Proposed IRS Regulations Could Increase Taxes on the Transfer of Your Business
f you own a family-controlled business, or if you will transfer or inherit an ownership interest in a family-controlled business, you need to read this information.
The IRS published proposed changes pertaining to the Section 2704 regulations on August 2, 2016. They’re open for comment through November 2, 2016, and a public hearing is scheduled for December 1, 2016, in Washington, D.C.
At the crux, should the proposed regulations become law, you will pay more taxes on the transfer of your business. The proposed regulations aim to limit the two main valuation discounts previously allowed to be taken on transfers through testamentary disposition.
The Section 2704 regulations currently control how certain lapses in voting or liquidation rights of family-controlled entities are treated in valuing the interest transferred. Right now, Section 2704(b) says that restrictions on the ability to liquidate are disregarded if the interest is transferred within the family, and the family has the ability to collectively remove the restriction.
However, certain exceptions exist, and they’ve been used as common estate planning techniques. First, Reg. Sect. 25.2704-1(c)(1) provides an exception to the rule as long as the rights with respect to the interest transferred is not restricted or eliminated. Second, the tax courts have found that 2704(b) applies to the ability to liquidate the entire entity, not a particular individual’s interest.
For example, assume Owner A owns a family business worth $5 million. For estate planning reasons, Owner A would like to gift his son 30% of the family business, which is believed to be $1.5 million. Owner A gets the 30% interest appraised at fair market value by a certified valuation analyst (CVA) for gift tax return reporting.
The CVA determines and appropriately substantiates that because of restrictions on liquidation and the 30% interest is a minority interest, the fair market value at date of gift more closely approximates $1 million as opposed to $1.5 million. This process has now effectively removed $500,000 from being subject to gift taxes.
In an unofficial poll, Business Valuation Resources, an industry-leading publication, expects an increase in the number of business valuations performed for family-controlled businesses. Topline Valuation Group agrees with this assessment and views this as a potential estate-planning opportunity for family-controlled businesses.
We’ve broken down the proposed regulations and what they mean for you:
The Proposed Section 2704 Regulations
The proposed Section 2704 regulations are designed to make the exceptions noted above narrower in several ways:
They extend the definition of a “covered entity” to include corporations, partnerships, LLCs, and other arrangements that are within the meaning of Section 301.7701-2(a). For family-controlled businesses, the restrictions apply to the transferor, applicable family members, and any lineal descendants of the transferor’s parents or spouse.
Regarding family-controlled businesses, “control” has been redefined to constitute holding at least 50% of the entity’s capital or profits, or arrangement or the holding of any equity interest with the ability to cause full or partial liquidation.
The proposed regulations amend the exception in Reg. Sect. 25.2704-1(c)(1) noted above to transfers occurring three years or more from the transferor’s death. Based on our example above, if the individual died within three years from the date the 30% interest was gifted, no valuation discounts would be allowed and the entire $1.5 million would be included in the individual’s gross estate.
They remove the exception under the current Section 2704(b) regarding “applicable restrictions,” unless such restriction is mandated by state law.
They create a new set of restrictions called “disregarded restrictions.” These address restrictions on the liquidation or redemption of transferred interests in family-controlled entities, regardless of the three-year exception above. If the restriction can be removed by the transferor or transferor’s family, the following provisions and/or limitations on liquidation will be ignored for valuation purposes:
Limitation on the ability of the interest holder to liquidate the interest;
Limitation on liquidation proceeds to a “minimum value” amount, which is proposed to be the pro-rata share of the family-controlled entity’s net value at the date of liquidation.
Provision which defers payment of liquidation proceeds more than six months; or
Provision that permits payment of liquidation proceeds besides in cash or in other property (certain notes may be allowed).
Applying these disregarded restrictions attempts to eliminate any limitation on liquidation or redemption. If no limitation on liquidation or redemption is allowed, no discount for lack of marketability can be taken on a transferred interest.
What Does This Mean for You?
The proposed 2704 regulations are anticipated to be finalized in early 2017.
Therefore, we strongly encourage interest holders in family-controlled businesses to meet with their CPA to discuss what the proposed Section 2704 regulations mean for you and your estate plan.
When the regulations are finalized, it is unclear if the IRS will honor valuations of transferred interests – with valuation discounts – that occurred since the proposed regulations were initially published.
However, if you were planning on gifting an interest in the near future, you may want to expedite the process before year-end.