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The Treasury Department recently released new Proposed Regulations under Section 2704 of the Internal Revenue Code (“§2704”) that, if adopted as Final Regulations in substantially the same form, would limit and possibly eliminate valuation discounts on intra-family transfers of family controlled entities.  Valuation discounts are a powerful estate planning tool allowing families to benefit from valuation adjustments historically allowed for lack of control and marketability on transfers of minority interests in family holding companies (such as  a Family Limited Partnerships or LLCs) as well as operating businesses.  Although it is too soon to know the exact effect of the Final Regulations, the Proposed Regulations would significantly decrease valuation discounts currently available for intra-family transfers.  Prompt action is recommended to take advantage of this opportunity while it lasts.

Scope and Effect of Proposed Regulations 

Entities Subject to §2704.  Entities subject to the new §2704 Proposed Regulations are defined broadly as any business entity or arrangement “controlled” by the family such as partnerships, limited partnerships and closely held corporations.  Also, the regulations specifically include LLCs, regardless of whether the LLC is a disregarded entity for income tax purposes.

State Law Applicable Restrictions.  Under the current §2704 Treasury Regulations, state laws with default restrictions on the ability of the family to liquidate closely-held entities fell under an exception to the Regulations.  Recognizing this exception, many states passed laws making their state a favorable location for family-controlled entities because the applicable restrictions under default state law allowed those restrictions to be considered in valuing the entity.  The Proposed Regulations do away with this exception.  State-imposed applicable restrictions that can be overridden by the family acting together would be disregarded and ignored for valuation purposes.  Therefore, if the family entity is located in a state where the restriction is limited to only family-controlled entities, or state law provides an option for the family to avoid the restriction, then the restriction will be disregarded for valuation purposes.

Disregarded Restrictions.  The Proposed Regulations define a new category of “disregarded restrictions” which apply to restrictions on the availability of forced liquidation or redemption on an interest in the entity, not the entire entity as previously defined in “applicable restrictions.” Generally, restrictions in family entities that limit a family member’s ability to redeem their interest will be disregarded.  This change in the regulations has the potential to completely eliminate valuation discounts that have historically been permitted.

Exceptions.  A “commerically reasonable restriction” exception exists for entities with active trade or business operations.  In order for this exception to apply, every owner must have the right to sell its interest to the entity or other owners, with payment made within 6 months, and generally a payment cannot be in the form of a note.  Furthermore, nominal non-family member interests are disregarded, with nominal defined as (i) less than 10%, or (ii) any size if all non-family interests together are less than 20%). 

Time for Action

Effective Date.  The Proposed Regulations will not take effect until published as Final Regulations.  A public hearing is scheduled for December 1, 2016, and publication as Final Regulations would likely not occur before year end. 

Early Planning for Timely Action.  However, we suggest initiating action well before December 2016.  Properly planning, documenting, executing, and valuing a transfer of assets significant enough for these Proposed Regulations to have an effect are not steps that can be completed in a few days.  The work involved for Handler Thayer LLP would not take long once undertaken, but there are many choices and steps required for the client and other advisors, and coordination of all those steps takes time. 

In additon, we expect the fourth quarter of 2016 to be busy for us (as well as for wealth transfer planners in general), so we will not be able to drop everything for a client who is slow in deciding to ask us to help plan and implement a transfer.  Therefore, it is essential for clients who would like to take advantage of the current valuation rules to contact us soon to discuss their plans and make arrangements with us so that we can provide timely assistance.  If arrangements have not been made with us by November 21, 2016, there is a real possiblity we would not have sufficient time for properly planning and implementing a transfer before the Final Regulations are issued. 

In addition to the practical reasons to start the planning sooner rather than later, the Proposed Regulations include a “three year rule” that would effectively cause a transaction made before the effective date to be subject to the Regulations if the transferor dies within three years of making the transfer.  Under this rule, the transfer could be subject to the new Final Regulations even if the transfer was made before those Regulations were finalized.


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