The Treasury Department and the Internal Revenue Service (“IRS”) have long planned to modify Internal Revenue Code (“IRC”) Section 2704. Finally, on August 2, 2016, the proposed new rules were announced. IRC Section 2704 is part of a group of IRC sections collectively known as Chapter 14. The purpose of Chapter 14 is to prevent taxpayers from using various strategies to reduce their exposure to federal gift, estate, and generation-skipping transfer (“GST”) taxes (these are generally known as the “wealth transfer taxes”) by using business entities to produce lower asset values than might otherwise exist. Section 2704 is a rule that applies in determining the value of certain kinds of business entities for wealth transfer tax purposes. In general, restrictions that a business entity places on its owners’ ability to use or transfer their interests to others are viewed as decreasing the value of those interests. In the situations where Section 2704 applies, it says that, when determining the value of a business interest for wealth transfer tax purposes, certain kinds of restrictions imposed by the business on its owners’ interests are disregarded, and the business interest is instead valued as if the restrictions imposed on it were no more restrictive than state law. This is intended to prevent the restrictions from lowering the value of the interests. However, for multiple reasons, IRC Section 2704 has often failed to effectively carry out its intended purpose.
The IRS hopes, with its proposed new regulations to Section 2704, to try to correct the flaws in the current rules and help Section 2704 better achieve its intended effect of preventing taxpayers from using restrictive business entities to manipulate the values of their interests for wealth transfer tax purposes. These Proposed Regulations may be found at: http://federalregister.gov/a/2016-18370.
Here is our initial take on these Proposed Regulations:
- IRC Section 2704 is a complex tax code provision that contains many details and addresses very complicated issues. Its current regulations are complex and these new Proposed Regulations increase this complexity.
- The intent of these rules is to close what the IRS perceives as loopholes that allow taxpayers to unfairly manipulate values. However, since the normal business entity valuation rules are designed to produce true fair market values, and since the 2704 Proposed Regulations change the normal business entity valuation rules in certain situations, applying the Proposed Regulations in valuing business entity interests will necessarily produce artificial values that do not reflect true fair market value. This will present both planning challenges and planning opportunities, as discussed in paragraph 8 below.
- The reason that taxpayers are able to manipulate the values of business entities results from the fact that taxpayers have the ability, in at least some cases, to create the terms of the agreements under which the business entities will operate. The terms of these agreements do actually affect the real values of the interests, because they affect what can be done with the interests and what real economic benefits the interest owners will enjoy. Even if a business entity agreement merely follows or relies upon existing state laws, the restrictions imposed by those laws do affect the values of the interests, and tend to mean that the value of an interest in a business entity is not simply a direct reflection of the value of the assets held by the business entity. However, the IRS appears to believe that the fact that taxpayers can decide whether to impose more restrictions than would apply under standard state laws or to simply rely on those laws means that the restrictions imposed by the agreements or by state laws are not real and should be ignored for wealth transfer tax purposes. The new Proposed Regulations under Section 2704 take this belief much further than either the Section itself or its existing regulations took it.
- This is neither the first nor the last time the Treasury Department and the IRS have attempted to make rules that do not follow general economic assumptions about the effect of supply and demand or to make rules that take the position that transactions between related parties should be viewed differently than transactions between unrelated parties, even where both transactions follow normal business practices. In many cases, these rules have not lasted for long because they disrupted normal business practices or caused unintended consequences because they ignored reality. For example: old IRC Section 2036(c), which came before the newer Chapter 14 rules and was found to be overly broad because it ended up having significant, negative effects on even normal, arms-length business transactions between unrelated parties; and the previous installment sales rules that made it almost impossible for a taxpayer entering into an installment sale in the ordinary course of business to be able to determine how the transaction would be taxed until the end of the tax year.
- The new Proposed Regulations under Section 2704 also represent the IRS’s attempt to add to the actual Section without going through the normal legislative process needed to amend the IRC. For example, the Proposed Regulations for Section 2704 would effectively add a family attribution rule for determining entity ownership to the Section, to help justify treating related party dealings differently than unrelated party dealings.
