer Tax Traps Involved in Related Party Transactions with Family or Closely Held Businesses, NOV-14 Koren Est. Tax & Pers. Fin. Plan. (Nov. 2014). 3

5 Thus, taxpayers have not had to worry about Section 2704 reducing or eliminating valuation discounts for gift and estate tax purposes when transferring interests in family-controlled entities or dying with such interests. Consequently, many individuals have transferred minority interests in their family controlled entities to their family members at a significantly lower transfer tax cost. IV. THE PROPOSED REGULATIONS A. Build Up to the Proposed Regulations For many years, practitioners have braced themselves for an overhaul of valuation discounts in the context of family-controlled entities, which would eliminate the "supercharging" benefit of estate freeze techniques. The Proposed Regulations were presaged by years of suggestions by the Treasury, the IRS and the Obama administration. Indeed, the Treasury and the IRS have included a regulations project under Section 2704 in their Priority Guidance Plan every year since Additionally, from 2009 through 2012, the Greenbook has included recommendations to clarify or enlarge Treasury's authority to disregard other restrictions through regulations as a budget proposal for Congress. 19 And throughout 2015, Proposed Regulations appeared imminent based on statements made by Cathy Hughes of the US Treasury's Office of Tax Policy at the ABA's Tax Section Meetings on May 10, 2015 and September 18, The long-awaited Proposed Regulations were finally released on August 2, 2016 and published in the Federal Register on August 4, B. Intent and Highlights of the Proposed Regulations The intent and goals supporting the regulations under Section 2704 are set forth in the Preamble to the Proposed Regulations. 22 As outlined in the Preamble to the Proposed Regulations, Treasury and the IRS have concluded that the current 18 The IRS's Priority Guidance Plans since 1999 are available at 19 The Greenbooks since 1990 are available at 20 Cathy Hughes of the US Treasury's Office of Tax Policy spoke at the ABA's Tax Section Meeting on May 10, 2015 and then spoke at the ABA's Tax/Real Property Probate and Trust Law Section Joint meeting on September 18, Fed. Reg (Aug. 4, 2016). 22 Preamble to the Proposed Regulations under I.R.C. 2704; 81 Fed. Reg (Aug. 4, 2016) (hereinafter, "Preamble to the Proposed Regulations"). The Preamble to the Proposed Regulations and the Proposed Regulations themselves are available at 4

6 regulations have been rendered "substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments." 23 Each of the changes set forth in the Proposed Regulations is intended to remedy or address a perceived issue in the current implementation of Section 2704 in order to better effectuate the purpose and intent of the statute. A special thanks to ACTEC Fellow Mickey Davis who provided redlines of the existing regulations as affected by the Proposed Regulations, attached hereto as Exhibits B, C and D. The new regulation created by the Proposed Regulations, Section , is attached hereto as Exhibit E. 1. Covered Entities a. Issue Identified in the Preamble The Preamble to the Proposed Regulations recognizes that since the promulgation of the check-the-box regulations, 24 "an entity's classification for federal tax purposes may differ substantially from the entity's structure or form under local law." 25 Additionally, Treasury and the IRS recognize that many taxpayers utilize a LLC as their preferred entity to hold family assets or business interests. 26 Under current law, however, the regulations purportedly only apply to partnerships and corporations. Therefore, Treasury and the IRS concluded that the regulations under Section 2704 should be revised to reflect these "significant developments" and the current landscape surrounding entity choice. 27 b. Change Made in the Proposed Regulations The Proposed Regulations expand the types of entities subject to Section 2704 beyond simply corporations and partnerships. Under the Proposed Regulations, entities subject to Section 2704 are broadly defined to include an association, a business entity taxable as a corporation, certain listed foreign entities, an S corporation, a qualified subchapter S subsidiary (which is treated as a corporation separate from its parent corporation), and any other business entity regardless of how it is classified for federal tax purposes, including an LLC. 28 Thus, the type of 23 Id. 24 Treas. Reg through Preamble to the Proposed Regulations at page Id. 27 Id. at Prop. Reg (a)(1); Prop. Reg (a). 5

