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Navigating the New Section 2704 Discount Valuation and Transfer Regulations: What Estate Planners Must Do Now

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, OCTOBER 11, 2016

Presenting a live 90-minute webinar with interactive Q&A Susan Peckett Witkin, Partner, Blank Rome, New York James G. Blase, Principal, Blase & Associates, Des Peres, Mo. Edwin P . Morrow, III, Esq., Director, Wealth Transfer Planning and Tax Strategies, Key Private Bank Family Wealth Advisory Services, Dayton, Ohio

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Proposed Regulations Threaten to Create Higher Valuations for Family Businesses

Understanding the Impact, The Proactive Planning Opportunities, the Traps and Uncertainties of Proposed Section 2704 Regulations

October 11, 2016 Strafford Webinar CLE/CPE

Speakers for Today’s CLE/CPE

Susan Witkin, J.D., LL. M. Partner, Blank Rome, LLP Tax, Benefits and Private Client Group- New York office Edwin P. Morrow III, J.D., LL.M. Director, Wealth Transfer Planning and Tax Strategies Key Private Bank Family Wealth Advisory Services James G. Blase, CPA, JD, LLM Principal Blase and Associates, LLC

6

• History and Principles of Valuation for Gift, Estate and

GST Tax Purposes and How Newly Proposed Regulations May Change This

• Explaining §§2701, 2704(a) and 2704(b) Proposed

Changes; Three Year Rule; Disregarded Restrictions

• Effect of §2704 on Income Tax Basis and §§1014-1015
• The Likely Effective Date of Proposed Regulations
• Are They Within Treasury’s Authority to Promulgate?
• Planning Opportunities Pre-Finalization and Effect on

Wealth Transfer Planning Assuming They Are Finalized – Effect on Trusts, Buy-Sell Agreements, Buy-Outs

• Panel Discussion

Topics Discussed – Agenda

7

A Brief History of (not Time, but) Code Section 2704 and existing regulations

October 11, 2016 Susan Peckett Witkin Partner, Blank Rome LLP

Su Susan Pec eckett Wit itkin

Par artner, Blan lank Rom

• me LLP

LLP New Yor

• rk, NY

21 212.8 2.885 85.51 5190 SWitk itkin@BlankRome.com

Susan Peckett Witkin concentrates her practice in the areas of trusts and estates and tax law. She advises clients on a wide variety of estate planning, estate and trust administration and estate and trust litigation matters, and represents both beneficiaries and fiduciaries. Ms. Witkin provides tax and related advice to individuals, fiduciaries and privately held companies in areas such as intergenerational transfer tax planning, business succession, insurance, entity formation and management, charitable giving arrangements, estate and tax planning for foreign individuals and trusts and multinational families, tax controversies and FBAR and FATCA compliance, distribution planning for IRAs and qualified plans, income tax planning and trust company formation, and provides counsel regarding the duties and responsibilities of trustees, executors, guardians and other fiduciaries in various situations. She is frequently involved in the negotiation and preparation of pre- and post-nuptial agreements and the tax and property issues relevant to divorces and separations.

• Ms. Witkin is an adjunct professor of law at New York University School of Law and previously taught as an adjunct professor of law at St.

John’s University School of Law.

• Ms. Witkin has written and co-authored articles for various publications, including the New York Law Journal, and was one of the principal

authors of the April 2012 report of the New York State Bar Association’s Tax and Trusts and Estates Law Sections titled “Report on Notice 2011-101: Request for Comments Regarding the Income, Gift, Estate and Generation-Skipping Transfer Tax Consequence of Trust Decanting,” providing the Internal Revenue Service with a response to its requests for comments on various tax issues implicated in the decanting of

• trusts. She has been a lecturer and moderator in various contexts, including for the American Bar Association, the California State Bar

Association and the Practicing Law Institute, and frequently presents programs to various groups, including attorneys, accountants, clients and their advisors, women entrepreneurs, and entrepreneurs in the healthy living space. She served for many years as a chair of various committees of the American Bar Association's Section of Real Property, Probate and Trust Law (now the Section of Real Property, Trusts and Estates Law). She is currently an active member of the New York City Bar Association's Animal Law Committee, focusing on legal issues of animal welfare and management, rights of individuals to have support animals in various settings, and the ethical treatment of animals in agriculture, among

• thers. She is heavily involved in various projects for the Committee that promote the welfare of animals particularly in the farm industry

(including, most recently, the Committee’s submission of extensive comments to the USDA’s proposed organic farming regulations), animal rescue operations, and proposals relating to endangered animals. She represents Ruff House Rescue, Inc., a dog rescue non-profit

• rganization, as a pro bono client. Ms. Witkin also serves as a member of The New York City Planned Giving Advisory Council of the American

Cancer Society.

