IRS Section 2704 Synopsis
The Internal Revenue Services (IRS) released their proposed Section 2704 regulations on August 2, 2016. IRS Section 2704 was originally enacted in 1990 with the primary goal to limit discounts for certain family partnership or LLC interests that were transferred to family members. In a nutshell, Section 2704 seeks to dramatically increase the value of intra-family transfers of ownership interests by reducing the ability to apply valuation discounts to those interests. These proposed regulations affect both operating and non-operating (family limited partnerships) entities.
Bottom line: if you’re considering transferring an ownership interest to family members, it makes sense to consider completing it sooner rather than later.
The proposed regulations could negatively affect your estate plan and transfer a chunk of your family wealth to the IRS. Currently, applying discounts to an intra-family transfer allows wealthy families to pack assets inside the $10.9 million lifetime exclusion from estate and gift taxes for married couples. The Wall Street journal referred to the proposed regulations as “A Stealth Death Tax Increase” (September 5, 2016).
Because these regulations are proposed and not finalized, I want to give an overview of some of the major issues being proposed. My goal for this month’s circular is to consolidate the available information in order to clearly inform estate planners, attorneys, and business owners of these changes and what they can do about them.
1. Who is involved?
The types of entities subject to IRS Section 2704 are described very broadly to include any “entity or arrangement that is a business entity that is controlled by the family, and a definition of control is provided below. In particular, LLCs are included (regardless of whether they are disregarded for federal tax purposes), as well as corporations and partnerships.
2. What is in IRS Section 2704
There are multiple proposed changes that fall within Section 2704. Here, I will explain the primary changes that are proposed. Before we dive in, I want to take a quick moment to go over a couple of terms, provided in Section 2.1 of this circular, that are referenced multiple times through the proposed regulations.
The rules affect transfers of family owned/controlled interest. The definition of “control,” as cross referenced in Section 2701(b)(2)(A)&(B) is clarified to mean LLCs or any other entity that holds a least 50% of either capital or profits interests of the entity or the ability to cause full or partial liquidation of the entity.
(Existing regulations provide that for corporations, control means at least 50% (by vote or value) of the stock, and for partnerships, control means at least 50% of the capital or profits interests or the holding of any interest as a general partner in a limited partnership.)
2.2. Applicable Restrictions
According to IRS Section 2704 an “applicable restriction” is any restriction that:
Effectively limits (disallows) the ability of the corporation or partnership to liquidate (i.e. Discounts for control and marketability); and
Lapses (entirely or partially) after the transfer OR the transferor or family members can remove the restriction (entirely or partially). Section 2.3 of this circular will explain this in more detail.
An “applicable restriction” does not include “any restriction imposed, or required to be imposed, by any Federal or State law” (or commercially reasonable restrictions imposed by unrelated persons in a financing transaction).
In laymen terms, an applicable restriction can also be viewed as a discount for lack of control and discount for lack of marketability. At times, the proposed regulations state that if an applicable restriction is disregarded, the fair market value of the transferred interest is determined as if the restriction does not exist. This is the most far-reaching aspect of the proposed regulations. The proposed regulations allow for the estate tax related to the transfer to be paid with a note, under certain situations, and the interest rate must be at market rate with the note no longer than six months.
Disallowing applicable restrictions does not accurately reflect the value in the market place and taxpayers will be taxed on a theoretical value that does not match the real world.
The IRS is proposing that if you own and control a family business and transfer or gift an interest to another family member then you can’t utilize a discount for control or marketability that you would otherwise get for a sell, transfer, or gift to a third party (including gifts to charity’s).
Understanding this concept is crucial and I have provided a quick example below. This means that if the fair market value of your transferred interest is $1 million and the applicable restrictions (discounts) are disregarded, then the value of your transferred interest is $1 million. Historically, restrictions (discounts) have been applicable and, for example, if the cumulative discounts are 50% then the value of your transferred interest is $500,000. In its current form, you would now owe taxes on the additional $500,000 because the discounts were disallowed.
2.3. 2704(a) Treatment of Lapsed Voting or Liquidation Right
Let’s fist look at this rule with an example followed by the actual nomenclature proposed by the IRS. Example: Assume a family LLC is 100% owned by a family. The father and mother own all of the voting membership interests. The LLC agreement states that when a voting member dies, their interest is converted into a non-voting membership interest. If we assume that the father dies in this example, Section 2704(a) states that the value for his interest should be a voting interest (as opposed to a non-voting interest stated in the LLC agreement).
This means that no matter how you contractually strategize the transfer of control rights upon death, it is no longer your decision.
The legislative history of Section 2704 states that the provision is intended, in part, to prevent results similar to that in Estate of Harrison v. Commissioner, T.C. Memo. 7987-8. Informal S. Rep. on S. 3209, 136 cong. Rec. S15629-4 (October 18, 1990); H.R. Conf. Rep. No. 101-964, 2374, 2842 (October 27, 1990).
2.4. 2704(b) Certain Restrictions on Liquidation Disregarded
This section provides that any applicable restriction is disregarded in valuing an interest in a corporation or partnership that is transferred to a family member if the transferor and family members control the entity.
This section gives the IRS the authority to provide in regulations that other restrictions may similarly be disregarded in valuing transfers of interests in the entity if the restriction merely reduces the value for transfer tax purposes but does not ultimately reduce the value of the interest for the transferee.
2.6. Transfer within 3 years
This rule seeks to extend the Tax Court’s decision in the Estate of Murphy v. Commissioner that applies to transfers within three years of death. Accordingly, transfers occurring within three years of death that result in the lapse of a liquidation right are treated like a transfer occurring at death. This means that if transfers within three years of death result in a lapse of liquidation right in the transferor, the transferred shares/units will effectively be included in the transferor’s gross estate for federal estate tax purposes.
3. Why does the IRS want these changes?
More tax money, of course! In fiscal 2016, the U.S. is projected to collect $20 billion in estate and gift taxes, less than 1% of federal revenue, according to the Congressional Budget Office. Estate and gift taxes apply at a top rate of 40% above the $5.45 million per-person exclusion, which means the estate tax affects about 0.2% of those who die each year. In 2014, about 5,200 estates filed taxable returns, according to IRS data.
If these proposed regulations are passed in their current form, the IRS may attempt to rationalize these changes to prevent the wealthiest families from avoiding taxes. However, there are 28 million privately held businesses in the United States today. According to a study conducted by Corporate Value Metrics, LLC in 2013 93.9% of privately held businesses in the United States have sales below $5 million and 5.8% have sales between $5 and $100 million.
These proposed changes will affect almost every family owned business with the greatest impact on small companies.
4. When do these changes apply, if at all?
The proposed regulations are not effective immediately, which is good news. The IRS is holding a public hearing on December 1, 2016. Most proposed regulations are not finalized for two years or more. If adopted in their current form, they will only apply to transfers of a family owned or controlled ownership interest 30 days after the proposed regulations have been finalized. The new rules might also apply to transfers made before that date if the transferor dies after the effective date but within three years of the date of the transfer.
5. What should you do?
It is uncertain if the current proposed regulations will go into effect as proposed. However, if you are contemplating gifting or selling an interest in your entity to family members or trusts in their behalf, it makes sense to consider capturing a current more favorable tax treatment by completing the transfer sooner rather than later. If this sounds like you, then I would strongly recommend for you to contact your estate planning attorney.