IRS Issues Proposed Regulations Affecting Advanced Estate Planning

Section 2704 of the Internal Revenue Code was enacted to limit the discounts available to certain transfers of limited partnership or limited liability company ownership interests among family members. Section 2704(a) deals with lapsing rights. An example of a lapsing right might be an LLC in which the parents own the voting shares and the children own non-voting shares. There is a provision that upon death the voting shares become non-voting shares. Should the shares be valued as voting shares or non-voting shares upon father’s death? Section 2704(a) provides the shares would be valued as voting shares.

Section 2704(b) provides “applicable restrictions” are disregarded for valuing an interest in a corporation, partnership, or limited liability company if there is a transfer to a family member and family members control the business entity. An “applicable restriction” is a restriction that: (1) effectively limits the ability of the corporation, partnership, or LLC to liquidate, and (2) lapses, in full, or in part, after the transfer to the family member OR the transferor or family member can remove the restriction after the transfer. “Applicable restrictions” exclude any restriction imposed or required under federal or state law or commercially reasonable restrictions imposed by unrelated people in a financing transaction. Many attorney groups have lobbied effectively for the enactment of state statutes limiting the ability of an owner to withdraw from an entity. With these state laws in place, the IRS believes Section 2704 has become “toothless” in deterring estate planning discounting strategies among family members.

On August 2, 2016, the IRS released the long awaited proposed regulations for Section 2704. The IRS is holding a public hearing on the proposed relations on December 1, 2016. It is anticipated that the IRS will receive lots of commentary on the regulations. Most regulations, even non-controversial ones, are not finalized for months or years after being released. This means it is unlikely the proposed regulations would become final in December. Whenever they become final, they would be effective thirty days later. This creates an opportunity for wealthy clients to continue to use advanced estate planning strategies, provided they act before the proposed regulations become effective. When the regulations become effective, they would only be applicable to transactions completed after that date.

Major provisions in the proposed regulations include:

  • Default restrictions under state law can no longer be considered in valuing transferred interests in these family owned entities.
  • The proposed regulations create a new category of “disregarded restrictions.” This rule values transfers of interests in family controlled entities as if the holder of the interest has a put right to sell the interest to the entity within six months for a value at least equal to the net value of the entity for cash or property. Sales using a promissory note would be very restricted and would require payment of the note within the six-month term.
  • The description of covered entities is expanded.
  • Transfers to assignees will no longer receive favorable treatment.
  • Transfers that result in the transferor losing a liquidation right may require inclusion in the transferor’s estate at death if the transferor dies within three years of making the transfer. The phantom transfer would sometimes be eligible for the marital or charitable deduction.
  • In determining whether the family can remove “disregarded restrictions,” the ownership interests of unrelated parties are not considered unless very stringent conditions are satisfied.
  • Because of the very broad brush with which the IRS is painting regarding these proposed regulations, certain commercially reasonable restrictions will not be considered in the application of the new rules.
  • Values generally will be applied consistently for both estate inclusion and estate or income tax deduction purposes (such as the marital deduction or charitable deduction).
  • Uncertainty exists regarding the manner of determining the values of transferred interests that are subject to the new rules, but one thing is certain, discounts for lack of control will be significantly reduced or eliminated.

People with taxable estates should see a qualified estate planning attorney as soon as possible. The opportunity to use family limited partnerships, family LLCs, and certain corporate planning strategies remain viable for the short-term, but these opportunities will likely disappear when the Section 2704 Regulations become final in the not too distant future. Transactions must be completed before the regulations become final or they will be subject to the new rules. Financial planners, CPAs, and other financial professionals should encourage their wealthy clients to seek advice before this window of opportunity closes.

People should note that while the IRS has been unsuccessful in using Section 2704 to thwart inter-family transfers thus far, it has achieved significant success in attacking poorly drafted and administered family limited partnerships and family LLCs using Internal Revenue Code Section 2036. Those who quickly transfer assets into an entity and transfer it to children and grandchildren in order to avoid the new proposed regulations under Section 2704 may be setting themselves up for a successful attack by the IRS using Section 2036. As such, people should seek the assistance of professionals who are familiar with these advanced estate planning strategies in creating and properly administering these entities.