Extended Thoughts on the IRC 2704 Proposed Regulations

This article was written by: Matthew E. Rappaport, Esq., LL.M, Tax Planning and Structuring Attorney

In the wake of the Internal Revenue Service releasing Proposed Regulations pertaining to IRC 2704 yesterday, I have received many questions and conducted many discussions about the Proposed Regulations' content and potential impact.  I posted a short status update about my preliminary thoughts yesterday and would like to expand on those thoughts with this article.

1. What is the simplest possible way to describe what these Proposed Regulations say?

In essence, these Proposed Regulations presume that:

(1) If a family unit (as a voting bloc) can change the terms of the governing agreement of any entity (partnership, LLC, corporation, etc.), then:

(2) the family has control of the entity for 2704 purposes, and therefore,

(3) any restrictions on liquidation or redemption of a fractional ownership interest in the family entity are necessarily a device concocted to manufacture valuation discounts.

As a simple example, if I co-own an LLC with my two sons and the Operating Agreement of the LLC allows for amendment by unanimous vote of the Members, the Proposed Regulations assume my family unit will tinker with the Operating Agreement to create transfer tax benefits for the family.  For example, my family can vote to institute restrictions on liquidation and redemption to give rise to valuation discounts—then, after I transfer my remaining Membership Interest to my two sons, they can simply amend the Operating Agreement to get rid of the restrictions. Clearly, in this scenario, the restrictions were only written into the Operating Agreement to achieve transfer tax benefits and did not have any independent economic significance.

Using this rationale, if a family voting bloc can amend the Operating Agreement before and after the transfer of a Membership Interest, the Proposed Regulations will disregard any restrictions the Operating Agreement may place on redeeming a Membership Interest or forcing liquidation.  As described below, the effect of disregarding these restrictions is that owners of fractional interests in family-controlled entities will not be allowed to use valuation discounts for transfer tax purposes.

The Service prescribes a "minimum value" for the right to redeem any and all fractional interests in family-controlled entities when the aforementioned restrictions are disregarded.  

This minimum value is calculated by first finding the "net value" of the entity.  "Net value" is basically the value of the entire entity (this includes going concern value for operating businesses and appraised value for real estate holdings), minus bona fide debt obligations.  The taxpayer then multiples this "net value" by the fractional interest being transferred.  Again, to use a simple example, if I own a one-third interest in a family-controlled LLC holding a parcel of real estate, I'd calculate the "minimum value" by appraising the real estate, subtracting bona fide debt on the real estate, and multiplying the result by one-third.  Therefore, if the net asset value of the entity's real estate is $300,000, the "minimum value" of my one-third interest in the entity is $100,000-- and no valuation discounts may be applied.  This "minimum value" must be redeemed (or paid out in liquidation) in the form of cash or property -- and if payment is not rendered immediately, payment must be rendered within a "reasonable" time frame using a note with a net present value equal to "minimum value."

My interpretation of the Service putting a deemed "minimum value" on the imputed right to redeem a fractional interest in a family-controlled entity is that the Service is trying to reverse-engineer an undiscounted or lightly discounted transfer tax value for all such interests.  In other words, if the Service deems that a taxpayer has the right to redeem her fractional interest in a family-controlled entity at a "minimum value," what reasoning would justify a substantial discount from "minimum value?"  By my count, this "minimum value" would effectively control the way valuation professionals would calculate the fair market value of a fractional interest in a family-controlled entity, leaving little or no flexibility to account for legitimate economic factors affecting transfer tax value.  Perhaps light discounts might be applied if a taxpayer argues, for instance, that ownership of an undivided tenant-in-common interest in real property justifies a discount; therefore, if an entity distributes such an interest in redemption of an entity ownership interest, the distributed asset still has practical issues associated with liquidation.  However, discounts attributable to tenant-in-common interests in real property have typically amounted to 10-12%.

The Service has also tried to zap out every possible workaround to circumvent the Proposed Regulations.  

For instance, the Service disallows the use of assignees to circumvent the way the Proposed Regulations measure family control.  If a transfer to an unrelated party brings the family voting bloc below the control necessary to implicate IRC 2704, valuation discounts will not even apply until three years after the transfer.  Therefore, deathbed and testamentary transfers will not be sufficient to get around these Proposed Regulations and give rise to valuation discounts.

2. What are the implications of these Proposed Regulations?

The Service has long detested the use of valuation discounts in transfer tax planning, but the courts have never held the same view, much to the Service's chagrin.  These Proposed Regulations are the latest salvo in the war to outlaw the use of valuation discounts in family-controlled entities forever.

While the Proposed Regulations as written do have some potential workarounds I discuss below, the Proposed Regulations are very well-written and would make the application of valuation discounts much more difficult for family-controlled entities.  In particular, the Service was very clever to frame these Proposed Regulations through a liquidation and redemption lens rather than through mere transfer to unrelated third parties (more directly implicating lack of marketability), which you'll notice was a concept never explicitly mentioned through the entirety of the Proposed Regulations.

If these Proposed Regulations become final as is, tax and estate planners would look to other techniques to achieve transfer tax benefits.  