7 entities for which restrictions may be disregarded for purposes of valuing transferred interests is greatly expanded by the Proposed Regulations. 2. Definition of "Control" a. Issue identified in the Preamble In conjunction with the expansion of the entities covered under Section 2704, Treasury and the IRS recognized that the definition of the term "control" for the purposes of Sections 2701 and 2704 and the regulations thereunder had to be redefined in order to address the additional entities that are now covered under the purview of the Proposed Regulations. Under current law and under the Proposed Regulations, Section 2704 only applies to transfers of an interest in an entity if the entity "is controlled by the holder and/or members of the holder's family immediately before and after the lapse," 29 and the definition of "control" is cross-referenced to Section b. Change Made in the Proposed Regulations The Proposed Regulations amend Section of the current regulations, where control is defined, to address what will constitute "control" in the case of an LLC or any other entity or arrangement (other than a corporation or a partnership). 30 Specifically, the Proposed Regulations define "control" in the context of a LLC or other business entity or arrangement to mean the holding of at least 50 percent of either the capital interests or the profit interests in the entity or arrangement or the ability to cause the liquidation of the entity or arrangement in whole or in part Assignee Transfers a. Issue Identified in the Preamble Treasury and the IRS recognized that taxpayers have attempted to avoid Section 2704(b) by transferring a partnership interest to a mere "assignee" rather than to a full-fledged partner. 32 By doing so, the taxpayers argue that the assignee status of the transferred interest is not an applicable restriction based on the same exception that excludes any restriction that is 29 IRC 2704(a)(1)(B); Prop. Reg (a)(1). 30 Prop. Reg (b)(5)(iv). 31 Id. 32 Preamble to the Proposed Regulations

8 no more restrictive than that of the state law (discussed below) that would apply in the absence of the restriction from the definition of applicable restriction. 33 Treasury seeks to eliminate this argument through the Proposed Regulations. 34 b. Change Made in the Proposed Regulations The Proposed Regulations eliminate any available valuation discounts based on a transferee's characterization under the governing document as a mere "assignee." To accomplish this, the Proposed Regulations state that "[a] transfer that results in the restriction or elimination of the transferee's ability to exercise the voting or liquidation rights that were associated with the interest while held by the transferor is a lapse of those rights" under Section Thus, any transfer to an "assignee" would be subject to Section 2704(a), even if the transferor cannot continue to exercise the voting or management rights associated with the transferred interest. 4. Interest Held by Nonfamily Members a. Issue Identified in the Preamble The Preamble to the Proposed Regulations specifically address the strategy taxpayers have used to avoid the application of Section 2704 by transferring nominal interests in the entity to nonfamily members, such as a charity, in an effort to ensure that the family alone does not have the power to remove a restriction for valuation purposes. 36 Treasury and the IRS have concluded that such a grant of an insubstantial interest to a nonfamily member should not preclude the application of Section 2704(b) because it does not actually constrain the family's ability to remove a restriction on the liquidation of an individual interest. 37 b. Change Made in the Proposed Regulations The Proposed Regulations create a "bright-line" test to provide clarity for when a nonfamily member's interest is economically substantial enough to avoid being an applicable restriction, while ensuring that insubstantial interests do not prevent the applicable of Section 2704(b). 33 Id. 34 Id. 35 Prop. Reg (b)(5). 36 Preamble to the Proposed Regulations at Id. 7

