On August 2, 2016, the IRS issued proposed regulations under Section 2704 of the Internal Revenue Code that, if finalized in their current form, will dramatically limit discounts with respect to the valuation of interests in family-controlled entities for estate, gift and generation-skipping transfer tax purposes.

The proposed regulations will affect you if:

• You own interests in a family limited liability company (“LLC”) or limited partnership, or you would like to obtain valuation discounts for gift or estate tax purposes by using such an arrangement.
• You own more than 50% of the general partner or management company of a hedge fund or private equity fund and would like to transfer interests in the entity to or for the benefit of your descendants.
• You own a minority position in a family-controlled business, or you own any interests in a family-controlled business that you intend to keep in the family.

These regulations are likely to be finalized (although possibly not in their current form) at some point early next year, and will be effective as to transfers occurring after that time. If you are contemplating making transfers of interests in family-controlled entities before the proposed regulations are finalized, or if you have any questions regarding this bulletin, please contact:

Hume R. Steyer
(212) 574-1555
steyer@sewkis.com

Scott M. Sambur
(212) 574-1445
sambur@sewkis.com

David E. Stutzman
(212) 574-1219
stutzman@sewkis.com

Additional information about the details of the proposed regulations is below:

Background on Section 2704

Traditionally, interests in family-controlled entities have been valued for transfer tax purposes by taking into account significant discounts for lack of marketability and, if the interest transferred is a non-controlling interest, discounts for lack of control. Congress enacted Section 2704 to limit a taxpayer’s ability to obtain these valuation discounts by specifying that certain lapsing rights and liquidation restrictions in family-controlled corporations and partnerships be disregarded in determining the value of the transferred interest. However, (i) it is not clear under the existing statute and regulations that Section 2704 applies to interests in an LLC, and (ii) an exception to the portion of Section 2704 focused on disregarded restrictions exists for restrictions imposed, or required to be imposed, by any federal or state law. Since the enactment of Section 2704, many states have included in their partnership and LLC laws default restrictions on the transfer of interests by limited partners or members of an LLC, so that such restrictions may be considered in calculating any valuation discounts on intra-family transfers of interests in family-controlled entities. As a result, Section 2704 has not traditionally had much of an effect on valuation discounts.

Proposed Regulations

The proposed regulations give Section 2704 much sharper teeth by including a number of provisions that attempt to reduce or even eliminate most discounts for lack of marketability and lack of control in a family-controlled entity.

Limited Liability Companies

The proposed regulations clarify that LLCs and other entities and arrangements where the family owns at least 50 percent of the capital or profits interest or has the ability to cause the full or partial liquidation of the LLC are also covered by Section 2704.

Assignee Status Disregarded

One technique traditionally used to obtain a valuation discount was for a transferor to give to a transferee only an “assignee” interest in the entity, rather than have the transferee named as a full member or partner. The proposed regulations eliminate this technique by providing that any transfer resulting in the restriction or elimination of any of the rights or powers associated with the transferred interest is treated as a lapse that is subject to gift or estate tax.

Three-Year Recapture

Currently, the transfer of an interest that results in the lapse of a liquidation right is not subject to Section 2704 if the rights with respect to the transferred interest are not restricted or eliminated. As a result, the transfer of a minority interest by a transferor owning a majority interest (and therefore having the power before the transfer to liquidate the entity) is not treated as a lapse under Section 2704. The proposed regulations attempt to avoid deathbed transfers resulting in valuation discounts by providing that if an interest is transferred within three years of the transferor’s death, the lapse of a voting or liquidation right as a result of the transfer is treated as a lapse occurring on the transferor’s date of death, and is included in the transferor’s estate for estate tax purposes.

State Law Exception Weakened

Section 2704 provides that if an interest in a family-controlled entity is transferred to a family member, certain “applicable restrictions” are disregarded in determining the value of the transferred interest. An “applicable restriction” for these purposes is defined as any restriction that (i) effectively limits the ability of the entity to liquidate and (ii) either lapses or can be removed by members of the transferor’s family (acting alone or together). However, as noted earlier, thanks to an exception for any restriction imposed, or required to be imposed, by any federal or state law, this particular provision of Section 2704 has not historically had much effect in limiting discounts on transfers of family-controlled entities because the default restrictions under state law usually are sufficient to generate a sizeable discount. Under the proposed regulations, this exception is severely limited and now applies only if the restriction cannot be removed or overridden, and is mandatory under local law.

New Class of Disregarded Restrictions

Currently, restrictions are disregarded if they limit the ability of the family to liquidate the entire entity in a manner that is more restrictive than the default rules under state law. The proposed regulations expand the class of disregarded restrictions to also include the liquidation or redemption of just a transferred interest. The expanded class of disregarded restrictions includes any restriction that limits the ability of the holder of the interest (i) to compel liquidation or redemption of the interest, (ii) to receive less than the interest’s pro rata share of the fair market value of the entity’s assets, (iii) to defer payment of the liquidation proceeds for more than six months, or (iv) to permit payment of the liquidation proceeds in any manner other than in cash or other property, which for these purposes does not include most promissory notes.

Non-Family Member Ownership

A common planning technique under the current rules has been to give a nominal interest in the family-controlled entity to a non-family member, such as a charity. In a subsequent transfer of interests in the entity to or for the benefit of family members, there would be no disregarded applicable restriction under Section 2704 if the unanimous consent of all of the members or partners were required to liquidate the entity. The proposed regulations eliminate this technique by stating that in determining whether the transferor and members of the transferor’s family have the ability to remove a restriction, any interest in the entity held by a non-family member is disregarded unless at the time of the transfer (i) the interest has been held by the non-family member for more than 3 years, (ii) the interest constitutes at least 10% of the capital and profits interest or equity in the entity, (iii) when combined with all interests owned by non-family members, the interest constitutes at least 20% of the capital and profits interest or equity in the entity, and (iv) the non-family member has an enforceable right to receive in exchange for its interest the interest’s pro rata share of the fair market value of the entity’s assets within six months of a notice of withdrawal.

The proposed regulations have been published for only a few weeks, but they have already generated substantial controversy and discussion among advisors, and many will likely be submitting comments to the IRS and speaking at the public hearing in December. As a result, the precise rules discussed in this Bulletin are likely to change; but regardless of their ultimate form, they will almost definitely be considerably more restrictive than the current regulations. Please contact us if you have any questions.