9

A refresher on Chapter 14 (relating to Code section 2704)

• Let’s all remember: essentially all transfer tax valuations harken back to

seminal rules of Rev. Rul. 59-60, 1959-1 C.B. 237

• Basically, fair market value is the price that a hypothetical willing

buyer would pay a hypothetical willing seller, neither being under any compulsion to buy or sell

• The gift tax regulations provide substantially the same rule at Reg.

§25.2512-1

• Fast forward to the late 1980s: Code § 2036(c) and Estate of Harrison v.

Commissioner, T.C. Memo 1987-8, 52 TCM 1306.

• 2036(c) related to estate freezes and attempts to retain an income or
• ther rights interest in an entity while transferring a “disproportionately

large” share of the potential appreciation. Quickly recognized as being unworkable, and was repealed as part of PL 101-508, the Omnibus Budget Reconciliation Act of 1990, which enacted Chapter 14.

10

• Estate of Harrison was particularly irksome to the Service:
• This case involved a partnership that parent and two children

controlled as the GPs. The parent also held all of the LP

• interests. The GPs could each liquidate at any time.
• At death, parent’s GP interest essentially became a LP

interest, because the estate of a deceased GP could not exercise the liquidation right. The liquidation right lapsed.

• The value of parent’s LP interest was considerably less when

held without the right to liquidate the partnership.

• These types of lapsing rights were addressed by §2704(a)
• Note that partnerships and corporations only were

addressed-LLCs not mentioned

A refresher on Chapter 14 (relating to Code section 2704)

11

Code § 2704(a)

• Provides that where a voting or liquidation right lapses

and the family controls the partnership or corporation both before and after the lapse, the lapse is a deemed transfer that is taxable

• As a gift if the lapse occurs during life
• As taxable in the estate if it occurs at death

The amount of the transfer (Code §2704(a)(2)) is the excess of (i) the value of all interests in the entity held by the transferor (or decedent) immediately before the lapse (determined as if voting and liquidation rights inherent in the interest were non-lapsing) over (ii) the value of such interests after the lapse

12

Restrictions on ability of corporation or partnership to liquidate-Code §2704(b)

• In addition to lapsing rights, of concern to Treasury were restrictions

placed on the ability of the entity to liquidate that could be removed by the transferor and her family

• Many donors and decedents had interests in entities that were governed by

shareholders and partnership agreements that precluded liquidation of the entity in the absence of consent of all shareholders or partners

• Such restrictions were taken into account in the willing buyer/willing

seller regime but were viewed as artificially depressing value for gift and estate tax valuation purposes because the transferor or her family could nullify its effect

• Code § 2704(b) requires valuation of an interest for transfer tax

purposes to ignore a restriction –labelled as an “applicable restriction” -

• that effectively limits the ability of a corporation or partnership to

liquidate (such as requiring consent of all partners or all shareholders) where the transfer is among family members, where the transferor and her family control the entity before the transfer, and where the “transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction. ”

13

Family members and control

• Family members include, with respect to an individual:
• her spouse
• her ancestors and lineal descendants
• The ancestors and lineal descendants of her spouse
• her siblings; and
• the spouse of any such ancestor, descendant or sibling
• Pretty comprehensive and captures siblings , who are notorious for not

cooperating in matters of the family business in many situations to frequently devolve into liquidation

• Control has the same meaning as in Code §2701(b)(2)
• Corporation: 50% by vote or value of the stock
• Partnerships:
• For a limited partnership, a GP interest ,
• r
• In all types of partnerships, the holding of at least 50% of the capital or

profits interest

14

Note th the el elements of f § 27 2704(b): : family control before th the tr transfer and th the exis xistence of f an applic icable res estric iction