9 Pursuant to this test, an interest held by a nonfamily member will be disregarded when a transferor makes a transfer to or for the benefit of a member of the transferor's family unless all of the following conditions are satisfied: (1) the nonfamily member held the interest for at least three years prior to the transfer, (2) the nonfamily member owns at least a ten (10%) percent equity interest in the entity, (3) the total equity interests of nonfamily members, collectively, constitute at least twenty percent (20%) of all equity interests in the entity, and (3) the nonfamily member has a put right (discussed in more detail below) to be redeemed or bought out for cash or other property (other than certain promissory notes) equal to "minimum value" (i.e., the interest's pro rata share of the net fair market value of the assets of the entity) on no more than six months' notice. 38 This change would prevent taxpayers from receiving valuation discounts when transferring interests in an entity to a family member by also transferring a small interest in the entity to a charity or other nonfamily members. 5. Deathbed Transfers Treated as Lapses a. Issue Identified in the Preamble The IRS and Treasury take issue with the regulatory exception created under Section (c)(1) in the current regulations relating to inter vivos transfers of interests in family controlled entities that result in the loss of the power to liquidate on a decedent's deathbed. 39 As mentioned in II(B), supra, Section 2704(a)(1) provides that, generally, if there is a lapse of any voting or liquidation right and the individual holding such right immediately before the lapse and members of such individual's family hold, both before and after the lapse, control of the entity, such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate, whichever is applicable. 40 Under the current regulations, however, an important exception exists that provides that a transfer that results in a loss of a voting or liquidation right for the transferor will not constitute a lapsed right subject to Section 2704(a) if the "rights with respect to the transferred interests are not restricted or eliminated." 41 As the IRS and Treasury point out in the 38 Prop. Reg (b)(4). 39 Preamble to the Proposed Regulations at page IRC 2704(a)(1). 41 Id. 8

10 Preamble to the Proposed Regulations, the effect of this exception is that the inter vivos transfer of a minority interest by a transferor who has the aggregate voting power to compel the entity to redeem the transferor's interest is not treated as a lapse even though the transfer results in the loss of transferor's presently exercisable liquidation right. 42 Treasury and the IRS believe this existing exception to Section 2704(a) allows for potentially abusive transactions when done on an individual's death bed. 43 As explained in the Preamble to the Regulations, such transfers are contrary to the statutory intent of Section 2704 and "generally have minimal economic effects, but result in a transfer tax value that is less than the value of the interest either in the hands of the decedent prior to death or in the hands of the decedent's family immediately after death." 44 b. Change Made in the Proposed Regulations The Proposed Regulations seek to ensure that the general rule under Section 2704(a)(1) applies when an inter vivos transfer that results in the loss of the power to liquidate occurs on the decedent's deathbed by imposing a bright-line "three-year rule." The Proposed Regulations state, in pertinent part, that "[t]he lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor's death is treated as a lapse occurring on the transferor's date of death, includible in the decedent's gross estate." 45 This change will treat any transfer within three years of the transferor's death as a deemed lapse of a voting or liquidation right occurring at the time of the transferor's death. The impact of this new "three-year rule" created by the Proposed Regulations is to include the value of the valuation discount received upon a transfer in the transferor's gross estate if the transferor dies after the regulations are published as final and within three years of the transfer. 6. "Disregarded Restrictions" a. Issue Identified in the Preamble 42 Preamble to the Proposed Regulations at page Id. 44 Id. 45 Prop. Reg (c)(1). 9

11 Treasury and the IRS concluded that restrictions exist that are not set forth in the statute itself but which nevertheless should be disregarded for transfer tax purposes because they do not reduce the value of the interest to the family-member transferee. 46 These additional restrictions seek to remedy what Treasury and the IRS perceive as an eroding of the purpose and intent of Section 2704 through case law. Specifically, the Preamble to the Proposed Regulations takes issue with the Tax Court's decision in Kerr v. Commissioner, 47 in which the court found that Section 2704(b) only applies to restrictions on the ability to liquidate an entire entity, rather than simply a restriction on one's ability to liquidate a transferred interest. 48 As a result of the decision in Kerr, under current law, a restriction on the ability to liquidate an individual interest is not considered an applicable restriction, and is therefore respected for valuation purposes. 49 b. Change Made in the Proposed Regulations The Proposed Regulations expand the scope of Section 2704 to apply to any restriction on the ability to liquidate an individual owner's interest in an entity, rather than only a liquidation of the entire entity. 50 Specifically, Section 2704(b) currently refers only to "applicable restrictions," which has been construed in Kerr to refer to as a limitation only on the ability to force the liquidation of the entire entity. Pursuant to the authority granted to the Secretary of the Treasury under Section 2704(b)(4), the Proposed Regulations set forth a new class of restrictions on liquidation rights with respect to individual interests in an entity that will now also be disregarded for valuation purposes, referred to as "disregarded restrictions." 51 Disregarded restrictions are defined as any restriction that does one or more of the following: (1) limits the ability of the holder to compel liquidation or redemption of the interest; 46 Preamble to the Proposed Regulations at T.C. 449, 473 (1999), aff'd, 292 F.3rd 490 (5th Cir. 2002). 48 Preamble to the Proposed Regulations at Page Id. 50 Prop. Reg Prop. Reg