Freeze techniques would likely be implemented earlier in a client's lifetime to approximate the effect of discounts later in life.  Clients especially concerned about transfer taxes would more strongly consider the idea of selling appreciated artwork, real estate, and marketable securities using tax-advantaged techniques.  Accordingly, charitable strategies may rise in use, especially split-interest trusts.  As detailed below, clients owning appreciated real estate and seeking to move on from active management would be more inclined to enact an IRC 1031 exchange into a Delaware Statutory Trust, which would still be eligible for valuation discounts even under these Proposed Regulations.  Finally, life insurance would become an even more critical part of the high-net-worth client's estate plan, and advanced techniques implicating life insurance would concomitantly become more popular.

3. How likely are these Proposed Regulations to stand as is?

If you think the Service will be hard-pressed to justify these Proposed Regulations, you're not alone -- nationally renowned expert Richard L. Dees of McDermott, Will & Emery LLP thinks so, too.  His 2015 open letter to the IRS listing his reservations about these Proposed Regulations is a dense but fantastic read.  I am in accord with Mr. Dees's positions, one of which is that Congress did not give the Service the authority to issue regulations of this nature.

Specifically, IRC 2704(b)(4) states the following:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. (my emphasis added)

Therefore, restrictions on liquidation and redemption included in governing agreements for independent non-tax purposes were not meant to be disregarded if they truly affected the economic value of fractional interests.

 Even in family-controlled entities, such restrictions may be motivated by legitimate non-tax considerations.  For instance, why would a family want to give one member the ability to redeem for cash a fractional interest in a real estate holding entity?  What would the family do to pay out the redemption?  Borrowing against the real estate might be quite undesirable, and selling the real estate perhaps more so.  Why would a family want to give one member the ability to even attempt to force liquidation of an operating business?  Besides liquidity and potential tax concerns when paying out the proceeds, the liability implications could be disastrous.  All of these reasons for instituting restrictions on liquidation and redemption have nothing to do with tax, and the valuation discounts associated with these restrictions are backed by real economic data and reasoning.

Furthermore, Mr. Dees correctly points out that these Proposed Regulations are not in line with the purpose and intent of Chapter 14 (IRC 2701-2704), which was to get rid of truly illusory techniques that had no independent non-tax significance whatsoever and were only designed to achieve transfer tax benefits.  Congress did not intend to disallow taxpayers from taking into account valuation discounts arising from real economic concerns about marketability, control, and other important aspects of owning a fractional interest in a closely held entity.

Mr. Dees's letter has an excellent analysis of the more technical reasons why the Proposed Regulations could be flawed, but suffice it to say I think the long-term prognosis for these Proposed Regulations as written is not very good. This is just one man's opinion—we found out exactly how worthless that was in the first months of 2013, when the lifetime gift and estate tax exemptions became "permanent."

The Service will begin a 90-day comment period tomorrow and hold a public hearing on December 1, 2016.  Who knows whether the Service will change the language of these Proposed Regulations after they absorb all of the comments they are bound to receive?  After responding to the comments, the Service can issue final regulations at any time.  Those final regulations may come sooner, later, or never at all.  I would say the very, very earliest any final regulations may come is in the first quarter of 2017.

4. Million dollar question: do these Proposed Regulations have potential workarounds if they go final as is?

By my count, there are at least three I can currently think of.

• Encumbrance with Debt - The Proposed Regulations will explicitly not disregard any restrictions imposed by an unrelated third party providing capital to the entity in the form of either debt or equity.  Most lenders and investors will require restrictions on liquidation, redemption, and transfer of ownership interests in an entity, so the existence of a bona fide third party debt may by itself be enough to preserve valuation discounts.  Therefore, debt might be a legitimate avenue to avoid the application of the "minimum value" requirements of these Proposed Regulations.
• Enacting an IRC 1031 Exchange into a Delaware Statutory Trust (Real Estate Only) - A bit of background: a Delaware Statutory Trust (DST) is an unincorporated business trust owning a syndicated and (most often) diversified portfolio of real estate interests managed by a corporate promoter.  Under Rev. Rul. 2004-86, fractional ownership interests in a DST are treated as tenant-in-common interests in the underlying real estate for all federal tax purposes, therefore making DST interests eligible as replacement property in 1031 exchanges.  Because (1) multiple unrelated investors are involved in a single DST investment, (2) management is exclusively and irrevocably vested in an unrelated third party, and (3) nobody has the opportunity to change the governing document of a DST, there is effectively no chance that the Proposed Regulations will apply to fractional interests in a DST.  The valuation discounts applicable to these DST interests are a fair bit larger than those applicable to traditional family real estate holding companies for various reasons.
• Admitting an Unrelated Investor to a Family Entity - This option is less practical because of the many unpalatable features of allowing an outside investor into a family enterprise, but the option will work as long as the unrelated investor owns a threshold percentage of the entity and the governing agreement is drafted correctly.  Even so, this option implicates the three-year rule under the Proposed Regulations, which will not even allow valuation discounts for transfer tax purposes until the unrelated investor has owned the interest for at least three years.

I hope this article helped you understand and analyze these rather complicated Proposed Regulations.  Buckle your seat belts for what should be a 2012-like surge in client activity and a painfully uncertain period until the Service decides what it will do about finalizing these Proposed Regulations.