• If there is a restriction on the entity’s ability to

liquidate, it is disregarded only if it is an applicable restriction

• To be an applicable restriction, it has to satisfy both of

these elements:

• It restricts the ability of the entity to liquidate, and
• It lapses or can be removed by the transferor or a

member of her family or any combination of one or more of the transferor and her family members after the transfer is made

15

This looked like an attempt at family attribution and an end to certain discounts

• As we all know, a minority discount reflects the

shareholder’s or partner’s (or LLC member’s) inability to direct the management of the entity, to compel the payment of dividends or distributions or to compel a liquidation and thus receive a pro rata share of the entity’s net asset value

• Lack of marketability discounts reflect the

relative difficulty the holder of an entity interest would have finding a buyer for such interest (i.e., not many people want to buy into a closely-held business)

16

Family attribution

• Family attribution had generally been discredited by numerous

decisions at the time. E.g., Estate of Bright, 658 F 2d 999 (5th Cir. 1981) and Estate of Andrews, 79 TC 938 (1982),which held that the hypothetical willing buyer/willing seller construct required the valuation to ignore that the most probable purchaser would be other family members who owned the other interests in a family business, where a decedent held only a minority interest

• There is an attribution rule in Code § 2704(c)(3) which invokes

2701(e)(3) for purposes of determining the interests held by an individual…but that deals with attribution for ownership indirectly held through other entities, including trusts

• 2704(b) did not cause a transferor to be deemed to hold interests

held by family members for purposes of valuing the entity

• Rev. Rul. 81-253, valuing family owned stock as if held by one

person, eliminating minority and lack of marketability discounts was revoked in Rev. Rul. 93-12

17

Discounts

• The Conference Report to Chapter 14 (H.R. Conf.

Rep.101-964 (1990)) is instructive

• The government acknowledged that Code § 2704(b) was

not intended to affect minority and lack of marketability discounts “The conference agreement modifies the provision in the Senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation. These rules are intended to prevent results similar to that of Estate of Harrison v. Commissioner, 52 T.CM. (CCH) 1306 (1987). These rules do not affect minority or other discounts available under present law.”

18

• Further support that discounts are not affected by

2704(b) in the Conference Report (Example 8):

• “Mother and Son are partners in a two-person
• partnership. The partnership agreement provides that

the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. Under the conference agreement, the value of Mother’s partnership interest in her estate would be valued without regard to the restriction. Such value would be adjusted to reflect any appropriate fragmentation discount.”

Discounts

19

Section 2704(b) also contained some important exceptions and also a broad grant of regulatory authority

• Code §2704(b)(3) provides that a commercially reasonable

restriction that arises as part of any financing by the entity with a person who is NOT related to the transferor, the transferee or a family member of either is not an applicable restriction

• That same section provides that any restriction imposed, or

required to be imposed by any Federal or State law is not an applicable restriction

• Code §2704(b)(4) is highly significant:
• It provides that the Secretary of the Treasury may “by regulations

provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or a 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.”

20

What about the broad regulatory authority granted in Code §2704?

• IRS proposed regulations in 1991
• Final regs were issued in 1992
• The disappearance of value where value is

rearranged within the family (with no loss of value to the family as a whole) was the target, but within the parameters of the statute as written and the legislative intent described above.

• Clearly, minority and lack of marketability discounts

were not the target

21

Reg §25.2704-1 deals with lapses; Reg § 25.2704-2 deals with transfers subject to applicable restrictions

25.2704-1 Lapses of voting and liquidation rights:

• Reg § 25.2704-1(a) makes it clear that if a lapse that is

reached by Code § 2704 occurs during life, the value “lost” as a result of the lapse is a gift and if the lapse

• ccurs upon death (like in Harrison), the lapse is

deemed a separate transfer that occurs at death and is includible in the gross estate.

• Notably, Reg. § 25.2704-1(c) states that a “transfer of

an interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated.”

22

• This is not specified in §2704, but the regulations were clearly

aimed at “Harrison shenanigans” where rights embedded in the donor’s/decedent’s entity interest lapse…not where a liquidation right incident to the amount of voting stock held by parent vanished by making a transfer that brings parent down below voting control.