12 (2) limits the liquidation proceeds to an amount that is less than "minimum value" (i.e., the interest's pro rata share of the net fair market value of the assets of the entity); (3) defers payment of the liquidation proceeds for more than six months; or (4) permits the payment of liquidation proceeds in any manner other than cash or other property (other than certain promissory notes). 52 In adding this new class of restrictions, the Proposed Regulations severely curtail available valuation discounts as a result of the breadth of this new class of "disregarded restrictions." ACTEC fellow Mickey Davis provided a redline, attached hereto as Exhibit F, comparing this new section under the Proposed Regulations that creates the new class of restrictions against section under the current. 7. Exception For Restrictions "Imposed or Required to Be Imposed" by Federal or State Law a. Issue Identified in the Preamble The Tax Court's decision in Kerr also construed the current regulations to exclude any restriction that is no more restrictive than that of the state law that would apply in the absence of the restriction from the definition of an applicable restriction. 53 According to the Treasury and the IRS, state statutes governing limited partnerships have been revised to be more restrictive, thereby allowing more restrictions to be excluded from the definition of applicable restrictions pursuant to Section 2704(b)(3)(B) and the Kerr holding. 54 b. Change Made in the Proposed Regulations The exceptions to the term "applicable restriction" are restated in the Proposed Regulations in an effort to restrict the application of the statutorily prescribed state law exception. The Proposed Regulations begin by restating Section 2704(b)(3)(B): "[a]n applicable restriction does not include a restriction imposed or required to 52 Prop. Reg (b)(1) T.C. at Preamble to the Proposed Regulations at page 51415, citing e.g., Tex. Bus. Orgs. Ann (West 2016) (limited partner may withdraw as specified in the partnership agreement); Uniform Limited Partnership Act (2001) 601(a), 6A U.L.A. 348, 448 (Supp. 2015) (limited partner has no right to withdraw before completion of the winding up of the partnership). 11

13 be imposed by federal or state law." 55 The Proposed Regulations add, however, that "[a] provision of law that applies only in the absence of a contrary provision in the governing documents or that may be superseded with regard to a particular entity (whether by the shareholders, partners, member and/or managers of the entity or otherwise) is not a restriction that is imposed or required to be imposed by federal or state law. A law that is limited in its application to certain narrow classes of entities, particularly those types of entities (such as family-controlled entities) most likely to be subject to transfers described in section 2704, is not a restriction that is imposed or required to be imposed by federal or state law." 56 Therefore, the extent of the exception for restrictions that are imposed by federal or state law is severely narrowed. A restriction will therefore only avoid being considered an applicable restriction that is disregarded for valuation purposes if it is a mandatory federal or state law applicable to most, if not all, entities Safe Harbor Put Right While the Preamble to the Proposed Regulations do not address the new deemed "put right" concept in response to an issue to be remedied, it is noteworthy that, in addition to the exceptions that currently exist under the statute for restrictions imposed by state and federal law and for commercially reasonable restrictions, the Proposed Regulations provide an additional safe harbor provision in the form of a "put right." Specifically, under the Proposed Regulations, a liquidation restriction will not be considered an applicable restriction or a disregarded restriction if each of the following conditions apply: (1) every owner has an enforceable "put right" to redeem or liquidate his or her interest in the entity for "minimum value;" (2) the payment is made in cash or other property (other than certain promissory notes); and (3) the payment must be made within six months of the exercise of the put right Prop. Reg (b)(4)(ii). 56 Id. 57 Id. 58 Prop. Reg (b)(6). 12

