Back in the 1980s, if a business owner wanted to transfer her business to her children at a reduced tax cost, she might start with a C corporation and recapitalize it. She would keep a class of preferred stock that entitled her to receive most of the business’ operating cash flow and that had the lion’s share of the voting rights. Junior family members would receive common stock entitled to residual cash flows and without much of a vote. The value of the common stock transferred (and thus the business owner’s gift tax liability) would be reduced because of discounts based on the senior member’s entitlement to cash flow and control over distributions from the business. On the death of the senior family member, the preferred stock would be cancelled, convert to common stock or otherwise lose many of its features. The business owner’s estate would take the position that there was no transfer of those features to the younger generation and therefore not much additional transfer tax liability, even though the younger generation was suddenly able to access the cash flows from the business.
Physics tells us that matter and energy are not created or destroyed, only changed in form. Congress and the IRS have a similar view about value: It can neither be created nor destroyed without tax consequences. In order to guard against ( inter alia) the so called Estate Freeze Recapitalization summarized above (so called because it attempted to “freeze” the value of the senior family member’s estate) Congress enacted Chapter 14 of the Internal Revenue Code, and in particular Sections 2701 and 2704. A discussion of 2701 is for another day. What 2704 did was to provide that some of those controls that the senior family member holds (and that might reduce value passing to the younger generation), particularly controls on the right to liquidate interests in a business entity, will be ignored if they lapse after the transfer.
The enactment of Chapter 14 did slow down Recapitalization activity. However, clever tax lawyers realized that a business organized as a partnership or limited liability company could achieve similar discounts without violating Chapter 14. With respect to the Section 2704 rules, there is a rule that allows you to take into account for valuation purposes restrictions on transfer consistent with state law, and another rule that allows you to respect restrictions that are the same as those accepted by third party investors. With a little judicious lobbying so that state law required unanimous consent of all partners or LLC members to liquidate, and the granting of interests in family entities to charities or trusted colleagues, the estate planning bar had pretty much solved 2704.
On September 6, 2016, the IRS issued a set of proposed regulations under Section 2704 of the Code. Apparently intended to address some of the workarounds that have been developed for Section 2704, the regulations have four main effects:
The proposed regulations, if adopted (possibly in December of this year or early next year), could have a significant impact not only on estate tax and business succession planning, but also on transfers of interests in existing Family Limited Partnerships (FLPs) or Family Limited Liability Companies (FLLCs) that may have been created 20 years ago in reliance on the planning opportunities then-available under Section 2704.
Because the proposed regulations can appear to attribute control of an entity for some purposes to persons who do not in fact have control, they could also be argued to impact the valuation of family-owned businesses in the support and equitable distribution context. In addition, if corporate attorneys are not aware of these proposed regulations when reviewing or preparing governing documents for family business entities, and sales or gifts of minority interests in family-owned businesses, they may be unwittingly creating problems for their clients in other contexts.
The regulations are merely proposed at this stage, but if they are adopted substantially as proposed, they could be effective retroactively to some extent. Persons with existing FLPs or FLLCs or who are making planned transfers of discounted interests in family entities should consult their advisers and counsel. These folks might consider either accelerating planned transfers so they occur before the proposed regulations’ effective date, or reevaluating the plan in light of the expected reduction in valuation discounts.
Strassburger McKenna Gutnick & Gefsky is prepared to assist with estate and succession planning and estate administration for business owners and others. Please contact Jillian Zacks, firstname.lastname@example.org or Dave Pollack, email@example.com at 412 281 5423 to talk about your estate or succession plan.