Transferring the Farm Before You Buy the Farm - Estate Tax & Family Businesses

How Uncertainty in Proposed Changes to §2704 Affects Tax Liability and Minority Interest Transfers for Family-Controlled Business Owners

Valuation discounts are a way for owners of family-controlled business to reduce the tax burden of their estates by transferring minority interests in the business to family members. These minority interests carry certain restrictions, such as non-liquidation provisions and a characteristic of non-marketability, the negative value of which can be used to offset the value of the estate for the purpose of calculating estate taxes. Critically, however, many of these restrictions on the marketability of minority interests are essentially solely for the purpose of reducing tax liability; after transfer, the restrictions either lapse or they can be lifted by the transferor and/or family member, such that the restrictions don’t actually affect the ultimate value of the transferred interest. Such are called “applicable restrictions” when it comes to the issue of valuation discounts.

1990, Congress stepped in to limit the ability of family-controlled business owners to take advantage of these valuation discounts by allowing the IRS to disregard, for the purpose of valuing a transferred minority interest (and thus an estate’s tax liability), applicable restrictions that have the effect of solely reducing taxes while not actually affecting the value of the transferred minority interest. These provisions are located in Chapter 14 of the IRC, more specifically at 26 USC §§2703 and 2704.

Back when the statutory limitation on applicable restrictions was created, the IRS also issued regulations that stated that the IRS could not disregard state law default restrictions and could only disregard those restrictions that were more restrictive than state/local restrictions (see Treas. Reg. §25.2704-2(b)). At the time, this made sense and had the actual effect of substantively limiting value reductions, and thus tax avoidance, in the manner that Congress intended. However, in the intervening years, state laws have changed so drastically - and default state law provisions regarding minority interest restrictions have become so restrictive - that this exception to the IRS definition of applicable restrictions is effectively meaningless. President Obama had hoped for a legislative fix, but when that was (quite obviously) not forthcoming, the proposed fix came bundled in a Federal Register notice in August of last year.

Thus the new proposed regulations aim to eliminate the exception pertaining to restrictions less onerous than state law defaults and instead state that applicable restrictions may be disregarded, for valuation discount purposes, as long as a restrictions are as restrictive as such local defaults. More specifically, the proposed regulations aim to delineate four specific types of restrictions that fall within the statutory definition of “applicable restriction” that the IRS would be permitted to disregard. These include any restriction that:

1.Limits the ability to compel liquidation or redemption of the transferred interest;

2.Limits liquidation proceeds to an amount less than a minimum value;

3.Defers the payment of the liquidation proceeds for more than six months; or

4.Permits the payment of the liquidation proceeds in any manner other than cash or property (or certain other).

Section 2704(b)(4) also gives IRS authority to select and add future restrictions to be disregarded for valuation purposes, as long as they reduce the value of the interest for transfer tax purposes but do not reduce the value of the interest to the transferee.

Another key provision of the regulations would create a bright-line rule that any minority transfers effected within three years of the decedent’s death would be clawed back (that’s to say, ineffective in affording the tax relief envisioned by the estate planning transfer). As to that last point, while the IRS has long held that the tax relief of valuation discounts was never intended to apply to deathbed transfers, there’s never been clear guidance on the matter.

As the IRS has put it, the point of these changes is to avoid “undervaluation” of transferred minority interests created after October 08, 1990, when Chapter 14 originally went into effect.

The reaction to these proposed changes was swift and bordered on the apoplectic. Of the 37 speakers at the December 1, 2016 conference on the changes, all but one were critical, and about 10,000 (overwhelmingly captious) written comments have been submitted to the IRS. The effect of the  language, which is frankly ambiguous, would seem to be the creation of a deemed put or redemption right, if the IRS is allowed to disregard restrictions both in written transfer documents as well as local/state default restrictions. If this were the intent, the minority interest value simply goes right back into the estate. From an estate planning perspective, then, what is the point of creating such interests at all? It would seem to strike a fatal blow to the very concept of valuation discounts for family-controlled businesses.