14 C. Timeline The effect of this new "put right" exception is to provide a safe harbor for liquidation restrictions that does not exist under the current law. The Proposed Regulations only apply to transfers on or after the date the regulations are published in final (and in some cases, thirty days thereafter). 59 The provisions of the Proposed Regulations concerning interests held by nonfamily members and the new class of "disregarded restrictions" are only effective as to transfers occurring 30 or more days after the regulations are published as final. Each of the other changes discussed in IV(c), supra, is effective for transfers on or after the date the regulations are published in final. 60 D. Constitutional Concerns In Connection With the Proposed Regulations Regulations issued by a federal agency are given deference, but are nonetheless subject to court review. 61 Many commentators believe that the Proposed Regulations promulgated by the IRS may be unconstitutional in light of the framework for review set out by the Supreme Court and interpreted by other courts. 62 Thus, if a taxpayer takes a valuation discount for a restriction that the IRS disallows under the Proposed Regulations, the taxpayer could potentially fight the IRS and raise constitutional challenges that may lead to the Proposed Regulations (or parts thereof) being invalidated as unconstitutional. The Proposed Regulations present other problems as well which may prevent them from being enacted in the same form. 1. Chevron, Walton, and Mayo Foundation The Proposed Regulations may be deemed unconstitutional in light of Supreme Court precedent. When an agency, such as the Treasury, promulgates regulations, they are subject to court review to determine the constitutionality of the provisions. The Supreme Court set out the standard for determining whether an 59 Prop. Reg Prop. Reg (b)(1), (2). 61 Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, (1984). 62 See Letter from Richard Dees to the Hon. Mark Mazur. 13

15 agency's construction of the statutes it administers is constitutional in U.S.A., Inc. v. Natural Resources Defense Council, Inc. 63 The Treasury Department can issue interpretative regulations under the general authority vested in the Secretary by Section 7805(a), or it can issue "legislative regulations issued under a specific grant of authority to address a matter raised by the pertinent statute." 64 Legislative regulations are afforded great deference and are to be upheld unless "arbitrary, capricious, or manifestly contrary to the statute." 65 On the other hand, interpretive regulations will be upheld if the provision "implements the congressional mandate in some reasonable manner." A two-part analysis is applied: "First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute." 66 Interpreting this in the context of regulations promulgated by the Treasury under another part of Chapter 14 of the Code, Section 2702, the Tax Court, in Walton v. C.I.R., added that "a challenged regulation is not considered such a permissible construction or reasonable interpretation unless it harmonizes both with the statutory language and with the statute's origin and purpose." 67 After stating that Section 2702 did not speak to the particular issue in the regulation, the Tax Court, in Walton, turned to the statute's legislative history. 68 Ultimately, the Tax Court found that the regulation was "manifestly contrary to the statute," and, therefore, the regulation was unconstitutional U.S Walton v. C.I.R., 115 T.C. 589, 597 (2000), citing Chevron, 467 U.S. 837, Chevron, 467 U.S. at Id. 67 Walton, 115 T.C Id. at

16 However, the Walton court also noted that it was uncertain whether Chevron replaced the traditional standard of review set out by the Supreme Court earlier in National Muffler Dealers Association v. U.S. 69 The Supreme Court clarified that Chevron applies in its 2011 decision in Mayo Foundation v. U.S., 70 but left open a new question: whether "legislative" and "interpretive" regulations continue to be subject to different tests. 2. Potential Judicial Review of the Proposed Regulations As discussed in II, supra, Section 2704 contains two specific grants of authority to the Treasury. First, the Secretary of the Treasury is authorized to apply Section 2704(a) "to rights similar to voting and liquidation rights" pursuant to Section 2704(a)(3). 71 Second, under Section 2704(b)(4), the Secretary of the Treasury may also provide that "other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or 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." 72 Sections and of the Proposed Regulations are purportedly issued under Section 2704(b), along with Section Another part of the Proposed Regulations, Section , also purports to be promulgated pursuant to the Treasury's authority under Section 2704(a) to disregard "rights similar to voting and liquidation rights." 74 It appears that the portions of the Proposed Regulations that fit within the specific authority provided by Congress under Section 2704(b) are likely to be afforded great deference upon a taxpayer challenge, and will only be found unconstitutional if they are "arbitrary, capricious, or manifestly contrary to the statute." Id., citing National Muffler Dealers Association v. U.S., 440 U.S. 472, 477 (1979) U.S. 44, 57 (2011). 71 IRC 2704(a)(3). 72 IRC 2704(b)(4). 73 See Preamble to Proposed Regulations. 74 See id. 75 Chevron, 467 U.S. at