• It could be argued that this is a helpful, but not mandatory

construction of 2704, although given the legislative history, a different construction would have been vociferously challenged as contrary to legislative intent

• Example 4 of 25.2704-1(f) illustrates this exception: If Parent has

84% of the vote and gives half away in equal shares to each of Parent’s children, the reduction from majority controlling shareholder

to minority shareholder (with a resulting loss in the value of those shares, no longer a control block) is not a lapse of a voting or liquidation right contemplated by §2704 because the voting rights (in the hands of the transferees) have not been eliminated.

23

Current regulations sanctioned reduction in values that were thought to be abusive

• Key example is a majority owner who gives away

just enough to no longer give her voting control and the right to unilaterally liquidate the entity by making transfers made close to death:

• example: 60% owner gives away 11% several months

before her death. She no longer has voting control, and the stock included in her estate will receive minority discount valuation. This gift clearly caused a lapse of a liquidation right. BUT

• The current regulations say that no lapse of a voting or

liquidation right occurs if the interest given (here stock) has all the rights in the hands of the donee that it had in the donor’s hands. Since the voting stock did not become non-voting upon the gift, no taxable lapse

• ccurred at the time of the gift

24

What about the shares the transferor retained?

• The donor is now put in a lower valuation position with

respect to the stock she retains.

• Under current law, if donor dies owning those shares

(and death follows the gift closely in this example) the transferor’s shares can claim a minority discount on the estate tax return.

• But shouldn’t this be the case? Unless there is agreement with

the donee that the donor would remain in de factor control (which brings up other estate tax inclusion rules), the donor’s property has become less valuable.

• As we will see the Proposed Regulations seek to address this

situation

25

Estate of f Mur urphy v. . Commissioner, T.C. . Memo. 19 1990- 472, , 60 TCM 645 (1 (1990) disallowed the minority discount in such a situation.

• As we will see, the Proposed Regs do not

remove this example or this exception to the reach of § 2704(a) but they limit it (and change this example and one other) to avoid so- called death bed transfers that reduce voting control

• The Proposed Regs in essence say, this type
• f loss of value will be respected if the

transfer occurs more than 3 years before Parent’s death.

26

Significant limitation on the definition of an applicable restriction in § 25. 2704-2

• Given the ostensibly broad read and reach of Code

§ 2704(b), as well as the legislative history, the government agreed to a compromise interpretation that would not eliminate discounts or reimpose family attribution

• The regulations at § 25. 2704-2(b) preclude the

application of § 2704(b) in certain circumstances by carving out from the definition of “applicable restriction” a restriction on liquidation that is no “more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.”

27

Developments that lead to the Proposed Regs

• Kerr v. Commissioner, 133 T.C. 449 (1999), aff’d 292 F.3rd 490 (5th Cir. 2002),

essentially provided that Code § 2704(b) did not apply to a restriction on the right to liquidate an interest in the entity, holding instead (after reviewing the legislative history and the plain wording of the statute and regulations) that § 2704(b) applies only to restrictions on the ability to liquidate the entire entity.

• The carve out just described (i.e., only being more restrictive than state law

gets you into trouble under § 2704(b)), together with significant changes in state laws governing partnerships and LLCs together rendered § 2704(b) fairly ineffectual.

• Default state law, which in effect provides the baseline for valuation

purposes, has evolved since 1992.

• Default rules preclude a limited partner or member of an LLC from withdrawing or

transferring his interest except as set forth in the governing agreement, so the default rule is that an interest cannot be liquidated

• In statutes that permit transfers in the absence of a governing agreement provision,

the transferee (In the absence of the consents required by the agreement) only receives an assignee interest, with no right to vote or participate

• This addressed the issue of permitting transfers as a default but not forcing the remaining

members or partners to accept the transferee as a fellow partner or member

• Many statutes provide a requirement that all members/partners consent to

a liquidation of the entity

28

Other areas of concern for Treasury

• Taxpayers’ use of nominal interests in non-family members,

including charity, to avoid the application of Code § 2704(b), by ensuring that the family could not remove the restriction

• The promulgation of check- the- box regulations and the

proliferation of LLCs that are taxable as partnerships require updates to the regulations

29

Highlights of the Proposed Regulations and the Heated Debate Over How Broad (or Narrow) They Are

Ed Morrow Director, Family Wealth Consulting Group Key Private Bank

• Section 25.2701-2 (expansion and clarification of definition of

controlled entity, not the most groundbreaking change)

• Section 25.2704-1 (lapse of certain rights, includes 3 yr rule)
• Section 25.2704-2 (transfers subject to applicable

restrictions)

• Section 25.2704-3 (transfers subject to disregarded

restrictions – the most controversial and confusing) – all the

• thers are amendments, this one is completely new
• Section 25.2704-4 (effective date)

These are uploaded as downloadable handout – pages 1-22 of pdf are the preamble, pages 23-50 are the proposed

• changes. I highlighted portions that will be discussed today

and will reference page numbers of these (more readable than slides).

