The window for a useful transfer tax planning tool may be closing shortly.  Clients contemplating transfers of interests in closely held businesses to family members should take action and consult with us immediately.

Congress and the Internal Revenue Service have been concerned that some people are not paying their fair share of transfer taxes. This perceived concern is especially true in the area of entity discounts. We have known for some time that the Internal Revenue Service frowns upon the use of discounts in transfers of entities within families. These discounts have the effect of lower transfer tax costs, when compared to the proportionate value of the underlying assets owned by the entity. However, the legal theory behind discounts is sound. Short of congressional action or legislative Regulations by the Internal Revenue Service, these discounts are available for transfer tax planning. Unfortunately, Congress authorized the Service to issue legislative regulations pertaining to discounts. For the last year and a half these Regulations were merely a rumor.

On August 2, 2016, the Treasury issued the long anticipated Proposed Regulations under I.R.C. Section 2704. 81 Fed. Reg. 51413-51425 (Aug. 4, 2016). In the current form, the Proposed Regulations would severely limit, and possibly eliminate, the use of certain valuation discounts on entity transfers between family members. This applies to closely held businesses, limited partnerships, corporations and limited liability companies.

If the Proposed Regulations are finalized without changes, the Proposed Regulations would:

  • Clarify that Section 2704 applies to corporations, partnerships, limited partnerships and limited liability companies, as well as other business entities.
  • Treat as an additional taxable transfer the lapse of voting and liquidation rights for transfers made within three years of death of interests in a family-controlled entity, thereby eliminating or substantially limiting the lack of control and minority discounts for these transfers.
  • Disregard for valuation purposes the ability of most nonfamily member owners to block the removal of covered restrictions unless the nonfamily member has held the interest for more than three years, owns a substantial interest in the entity, and has the right, upon six months’ notice, to be redeemed or bought out for cash or property.
  • Disregard for transfer tax valuation purposes restrictions on liquidation that are not mandated by federal or state law in determining the fair market value of the transferred interest. This has the effect of disregarding limitations on liquidation contained in the governing document of the entity.
  • Eliminate discounts for transfer tax valuation purposes based on the transferee’s status as a mere assignee and not a full owner and participant in the entity.

The effective date for these proposed rules is somewhat confusing. The effective date for the Proposed Regulations for (i) lapses of rights, and (ii) applicable restrictions is the date the Proposed Regulations are published as Final in the Federal Register. The effective date for the Proposed Regulation dealing with transfers subject to disregarded restrictions is 30 days after the Proposed Regulation is published as Final in the Federal Register.

The Proposed Regulations are currently open for comment. Written and electronic comments on the Proposed Regulations must be received by the Internal Revenue Service by November 2, 2016. A public hearing is scheduled for December 1, 2016.

Regardless of modifications that may be made to these Proposed Regulations when issued in final form, the use of discounts on transfers of entity interests is going to be curtailed. This will have the effect of increasing the transfer tax values, and therefore increasing transfer taxes.

Things to consider:

  • Make transfers of family-owned entities before the proposed regulations become final.
  • Review Buy/Sell agreements that govern family-owned entities.
  • Review business agreements for any covenant that affects the owner’s ability to cash out, such as shareholder agreement, loan documents, and stock purchase agreements.

Saving transfer taxes must be considered with optimal income tax and property tax outcomes. All three tax systems intersect. For example, reduction of transfer taxes must be weighed against the benefit of the capital basis adjustment upon the death of the transferor.

If you would like to discuss these issues further, please contact us.