17 Accordingly, unless it can be proven that the newly disregarded restrictions under Prop. Reg and ultimately do reduce the value of such interest to the transferee, the Proposed Regulations would likely be upheld. Similarly, unless it can be proven that the rights subject to Prop. Reg are not similar to voting or liquidation rights, the Treasury's treatment of those rights will likely be upheld pursuant to Chevron. Other portions of the Proposed Regulations, however, may be considered as issued under the general authority vested in the Treasury Secretary under Section 7805(a), and would therefore be considered interpretative regulations. The new three-year rule for example, does not appear to be based on either the specific grant of authority in Section 2704(a)(3) or in Section 2704(b)(4). If there is only one test for both legislative regulations and interpretive regulations after the Mayo decision, the new three-year rule would similarly be entitled to great deference. However, if there are two tests still, the portions of the Proposed Regulations that are considered interpretive regulations would be more likely to be found unconstitutional upon a taxpayer challenge. 16

18 V. WHAT'S ALL THE HOOPLA ABOUT? EFFECTS OF THE PROPOSED REGULATIONS A. Positive Results of Removing Future Appreciation Still Available While the Proposed Regulations, if adopted in their current form, would certainly be a blow to the use of valuation discounts, it must be emphasized that the positive results of removing appreciation from a client's estate will still be available and cannot be overlooked. Indeed, valuation discounts under current law have effectively supercharged the tax savings associated with traditional estate freeze techniques, but the real emphasis behind such techniques has always been, and should continue to be, the transfer of an appreciating asset outside of the transferor's estate. Tried-and-true estate planning techniques such as grantor retained annuity trusts ("GRATs"), charitable lead annuity trusts ("CLATs"), sales to intentionally defective grantor trusts ("IDGTs") (using interest-only or selfcancelling installment notes) and private annuities remain viable methods to freeze asset values and minimize transfer taxes. Again, any discounts associated with these techniques have always just been the "cherry on top." Thus, the mandate should be "full steam ahead" for clients to continue to use classic estate planning techniques to remove future appreciation from their estates. B. Example of the Effect of the Proposed Regulations It is relatively simple to quantify the implications of the Proposed Regulations on such techniques. Assume that there are clients who are a couple in their late sixties with excess liquid assets and $10 million remaining in estate, gift and GST tax exemptions, and who want to create a dynasty trust for their grandchildren and more remote descendants. The couple could form a family-controlled entity and gift $10 million worth of interests in such an entity to the dynasty trust. Assuming the transfer of interests in the family-controlled entity were eligible for a twenty-five percent (25%) valuation discount, in transferring $10 million of interests, the resulting transfer is $13.33 million of underlying value ($13.33 million x 25% = $3.33 million; $13.33 million - $3.33 million = $10 million). 17

19 The charts below summarize the appreciation removed from the clients' estates and the resulting federal estate tax savings assuming a modest appreciation rate of five percent (5%) and an appreciation rate of ten percent (10%), which approximates the rate of return for the S&P over the last twenty years (the "Average S&P Rate"), under both current law and after the Proposed Regulations come into effect. Note that the examples below reflect the economic benefit of the valuation discount achieved under current law and the compounding rate of return on the additional assets that are removed from the clients' estates as a result of the valuation discount. Future Value of Assets after 20 5% Gift Assuming 25% Discount under Current Law Gift Assuming No Discounts under Proposed Regulations $35.4 million $26.5 million Appreciation Removed $22.0 million $16.5 million Estate Tax Savings on Appreciation Removed $8.82 million $6.61 million Future Value of Assets after 20 the Average S&P Rate Gift Assuming 25% Discount under Current Law Gift Assuming No Discounts under Proposed Regulations $89.7 million $67.3 million Appreciation Removed $76.4 million $57.3 million Estate Tax Savings on Appreciation Removed $30.56 million $22.9 million As depicted above, the effect of the Proposed Regulations is to diminish the federal estate tax savings of the clients by approximately $2.2 million (assuming a modest five percent (5%) rate of return), or by $7.7 million (assuming the Average S&P Rate). But with $6.61 million and $22.9 million, respectively, of transfer tax savings still on the table (depending on the rate of return). 18