IRS representatives, including the drafter of the proposed regs, Kathy Hughes, have tried to emphasize in written statements that this wasn’t the intent. “To put your mind at rest, as we have said publicly before, there is no intended put right, and we will absolutely make that clear in the final regulations. We will also make clear that there is no retroactive effect on the three-year rule.” While a foolish person might sense ease at such vocal assurances, most people watching the issue are understandably less inclined to breathe any relief in the absence of clear written amendments. So far, such changes have not been forthcoming, nor has there been any guidance on when they might be expected.

To throw an additional kink into the process, on April 21 of this year, President Trump signed EO 13789 directing Treasury Secretary Mnuchin to review all tax regulations proposed since the beginning of 2016. The EO required an interim report be issued within 60 days identifying all proposed regulations doing the following: 1.) imposing an undue burden on taxpayers; 2.) adding undue complexity to the tax code (hah); or 3.) or exceeding IRS authority. While it’s widely believed that the aim of the Order was to address the debt/equity provisions of §385, many others have submitted separate concerns, including concerns about the proposed §2704 provisions. The interim report, technically due by June 20^th, has not been issued yet, and I frankly don’t expect it any time soon. We are yet to see, then, whether family business owners and estate planning professionals might encounter any relief. (The final report under the EO is due by September 18, 2017.)

So, considering the current anti-tax and anti-regulatory climate, one would think that a set of regulations so potentially onerous, and so politically unpalatable as those affecting family-controlled business owners (Farmers, of all people! Salt of the earth!), would be quick to the chopping block. That may perhaps be the case, and as many have speculated, these particular regulations may eventually die a quiet and ignominious death. There are other considerations, however, that may indicate a less ambiguous version of these rules will eventually go into effect.

In my estimation, the most obvious ground listed in the the EO for jettisoning the §2704 changes would be number 3: the IRS exceeded its authority in attempting to promulgate the rules. In other words, these changes should have come via the legislative process and not through the executive agency. This was already a loud concern even before the EO was issued; after all, the Obama administration had tried unsuccessfully to push these changes through Congress for quite some time before throwing up its hands and going the regulatory route. That alone seems to indicate an awareness of the proper channels. But beyond that, the argument may be made because of the following language of §2704(b)(4):

“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.”

The end of that sentence could arguably be read to mean that while the Secretary can propose rules regarding the valuation of family-owned interest transfers, such regulations cannot actually themselves reduce the value of the interest transferred to the transferee. If the regulations are read to actually create a deemed put or redemption interest, that could in fact be seen as a reduction in actual value of the transferred interest. (Of course, as noted above, the drafters claim not to have intended this much, but until further written clarification, this is a plausible reading of the scheme.) The counterargument is that this final provision of the statute was only referring to the restrictions’ effect on the value of the transferred interest - and not to the Treasury regulations’ ultimate effect on such interests. The language at this point is ambiguous at best.

As for the other two grounds - undue burden on taxpayers and undue complexity of the regulatory scheme - there are a couple of practical (if not fundamental or structural) considerations that may lead the Secretary to avoid pulling the regulations altogether. First is that the point of the regulations is arguably quite valid: spiking tax avoidance schemes is, after all, not an altogether bad reason for enacting a regulation, and the whole purpose of valuation discounts is to avoid taxation by creating somewhat phantom minority interests and illusory restrictions thereon. And second, there is a good argument to be made that the reason such regulations are necessary is to provide clarification for an already-complex tax framework. As one observer put it, it’s a “blame the statutory language and not the clarifying regulation” tilt. And it does have merit, in a sense.

And finally, the plain fact of the matter is that the Treasury Secretary, who is not familiar with the intricate delicacies of arcane estate tax provisions, is going to have to rely on experts to advise him. Where we end up seems to depend entirely on who has the fortune of tugging his ear most forcefully. Put more succinctly, we really have no earthly idea how any of this ends.

Where does that leave the family-controlled business owner trying to decide how to plan for the inevitable future? For now, it may be advisable to create the interests in an expedited fashion in anticipation of the changes (and in particular, the three-year clawback that we’ve been assured will not be retroactive). On the other hand, it may be best to rely on alternative schemes to reduce liability: deferrals, the qualified business interest deduction, and special use valuations.

And in the meanwhile, we can hope the IRS has been reading Kerouac: “One day I will find the right words, and they will be simple.”

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