The Newly Proposed Treasury Regulations

31

Who is potentially negatively impacted? Anyone with a taxable estate ($5.45 /$10.9 million married, increasing to $5.49/$10.98 million in 2017), who owns a business entity or arrangement, which the family could control if aggregated together (control meaning 50% or more). Who Wins? Potentially, anyone with a non-taxable estate with affected business entities (since they may benefit from higher valuations, which would increase basis - but this is very uncertain, especially for non taxable estates – see Morrow article). Indirectly: valuation, law and accounting firms, maybe even life insurers to cover a three year lookback! Who is unaffected? Those who do not own closely held business interests nor would ever establish one, or those families with non-controlling (<50%) interests in a closely held business (aggregated).

Who Wins and Who Loses if Proposed Regulations Become Law

32

• Prop. Reg. §25.2701-2:

Clarifying Application to Various Entities

33

• Addresses what constitutes control of an LLC
• r other entity or arrangement that is not a

corporation, partnership, or limited partnership and clarifies what entities the regulations apply to.

• Prop. Reg. §25.2704-1 “Lapse of Certain Rights”

(Page discussion in preamble at p. 3-5, page 26-28 of the pdf file containing regs, page 29-30 for Examples) first clarifies the scope of affected entities and application to assignees (e.g. if I transfer LLC interest but donee is mere assignee, it’s a lapse), but (c) is the most far reaching – it is essentially “correcting” the result in the Murphy case, and superseding Rev. Rul. 93-12 (where IRS permitted non-aggregated minority interest discounts where donor gifted 5 20% shares of business) for transfers within 3 years.

• When the dust settles and we have final regulations,

this is likely to be the most far-reaching, and potentially most devastating.

• Prop. Reg. §25.2704-1:

New “Assignee” and “Three Year Rule”

34

• The proposed regulations would create a valuation

penalty for transfers occurring within three years before the transferor’s death if the entity is controlled by the transferor and members of the transferor’s family immediately before and after the lapse. They “apply to transfers of property*** occurring on or after [date regulations are final]”

• Is the “transfer” the original transfer or the deemed

lapse/gift at death? E.g. if owner gifts shares in 2016 but dies in 2018, assuming this is after similar regs are made final, when is the “transfer”?

Three Year Rule – Prop. Treas. Reg. §25.2704-1(c)

35

• This could affect transfers made pre-final regulation if

the transferor dies within three years. Treasury will very likely clarify this and may ultimately resolve the uncertainty with a more taxpayer-favorable

• interpretation. Nonetheless, we have to warn clients
• f “clawback” possibility, even if regs take 2 years

to finalize.

• WORSE: it may lead to phantom inclusion that does

NOT qualify for the marital deduction (there is a marital deduction valuation symmetry in proposed §2704(b) regulations (see highlighted portion of preamble on page 20 of pdf and §25.2704-3(g) Ex 4, but this is not mentioned anywhere in §25.2704-1.

Three Year Rule – Prop. Treas. Reg. §25.2704-1(c)

36

• Calculating the value of the lapse under the three

year rule is uncertain. The regulations state that the value is calculated by comparing the value of the interests before and after the lapse (see current Reg. §25.2704-1(d)).

• But, is this at the time of the gift, or at the time of

death when the deemed lapse occurs? I believe the latter.