20 As mentioned above, there are plenty of strategies available for taxpayers to use that do not require the use of any gift or GST exemptions (i.e., zeroed-out GRATs and CLATs, sales to IDGTs and private annuities). This is demonstrated by the effects for discount purposes that the Proposed Regulations may have on a traditional installment sale transaction to a pre-seeded IDGT. In order to do this, assume that the clients are very wealthy and that the clients have a pre-seeded IDGT valued at $10 million, such that (assuming a 10-1 ratio) the trust may support a sale of up to $100 million of assets (or $ million of underlying value if a twenty-five (25%) valuation discount is assumed). The charts below depict the appreciation removed from the clients' estates and the resulting estate tax savings of a sale under current law assuming a modest twenty-five percent (25%) discount and once the proposed regulations come into effect, using both a five percent (5%) rate of return and the Average S&P Rate. 76 Sale Assuming 25% Sale Assuming No Discount under Discounts under Current Law Proposed Regulations Future Value of Assets after $193.8 million $142.1 million 20 5% Appreciation Removed $60.5 million $42.1 million Estate Tax Savings on $24.2 million $16.8 million Appreciation Removed Sale Assuming 25% Sale Assuming No Discount under Discounts under Current Law Proposed Regulations Future Value of Assets after $298.4 million $219.8 million 20 the Average S&P Rate Appreciation Removed $165.0 million $119.8 million Estate Tax Savings on $66.0 million $47.9 million Appreciation Removed 76 For purposes of these calculations, the authors have assumed a nine year promissory note, with an annual interest rate of 1.18% (mid-term AFR rate for August 2016) compounding annually. The authors have also assumed that at the end of the nine year period, the note will be extended using the same interest rate and, therefore, have not factored the balloon payment of principal into the debt serviced in above calculations. 19

21 The effect of the Proposed Regulations is to diminish the federal estate tax savings on the sale by approximately $7.4 million (assuming a modest five percent (5%) rate of return), or by $18.1 million (assuming the Average S&P Rate). But again, with $16.8 million and $47.9 million of transfer tax savings still on the table, respectively, even assuming no discounts are allowed, an installment sale to an IDGT remains a highly effective estate planning strategy. Note that the examples in this section do not factor in the additional income tax benefits achieved as a result of the IDGT's grantor trust status. In essence, the grantor is able to make "tax free" gifts to the trusts in the amount of the income taxes owed annually, thereby further diminishing the clients' estates for estate tax purposes. C. Minimal Negative Effect on GRAT Planning In theory, planning with short-term GRATs should benefit from valuation discounts because the annuity payments are determined using the discounted value of the transferred assets, while the undiscounted value of the assets generates income and gains during the GRAT term. In practice, however, the need to fund annuity payments with in-kind distributions often necessitates the application of a valuation discount on the way "out" as well, thereby negating the benefit of the discount. Therefore, the elimination of valuation discounts under the Proposed Regulations may not have a dramatic effect in many cases when planning with short-term GRATs if no discount is to be applied on the value of assets transferred back to the grantor in-kind to fulfill the required annuity payments. Moreover, the 2704 proposed regulations may even prove helpful in some cases for existing GRATs. For example, if the GRAT is able to make in-kind annuity payments to the grantor using higher Section 2704 values once the regulations come into effect, fewer assets will be needed to make those annuity payments which will result in a value-shift. D. No Effect on Rights Created On or Before October 8, 1990 The Proposed Regulations, like the current regulations under Section 2704, apply only to rights created after October 8, Therefore, the Proposed Regulations will have no effect on rights created on or before October 8, Indeed, when incorporating any unaffected right in a family-controlled entity in an estate freeze transaction, practitioners should continue to utilize valuation discounts to help clients supercharge the tax savings. Note that practitioners should also carefully consider amending or restating organizing documents that created rights on or before October 8, 1990 so as to not 77 Prop. Reg ; Treas. Reg

