Client Alert

In August, the U.S. Treasury released 50 pages of “Section 2704 proposed regulations” which are designed to dramatically reduce or even eliminate valuation discounts when valuing gifts of interests in entities (i.e. corporations, partnerships and LLCs) to members of the transferor’s family1 for federal gift and estate tax purposes. There is still much uncertainty regarding various key aspects of these proposed regulations (including the ultimate effect on valuation discounts, the timing of the effective date of any change, and whether a three-year “look-back” would render ineffective new planning implemented even prior to issuance of final regulations). However, we want to provide this alert to clients who may be contemplating transfers that would be affected by these proposed new rules.

The proposed regulations are extremely broad and contain few, if any, practical or useful exceptions. If enacted in their present form, the regulations could have the effect of limiting or eliminating discounts for any transfer of an interest in a family controlled entity made to a family member, regardless of:

  • Whether the transfer occurs during the transferor’s lifetime or at death;
  • Whether any non-family member owns an interest in the entity (subject to a very limited exception2);
  • The composition of assets owned by the entity;
  • The length of time that the entity has been in existence;
  • Whether the entity’s activity is an operating business or not; and
  • Whether the transfer assumes the form of a gift or sale.

Significantly, the proposed regulations do not appear to affect the ability to claim discounts with respect to:

  • Transfers of entity interests to non-family members;
  • Transfers of tenant-in-common interests in real property; and
  • Promissory notes.

Initial commentators had feared that the proposed regulations would imply a right to force an entity to buy out a partner’s interest for cash within six months, even if no such right actually existed under the terms of the partnership or LLC agreement, so as to effectively reduce or eliminate valuation discounts. By imputing, for valuation purposes only, such a right to liquidate one’s interest, a discount for illiquidity would not be justified. On the other hand, more recent informal guidance from commentators and from a high-level IRS representative has suggested that may not be the case after all (and that some valuation discounts may therefore still be applicable even after final regulations are issued).

The foregoing proposed rules will not generally become effective until final regulations are published. Historically, final regulations are not published until a year or two after proposed regulations are issued; however, we cannot predict when final regulations may be published and, theoretically, they could be published and become effective as early as December 2016 (although commentators have opined that it would more likely be no earlier than the first quarter or half of 2017). Until then, valuation discounts remain subject to current rules.

For this reason and despite the uncertainties noted, we recommend that clients who are contemplating transfers of interests in closely-held, family-owned entities contact us to discuss possibly accelerating transfers to family members before final regulations are published.

Please note that even if a client accelerates such transfers of entity interests to family members, some commentators have opined that the regulations could “pull back” such transferred interests into the client’s gross estate for estate tax purposes if the client dies within three years after the transfer. This is but one of many uncertainties under the new rules.

Of course if you would like additional guidance concerning these new proposed rules or any other aspect of your estate and personal tax planning, please let us know.

1 Family members are defined as the transferor’s spouse, descendants, ancestors, siblings, and the spouses of such persons.
2 The proposed regulations allow for continued discounts where one or more non-family members or charitable organizations (each holding at least a 10% interest) cumulatively own at least 20% of the entity, have held the interests for at least three years, and possess a put right to force the entity to redeem their interest for “minimum value” (i.e. net asset value without discounts) in exchange for cash or other property due within six months of exercise.