Three Year Rule – Prop. Treas. Reg. §25.2704-1(c)

37

• Practical example of what would change:

Dad Donor owns 100% of DonorCo, worth $10 million. He gifts three 20% full membership/voting shares to his

• children. Let’s assume for now that 2704(b) does not

apply– at 30% discount this is a $4.2 million gift. If Dad Donor dies two years later, the proposed regulation would cause a taxable lapse of Dad’s previously held right to redeem/liquidate DonorCo, the value of which would be added to Dad Donor’s estate. Let’s say in 2 years DonorCo is now worth $11 million. So, Dad Donor’s 40% share that might have been $3.08 million discounted will now have §2704(a) additional inclusion of $1.32 million for a total of $4.4 million. However, if Dad Donor leaves this to his wife, the marital deduction may only be $3.08

• million. Basis to wife?

Three Year Rule – Prop. Treas. Reg. §25.2704-1(c)

38

But wait, there’s more – it’s not just the value of the retained portion of the stock that is increased!

• What about the value of the three gifts of 20% of DonorCo two

years earlier? The value of the inclusion would be calculated by comparing the value at the time of death with or without the lapsed control. This may cause more inclusion than the prior discount! For example, in our previous slide, gifts were 3x$1.4 million=$4.2 million. But the proposed §2704(a) inclusion would likely be based on the value 2 years after the gift, at death -10% higher. Not $6 million minus $4.2 million (the $1.8 million “discount” valued two years earlier at time of gift), but $6.6 million minus $4.62 million (amounts two years later at death)=$1.98 million. In other words, you don’t get the two years growth removed from the estate either (at least, not all of it)!

Three Year Rule – Prop. Treas. Reg. §25.2704-1(c)

39

• It is unclear whether any increased valuation resulting from

§2704 or the proposed regulations leads to an increased income tax basis pursuant to §1014, because the statute and regs specifically limit application “for purposes of this subtitle”, which is estate, gift and GST tax, not income tax.

• See attached LISI article. Estates that are required to file

estate tax returns pursuant to Section 6018 (which would be most of the people we are trying to actively do estate tax planning for) have a good argument that basis should symmetrically follow estate tax valuations. However, even this is uncertain for “phantom” inclusions (e.g., in our prior example, the amount added to the three 20% gifts, not the 40% retained, which is clearer) – the basis could be reduced by depreciation taken post-transfer per §1014(b)(9)

Effect of 2704 Application on Income Tax Cost Basis

40

• Prop. Treas. Reg. 25.2704-2 and Applicable

Restrictions: Attacking State Laws Causing Higher Discounts by Prohibiting Withdrawal

41

• Section 25.2704-2(b) provides, in part, that an applicable

restriction “is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.”

• This regulation amends §25.2704-2 to refine the

definition of the term “applicable restriction” by eliminating the comparison to the liquidation limitations

• f state law (sorry Nevada!), if there are comparable

state law alternatives that would not have such limitations – see highlighted portion on page 33 of pdf.

• In explaining the three year rule, we assumed that the

traditional discounts were still in place. In explaining the three year rule, the §25.2704-1 regulations do not mention any application of §2704(b) or proposed §25.2704-3 in the examples to such transfers in the first place.

• Back to our earlier example, if I gift three 20% interests and

retain 40%, are these three gifts entitled to the same discounts as previously in most cases, or do the proposed §25.2704-3 regulations only apply to a narrow subset of restrictions and less common situations? This is the big debate. If discounts are mostly removed by 2704(b) anyway, then the proposed three year rule is close to meaningless.

• I will refer to the two interpretations as “weak” (not having

much valuation effect at all) or “strong” (profound effect).

Prop Reg. §25.2704-3: “Disregarded Restrictions”

42

• Does this, as some argue, create a minimum value, a “put

right”? This “strong” interpretation would effectively eliminate most of a discount for lack of marketability or lack of control, because someone would be deemed to have access to the underlying assets for valuation (with a mere 6 month delay). This interpretation has caused the huge uproar in the business

• wner community, and has been widely disseminated by many

noted experts.

• Or, is 2704-3 just an awkwardly worded and confusing

provision that has very little effect on traditional discounts at all? Informal comments by Treasury officials are indicating this is the more likely interpretation that should be clarified upon finalization.

• If this “weak” version holds, §25.2704-3 is a big yawn.