- The general effect of the Proposed Regulations is to try to ensure that a business owned primarily by related parties is valued as a whole, and that an interest in the business is then deemed, in many situations, to be worth a pro-rata portion of that entity’s full fair market value, as if the owner of the interest had the ability to unilaterally liquidate the entity or their interest in the entity at will and take her share of the underlying assets outright. These Regulations are also intended to have other effects, including, for example: eliminating any tax valuation advantages for deferred sales using promissory notes; eliminating any tax valuation advantages produced by relying on state law; and eliminating any tax value advantage produced by having non-family member owners, except where certain strict requirements are satisfied.
- The Proposed Regulations will not be effective until they are officially finalized, which will not happen until after the first hearing at the earliest. That hearing is currently scheduled for December 1, 2016, so it is likely that the earliest possible effective date will be sometime in December 2016.
- What do these Proposed Regulations mean for estate and tax planning purposes? While these rules will be the focus of much more study over the following days, months and years, and it will take a long time to determine all of their implications, and while the Proposed Regulations may yet be changed before they appear as Final Regulations, we can make some predictions now:
- These rules are very broadly written, and they may turn out to have an adverse effect on normal arms-length transactions, especially in light of their intended application to business deals that involve both related and unrelated parties.
- We have some time to take advantage of current law before the Proposed Regulations are officially finalized. This means that people who may be able to achieve significant tax savings from transactions that may not be as favorable after the Final Regulations are issued have a very strong motivation to do those transactions as soon as possible.
- There may be at least one positive result if the Proposed Regulations are finalized in a form similar to their current form: let’s assume that, before the final regulations are issued, the owner of an interest in a family business sells that interest to a grantor trust he created in exchange for a promissory note issued by the trust, and that the sale price is based on the value determined for that interest under current law (so that the value of the interest is not equal to the exact pro-rata value of that interest in the business’s underlying assets). Then, after the final Regulations are issued, the business interest now has to be valued as if it were simply a pro-rata share of the business’s assets. The trust may be able to pay off the sale price and interest by returning portions of the purchased interest itself to the original owner (the seller). Because the same interest is now valued at a higher value, less than the full interest originally transferred to the trust would need to be transferred back in order to fully repay the purchase price, even if the interest didn’t appreciate in actual value at between the time of the sale and the time of the repayment. This would allow a significant tax benefit, effectively allowing the original owner to make a free gift to the trust, simply because of the effect of the two different applicable sets of valuation rules. This shows at least one potential, and likely unintended, effect of the IRS’s attempt to create artificial values instead of allowing normal valuation rules designed to reflect true fair market values to apply.
- Another potentially positive, and likely also unintended, effect if the new Proposed Regulations are made final may exist for taxpayers who have a family business entity, but who do not have a large enough estate to cause a federal estate tax or state estate or inheritance taxes. For these taxpayers, disallowing valuation discounts that would normally apply when the family business entity interests are valued at an owner’s death can mean that the family receives a larger income tax basis step-up at that time, even though the increased value does not produce any increased estate or inheritance taxes. Many people who previously used family business entities as part of their estate tax planning but who are no longer exposed to estate taxes may have been contemplating the need to change their entity documents or even eliminate the entities (which would cause the loss of other benefits these entities can provide), to increase the potential income tax basis step-up available on the entity assets at their deaths. If the Proposed Regulations take effect in the same basic form, these clients may be able to keep these entities in place as is, continuing to be able to enjoy the benefits provided by the entities without risking the loss of potential basis step-up and potentially increased capital gains taxes.
- Finally, anytime the government makes laws that distort the effects of reality, taxpayers and their advisers normally figure out a way to take advantage of this disconnect between reality and the law. As an example, before the check-the-box regulations enabled taxpayers to elect what type of entity they wanted to be for income tax purposes, the government had pushed many entities to be taxed as partnerships in order to combat perceived abuses in one area of income tax law. This push helped create the tax shelter craze of the 1980s, the explosion in the use of various types of limited partnerships for wealth transfer tax planning purposes in the 1990s, and the later use of limited liability companies for the same purposes. Tax planners will eventually figure out ways to benefit from, or at least minimize the impact of, whatever rules the Final Regulations contain. We don’t know what this planning will be or how long it will take, but we can be assured that it will happen.
If you have questions about whether you might be able to benefit from planning that may be affected by the final version of the new Section 2704 Regulations, we are here to help you find answers. Please contact our office administrator at (678) 720-0750 or firstname.lastname@example.org to schedule an appointment for an estate planning consultation.