Using a Family Limited Partnership (FLP) or Family LLC to obtain favorable valuation discounts on gifts or bequests has been a staple of high-net-worth estate planning for the past 15 years. While IRC Section 2704, passed in 1990, was intended to limit the aggressive use of valuation discounts, over the decades since a number of Tax Court cases, along with evolving state laws, have undermined the IRS’ ability to enforce those rules.
Accordingly, after years of failed attempts to get Congress to update the rules, the Treasury department has decided to pursue its own crackdown, in the form of newly proposed 25.2704 Treasury Regulations. In fact, the proposed Regulations under Section 2704 are so expansive, that they would severely limit the use of valuation discounts for any type of family limited partnership or other family business transfer, where the family will retain control before and after the gift or bequest occurs.
The new rules would include the imposition of a new 3-year lookback to determine whether a minority valuation discount should apply (limiting deathbed transfers used to create a minority interest), the introduction of new “disregarded restrictions” that go beyond the already-ignored “applicable restrictions” in situations where the family will retain control after the transfer (and effectively create an implied put right for any recipients of a transfer, which significantly curtails most valuation discounts), and a shift away from only looking at restrictions that are “more restrictive” than available state law (given that many states have already shifted their laws to become more restrictive in recent decades).
Fortunately, the proposed Treasury Regulations must go through a 90-day public comment period through November, following by a public hearing in December, and must then be re-evaluated before final issuance (which in turn wouldn’t take effect until 30 days thereafter). And of course, the more restrictive rules are a moot point for the overwhelming majority of families – including family businesses – that still don’t have a value high enough to trigger estate taxes given an exemption of $5.45M for individuals and $10.9M for most couples.
Nonetheless, for those high-net-worth families who are over the estate tax thresholds, just a few months remain to engage in transfer planning to maximize current valuation discounts before the new rules take effect!
Existing Limitations On Family Limited Partnership Valuation Discounts Under Section 2704
As a part of the Omnibus Budget Reconciliation Act of 1990, Congress enacted IRC Section 2704, entitled “Treatment of Certain Lapsing Rights and Restrictions”, and intended to crack down on perceived abuses in the valuation of family businesses.
The rules were written primarily to target the then-recent 1987 court case of Estate of Harrison v. Commissioner (T.C. Memo 1987-8). In the case, the decedent (Daniel Harrison, Jr.) and his two sons each owned a general partnership interest in a family business (with a right to compel liquidation), and the senior Harrison also owned a 77.8% limited partnership interest. Upon Harrison’s death, his general partnership power to liquidate the business expired, and accordingly his estate claimed a substantial lack-of-control discount for the remaining 77.8% limited partnership shares, even though Harrison had had the full power to do so up until the moment of his death, and his sons (inheriting the shares) would continue to have such control immediately thereafter (as the remaining general partners). The IRS felt it was inappropriate that the family had full general partner control of the shares both before and after Daniel Harrison’s death, yet “somehow” the bulk of the business – in the form of a 77.8% limited partnership interest – still received a discount for the lack of liquidation control in Harrison’s estate.
Accordingly, in IRC Section 2704(a), Congress stipulated that in situations where there is a lapse of any voting or liquidation right in a business, but the individual and his/her family have control of the entity both before and after the lapse, the full value of the entity must still be included in the decedent’s estate (technically by adding back to the estate any reduction in value triggered by the lapse of the power). More generally, the 2704(a) rules prevent families from obtaining discounts by splintering the ownership of the business into small pieces, where no particular family member maintains control, but the family in the aggregate is clearly still in full control of the business and when/whether to liquidate it.
In addition, IRC Section 2704(b) further provides that when a business interest is transferred within the family, certain “applicable restrictions” will be ignored when determining the value of the business for gift and estate tax purposes, if the family retains the ability to eliminate the restriction after the fact. Notably, such restrictions would still be allowed if they were already imposed under state law. But if the family ‘voluntarily’ added more restrictive provisions to their family business than what the default law specifies, just to limit its marketability or the ability to control liquidations, and could remove those restrictions later (e.g., after the transfer), they wouldn’t be considered in the valuation to begin with.
Cracks Emerge In Section 2704 Limitations On Valuation Discounts
While early on, IRC Section 2704 and its supporting Treasury Regulations were able to limit perceived abuses in discounts on family businesses, the evolving nature of state laws, along with several Tax Court cases, reduced the effectiveness of the rules over time.
