Proposed Regulations Add Tax Bite To Family Transfers


Scott Cress, CPA, CVA, CM&AA at Barnes Dennig CPAs

In early August 2016, the IRS released proposed regulations regarding the valuation of interests in family-controlled entities. Specifically, the Proposed “2704” Regulations focus on the elimination of most discounts when ownership interests are transferred between family members when a majority interest is held inside the family. If adopted in their current form, they only apply to transfers made at least 30 days after the restrictions become final. Huge opposition has been mounted and the Treasury has received thousands of pages of comments for a December 1st hearing that is only scheduled to last two hours. As of the time of this writing, it is the consensus of most experts that the form they end up taking will be substantially different and the timing of implementation is uncertain.

By way of background, valuations of interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes can currently be discounted for minority ownership, lack of marketability, and lack of control. This allows a taxpayer to transfer family owned entities to the next generation at a discount from what the underlying value is. The new rules would eliminate the lack of control discount and suppress the lack of marketability discounts that are typically available.

We believe the main points of the proposed regulations are as follows:

  • Transfers within three year rule (“deemed death bed planning”) – The proposed regulations have added a bright line test for lapsing rights. If transfers within three years of death result in a lapse of a liquidation right for the transferor, the transferred shares will be included in the transferor’s gross estate for Federal estate tax purposes. Per the IRS, this bright line test will avoid the fact-intensive inquiry which both the IRS and the taxpayer must go through to determine a donor’s subjective motive.

We personally believe that this is a gross over-reach by the IRS.  Three years is a long time, and a company’s strategic plan may be updated several times within that time-frame.

  • Disregarded restrictions – This is the most far reaching aspect of the proposed regulations, which essentially values transfers of interests in family-controlled companies as if the holder has a put right to sell the interest within six months. They will allow the holder to be paid by a note as long as the note is at market rates (no AFR) and the term is no longer than six months.

How many companies operate in such a manner where all shareholders can (in theory) take their share at any time? Is every company now required to keep cash on hand or maintain enough untapped credit to fund the liquidation events when requested?  Many valuation experts believe this “put right” would create a new form of discounting in and of itself.

  • Definition of family control – The regulations have tightened the definition of family control of an entity. The IRS concluded that the grant of an insubstantial interest in the entity to a nonfamily member should not preclude the application of 2704(b), because such nonfamily member interest generally does not constrain the family’s ability to remove a restriction on the liquidation of an individual interest. The IRS concluded that the presence of a nonfamily-member interest should only be recognized where the interest is economically substantial and longstanding, thus likely to have a more substantive effect.

In essence, no inviting friends and neighbors to join the family business to circumvent the rules.

To date, the regulations are proposed, and are not effective until made final and promulgated.  Most proposed regulations, even non-controversial ones, are generally not finalized for two or more years. 

And, let’s not forget our new President-elect.  Trump’s campaign called for a repeal of the federal estate tax.  Many believe this is simply unaffordable and unpassable in a Senate where he does not have a filibuster-proof majority.  However, we may see an estate tax overhaul whereas the current top federal estate tax rate of 40% is traded for a softer capital gains tax rate at 20%.

Nothing is certain but uncertainty.  As we’ve seen in the past, any changes in the law are subject to change in the future but we believe valuation-based planning will remain an important strategy for estate tax purposes for years to come.