22 unintentionally destroy these grandfathered rights and forfeit the potential valuation discounts that could be taken upon a transfer to a younger generation. VI. WHAT TO DO NOW AND IN THE FUTURE A. Before the Regulations are Final The provisions of the Proposed Regulations only apply to transfers after the date the regulations are published in final (and in some cases thirty days thereafter). 78 Assuming that the IRS does not substantially modify the Proposed Regulations after comments are received, the Proposed Regulations are likely to become final sometime in Therefore, practitioners should immediately contact any clients who are considering transferring an interest in a family-controlled entity (either during life or at death) that may be affected by the new regulations. Patrick Duffey of Holland & Knight provided a helpful chart, attached as Exhibit G, which assists in determining if a given restriction will be disregarded under the Proposed Regulations. Note that, as discussed above, if a client dies within three years of the transfer and after the date the Proposed Regulations become final, the value of any lapse or restriction may nevertheless be includible in the client's taxable estate under the new "three-year rule" for death-bed transfers imposed under the Proposed Regulations. In addition to immediate planning that should be done to take advantage of valuation discounts while clients still can, planners should also analyze whether any future planning opportunities exist to take advantage of the higher value imposed on interests in family-controlled entities after the regulations become final. B. Planning in the Future 1. Fractional Interest Discounts May Remain Intact Fractional interest or tenancy-in-common discounts may still be available to planners for real estate (and, possibly tangible personal property). Notably, Section 2704 only applies to interests in a family-controlled entity. If the asset sought to be discounted for valuation purposes is not an interest in such an entity, but rather, underlying real estate assets (or tangible personal property), discounts for fractional ownership of these 78 Pursuant to Prop. Reg , the effective date for Prop. Reg "Transfers Subject to Disregarded Restrictions" applies to transfers occurring thirty days (30) or more after the date the regulations are published as final regulations in the Federal Register. 21

23 assets have been recognized in the past 79 and should theoretically still be allowed. With respect to such a co-tenancy arrangement, the Service could use the Proposed Regulations to disallow the discount, if the Service is able to characterize the arrangement as a partnership or other separate taxable entity. 80 Under long-standing regulations, the Service may construe the co-tenancy arrangement as a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or other venture and divide the profits therefrom. 81 Nevertheless, as the IRS recognized in Revenue Procedure , "mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes," 82 and the contents of such Revenue Procedure does provide somewhat of a roadmap for practitioners to follow to avoid such characterization. Of course, the line between "mere co-ownership" and carrying on a trade or business often can be blurry at best; indeed, according to the Tax Court, "the distinction between mere co-owners and co-owners who are engaged in a partnership lies in the degree of business activity of the co-owners or their agents." 83 Nevertheless, if a co-tenancy arrangement is formed to own real property (or tangible personal property) and the activities related to co-ownership of that asset do not rise to the level of an active trade or business, then, notwithstanding Section 2704 and its regulations, fractional interest discounts may still be achieved. Assuming that fractional interest discounts are not eliminated under the Proposed Regulations, these discounts will become increasingly important in minimizing transfer taxes owed in future planning. 2. Discounts Still Available for the Charitable Inclined The Proposed Regulations take direct issue with the perceived abuse of undervaluing interests in family-controlled entities through the ownership 79 See e.g., Estate of Whitehead v. C.I.R., T.C. Memo (1974), recommendation regarding acquiescence, 1974 WL (I.R.S. AOD 1974) (recognizing a fractional interest discount for real estate); see also Samuel J. LeFrak v. C.I.R., T.C. Memo (1993); Estate of Ellie Williams v. C.I.R., T.C. Memo (1998); Estate of Baird v. C.I.R., T.C. Memo (2001); Estate of Elkins v. C.I.R., 767 F.3d 443 (5 th Cir. 2014), rev'g, 140 T.C. 86 (2013) (upholding a fractional interest discount for artwork in a case with very unique facts and a specific procedural nuance). 80 Cf. Rev. Proc , I.R.B Treas. Reg (a)(2). 82 Rev. Proc , I.R.B Cusick v. C.I.R., 76 T.C.M. (CCH) 241, 243 (1998) (finding rental real estate activities created a partnership). 22