Most significantly, the Tax Court case of Kerr v. Commissioner (113 T.C. 449, ) declared that the Section 2704(b) rules to disregard “applicable restrictions” that caused valuation discounts would only apply to restrictions that impacted the ability to liquidate the entire entity, not just the portion of the entity that was transferred. Thus, for instance, where all the partners retained the power to liquidate the partnership (by unanimous vote), but any one partner’s transferred shares had no control over their own liquidation (due to the requirement of a unanimous vote of all partners), a “lack of marketability” discount would still be permitted for a partial transfer of shares (even though the partners could collectively liquidate the full business at full value). And in the case in Kerr, the IRS couldn’t even fight the outcome based on state laws, given that the applicable state’s default rule for partnerships was that partnerships could only be liquidated by unanimous vote, thus ensuring that the Kerr partnership itself was no more restrictive than what state law already provided.
In the aftermath of the Kerr case, numerous states began to shift their default partnership laws to become more restrictive – still allowing partnerships to choose less restrictive rules, but ensuring that Section 2704(b) would be rendered largely irrelevant because all partnerships by default would end out being restrictive. In other words, Section 2704(b) granted the IRS the ability to invalidate “applicable restrictions” that went beyond otherwise lax default state laws; it hadn’t contemplated a future where the state laws would become restrictive by default (e.g., by requiring a unanimous vote of partners to liquidate, and preventing a limited partner from withdrawing), and then give business owners the ability to choose to be more lax instead if they wanted to for other business reasons.
The end result of these shifts over time was that the IRS has increasingly struggled to invalidate substantial valuation discounts on transfers and bequests of family limited partnerships and other family business entities over the past 15 years. Gifts of minority interests during life were able to obtain both lack of control discounts (because under Treasury Regulation 25.2704-1(c)(1) the elimination of the lack-of-control discount only applied to the shares the transferor retained, not the actual gifted shares themselves), and lack of marketability discounts as well (as under Kerr, such restrictions were still permitted for individual shares, as long as the restrictions didn’t impair the marketability of the entire entity). And increasingly restrictive state laws made it easier and easier to structure partnerships in a manner that would maximize those marketability discounts.
Accordingly, the IRS and Treasury for years have been asking Congress for updates to the IRC Section 2704 rules to more effectively limit valuation discounts for family businesses. The IRS has listed valuation discount concerns as a part of their Priority Guidance Plan in every year since 2003, and for several years a crackdown was proposed in the President’s Budget proposals. However, after failure to gain any traction in Congress, the IRS announced earlier this year at the ABA’s Tax Section meeting in May that it would put forth updated Regulations on Section 2704 to try to limit the abuses, which it is permitted to do under IRC Section 2704(b)(4).
And making good on its word, last week on August 2nd, 2016, the Treasury proposed its new 25.2704 Regulations, attempting to close a wide range of “loopholes” in the valuation discounts that apply to family businesses.
New Section 2704 Treasury Regulations Limiting Family Business Valuation Discounts
As proposed, the new Section 2704 Treasury Regulations would crack down on both lack-of-marketability valuation discounts for family businesses (by expanding the scope of Section 2704(b)), and also the lack-of-control valuation discounts for such businesses (with a further expansion of Sections 2704(a) and (b)).
New 3-Year Lookback To Determine Lack Of Control Discounts
Under the new Treasury Regulation 25.2704-1(c)(1), any lapse of a restriction or liquidation right within 3 years of death is treated as a lapse at death (which in turn would be re-included in the decedent’s estate under Section 2704(a)). In essence, this provision means that changes in ownership intended to trigger a minority discount on shares held at death may no longer produce such a discount.
For instance, if the family patriarch owned 51% of the family’s stock, and upon his/her deathbed made a gift of 2%, it would not only be possible to claim a minority discount on the 2% share being transferred, but at death the remaining now-minority 49% interest would also be eligible for a discount. Under the new rules, though, while the 2% interest might still be eligible for a lack-of-control discount (or not, per the further rules described below), if those 2% of shares were transferred within 3 years of death, the minority valuation discount on the remaining 49% would be invalidated. Notably, the decedent would still only report the value of 49% of the shares at death (and not necessarily the full 51%, as the other 2% really was transferred), but in determining any potential minority discount, the 49% would be valued assuming the 51% interest was still present (which means no minority discount).
In point of fact, a version of this strategy – where the decedent transfers 2% from a 51% interest just to reduce to minority status on their deathbed – is exactly what occurred in the 1990 Tax Court case of Estate of Murphy v. Commissioner, and appears to be exactly what the IRS and Treasury were aiming to prevent with the new 3-year lookback period. Going forward, it will no longer be feasible to winnow down a majority interest to a minority interest at/near death just to obtain a minority valuation discount on the remaining shares held at death.
Implied Put Right For Minimum Value And Disregarded Restrictions Beyond Applicable Restrictions
Under the existing Section 2704(b) rules, certain “applicable restrictions” that might otherwise reduce the valuation of a family business are ignored if the transferor or his/her family have the right to remove the restriction after the transfer (and if the restriction is more restrictive than what state law already provides).
However, Treasury’s proposal includes the new Treasury Regulation 25.2704-3, which would define an additional category of “disregarded restrictions” that are ignored when determining the valuation of the business, if the family still has control in the aggregate to eliminate the restriction after the transfer or bequest.
These disregarded restrictions would include anything that: (a) limits the ability of the holder of the interest to liquidate the interest; (b) defers the payment of the liquidation proceeds for more than six months; (c) permits the payment of the liquidation proceeds in any manner other than in cash or other property (other than certain notes); or (d) limits the liquidation proceeds to an amount that is less than a “minimum value”. For the purpose of these rules, “minimum value” is the fair market value of the entity, reduced by outstanding obligations (i.e., debts) of the entity.
In practice, this means that a transfer subject to the “disregarded restrictions” rules would be unable to take advantage of most traditional business valuation discounts – including a lack-of-control and lack-of-marketability discounts that wouldn’t otherwise be reflected in the calculation of minimum value – whenever the family will retain control of the business after the transfer occurs (whether a gift during life or a bequest at death).
Notably, certain exceptions do apply to the disregarded restriction limitations. In determining whether the family has the control/ability to remove restrictions after the transfer, nonfamily owners may be considered (as long as they have owned the shares for at least 3 years, have the ability to liquidate within 6 months, and meet certain minimum ownership guidelines). In addition, a restriction is not disregarded if each owner has an enforceable “put” right to receive (via liquidation or redemption), within 6 months, either cash or other property equal to “minimum value” of the business. (If ‘other property’, though, it cannot be a mere promissory note issued by the entity or other family members, unless the entity is an active trade or business, where at least 60% of the value is non-passive assets.) Or viewed another way, the proposed regulations would implicitly apply a "put right" to the valuation of any transfer of the family business to other family members, effectively eliminating most forms of discounts.
Expanding Reach Of Business Entities And Limiting Role Of Restrictions Imposed Or Required By Law
In addition to the new 3-year lookback for determining lack-of-control discounts on bequests at death, and the new disregarded restriction rules, other key changes proposed in the new Section 2704 Regulations include:
- Clarification that the rules apply not just to corporations and traditional partnerships, but also LLCs, and any other “arrangements that are business entities”.
- A narrowing of the rule that allows an “applicable restriction” to be ignored if it is no more restrictive than state (or Federal) law; instead, an applicable restriction will only be ignored in the future if it is a restriction required under law (i.e., it is a mandatory imposed requirement under law). And notably, such mandatory provisions will only be considered if they apply to all entities covered by the law; a “special” form of a restrictive entity will be ignored if the state also provides for a non-restrictive version of the same entity (preventing states from trying to dodge the rules by creating a special class of restrictive entities).
- Transfers of a family business interest to an “assignee” (who under some state laws may receive an allocation of partnership income, but does not have the full rights and powers of an owner) will be treated as the lapse of rights, which means transfers to assignees will be subject to the 3-year lookback for the purposes of valuing a decedent’s ownership interest and any applicable lack-of-control discounts.
New Section 2704 Treasury Regulations Would End Most FLP Valuation Discounts
The substantive impact of the newly proposed Section 2704 Treasury Regulations on valuation discounts is that it would end most forms of lack of control and marketability discounts for intra-family transfers of businesses, as most such restrictions would easily be captured as “disregarded restrictions” under the new Section 2704(b) rules. In addition, the expanded Section 2704(a) rules will not even allow family business owners to attempt to diminish their ownership interests in order to claim a minority or lack-of-control discount at death on their remaining shares, either.
In fact, the proposed Treasury Regulation 25.2704-3(g) provides a series of examples, that demonstrate the incredibly broad scope of the new rules.
Example. Samuel and his children Joe and Sally are partners in a limited partnership. Samuel owns a 98% limited partner interest, and Joe and Sally are each 1% general partners. The partnership agreement states that the partnership will automatically liquidate in 50 years (or earlier by agreement of all partners), but otherwise prohibits the withdrawal of a limited partner (a marketability and control restriction). This restriction is permitted, but not required, under state law. The partnership can be amended by the approval of all partners.
Samuel transfers 33% of his interest to Joe, and another 33% of his limited partnership shares to Sally. Because Joe and Sally could change the partnership to eliminate the liquidation provisions after the transfer, though, the marketability and control limitations would be “disregarded restrictions” in valuing the partnership shares. As a result, the transfers would be fully valued at 33% of the fair market value (i.e., the “minimum value”) of the business, and the valuation discounts would be lost altogether as a result of the new rules.
Notably, upon Samuel’s subsequent death, his remaining 32% interest would also be ineligible for any minority or marketability discount, if bequeathed to a family member (whether Joe and/or Sally, or a surviving spouse). Because, again, the restrictions would be disregarded, since they could be removed by the family after the transfer/bequest.
Fortunately, if the business includes ownership by, or distributions to, nonfamily members as well, a more favorable result may occur (subject to certain nonfamily ownership requirements discussed earlier). The rules for disregarded restrictions apply primarily in situations where the family retains control over the business – including the ability to change or remove restrictions – after the death or transfer of the original owner.
Nonetheless, the end result remains that most forms of intra-family transfers will be unable to obtain previously common minority and marketability discounts once the new rules take effect.
Effective Date And FLP Planning Opportunities Of The Proposed 25.2704 Regulations
At this point, the reality is that the Treasury’s proposed regulations are just that – proposed. Per the standard process for considering the adoption of new Regulations, they will now go into a Public Comment period running through November 2nd, followed by a public hearing on December 1st. After that, the IRS and Treasury must consider the comments before issuing final rules, which in turn would not be effective until 30 days after being entered into the Federal Register.
Nonetheless, the IRS and Treasury have been building up to this change for the better part of 13 years (since first introducing Section 2704 valuation discount concerns as part of the IRS Priority Guidance Plan in 2003). And while some family business groups are already gearing up objections, and a few tax commentators have already raised the question of whether the IRS and Treasury are overreaching (as arguably if Congress really wanted to eliminate all family valuation discounts, they could have made Section 2704 more restrictive in the first place), it seems highly likely that some form of these rules will be finalized soon. A realistic timeline would be for the Final Regulations to be issued and take effect sometime in 2017.
The Clock Is Ticking For FLP Gifting
Fortunately, though, the new rules would only apply to transfers that occur after the effective date. Which means families holding businesses entities have a limited number of months to engage in transfer planning now, before the new rules take hold. This may include accelerating current gifts of shares of a family business – while minority and marketability discounts still hold – and possibly even beginning the process of (quickly) forming a family limited partnership (FLP) or FLLC to facilitate the beginning of a transfer process. The limited time opportunity to take advantage of the implied leverage of discounted gifts means very affluent families may even use some or all of their lifetime gift tax exemption just to maximize the available transfers. And of course, gifts made now will not only enjoy the benefit of valuation discounts, but as with any inter vivos gifting will also shift all future appreciation out of the original owner’s estate, too.
On the other hand, while the new rules won’t apply until after the effective date, a death that occurs after the effective date will be subject to the 3-year lookback period in determining whether any family business bequest is eligible for minority or marketability discounts (or not). This wouldn’t necessarily make it “bad” to transfer shares of the family business – which would still lock in any current valuation discounts on transfers that occur now – but still means there’s a risk that gifting enough to get the original owner down to a minority interest may not ultimately enjoy a minority discount when the time comes.
Of course, it’s important to remember that gifts, once made, are irrevocable, and that family business owners should be ready to make such gifts in the first place. If the business owner isn’t ready to make the gift, and/or isn’t comfortable with who will receive the shares (either outright or in trust), then trying to maximize the valuation discounts of gifting before the rules change is a moot point. Family dynamics around gifting and the ownership of the family business should still trump the tax consequences alone.
It's also important to bear in mind that the new rules will only be relevant for those who have estate tax exposure in the first place, which means generally those families with more than $5.45M individually (or $10.9M as a couple) of combined assets (plus a few states whose estate tax exemptions are still lower). Thus, family businesses that are below this threshold for estate tax exposure, and don’t anticipate rising above the threshold going forward, still won’t need to worry about the new rules at all. In fact, for those who do not have any estate tax exposure, arguably the new rules may be good news, potentially allowing the estate to claim a higher estate valuation reported on Form 8971, resulting in a more favorable step-up in cost basis at death!
Nonetheless, for the subset of ultra-high-net-worth families that have created enough wealth to face estate tax exposure, where the wealth is either centered around a family business, or can/will be transferred into a family business, the clock is ticking to complete transfers for potential minority or marketability discounts. While it remains to be seen exactly when in 2017 the new rules will take effect, and there may be some strategies that remain (or new "loopholes" that emerge?), it appears to be only a very limited matter of time before intra-family valuation discounts are drastically curtailed.
So what do you think? Will the proposed crackdown on FLP discounts impact your planning with clients in the coming months? Do you have clients you'll be reaching out to about this? Please share your thoughts in the comments below!