“Disregarded Restrictions” in §25.2704-3 – the Debate

43

• Prop. Reg. §25.2704-3 “The term disregarded restriction means a

restriction that is a limitation on the ability to redeem or liquidate an interest in an entity that is described in any one or more of paragraphs b)(1)(i) through (iv) of this section, if the restriction, in whole or in part, either lapses after the transfer or can be removed by the transferor or any member of the transferor’s family (subject to paragraph (b)(4) of this section), either alone or collectively.” If you stop reading here, you see why the effect may be mild – if you don’t restrict someone from selling their interest, no big deal, this is not triggered, keep your discounts. What has unfortunately led to the confusion is how Treasury described the restrictions in paragraphs i-iv. See p. 16 of pdf for preamble’s discussion, p. 36 for reg’s definition.

“Disregarded Restrictions” in §25.2704-3 – the Debate

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(i-iv), on page 36-37 of the uploaded pdf, are too long to paste in a slide, but summarized, includes provisions that: i)limit the ability to sell (easy to understand) ii)limit the ability to sell for less than a “minimum value” (OK, sounds easy, just avoid adding any such restriction, but it is very convoluted the way they word it because they imply there is a minimum value of the interest based on pro rata value of the entity) iii)limit the ability to get payment for more than 6 months iv)limit the ability to get cash/property for interest (no notes) “Disregarded Restrictions” in §25.2704-3 – the Debate

45

Ed’s take: the restrictions that are disregarded only pertain to the ability to redeem or liquidate an interest in an entity, not the ability to liquidate the entity itself. In a typical situation, you do not limit or prevent an owner from: i) selling; ii) selling for more than $X; iii) getting paid immediately; or (iv) getting cash/property for sale.

The examples in the regulations imply that the same discounts apply, except for the effect of disregarding the specific provision, valued under “generally accepted valuation principles” (e.g. in Ex. 1-5 on page 44-46 of the attached regs, the 33% share is still valued as a 33% share, but just with the right to sell it on open market. If they had meant to force valuation based on put right, wouldn’t they simply say directly that the 33% is valued at “minimum value” in the examples?)

“Disregarded Restrictions” in §25.2704-3 – the Debate

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Here are examples of provisions that might still be disregarded for valuation, even under the “weak” interpretation of the regs (i.e. no big effect):

• prohibition on withdrawal (obvious from examples);
• party receives or can only receive assignee interest (also

covered in §25.2704-1), or

• the right of first refusal allows the company to purchase

but only pay with issuance of a note. Treasury could have avoided a lot of controversy with clearer examples! The key question: if a party cannot withdrawal and demand pro rata purchase, yet can sell interest on open market, is the inability to instantly redeem a “disregarded restriction” (aka “strong interpretation”)? “Disregarded Restrictions” in §25.2704-3 – the Debate

47

Argument for the 6 month put right: What if documents are merely silent on restrictions (in some cases you may not even HAVE an operating agreement)? For instance, a document might restrict an owner from having the ability to withdrawal and be paid for the interest, or dissolve the company and receive a pro rata share, but these are usually baked into state law without needing to be drafted into an operating agreement. Are the lack of such powers “disregarded restrictions”? Is the fact that state law or document does not grant liquidation or dissolution rights a “limitation on the ability of the holder of the interest to compel liquidation or redemption of the interest”? “Disregarded Restrictions” in §25.2704-3 – the Debate

48

Would Treasury go to all the trouble of the regulations to merely bite at the periphery attacking only extreme state law effects or outright prohibitions on sale or withdrawal that are not often used?

• Perhaps. “The term disregarded restriction means a restriction

that is a limitation on the ability to redeem or liquidate an interest in an entity” – this phrase should not be interpreted to impose a right to redeem or liquidate an interest in an entity for a minimum amount. That said, many more distinguished practitioners than I think

• therwise, so I’m going to warn clients anyway until clarified.

“Disregarded Restrictions” in §25.2704-3 – the Debate

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Obviously the “strong” interpretation of 2704-3 would have extremely profound valuation effects! The “minimum value” is the net value of the entity multiplied by the interest’s share of the entity. (see page 17 (preamble), page 36 of handout). The “put right” is a right, enforceable under applicable local law, to receive from the entity or from one or more

• ther holders, on liquidation or redemption of the holder’s

interest, within six months after the date the holder gives notice of the holder’s intent to withdraw, cash and/or other property with a value that is at least equal to the minimum value of the interest determined as of the date of the liquidation or redemption (page 42 of handout) “Disregarded Restrictions” in 25.2704-3 – if the “strong” interpretation applies

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Example: Francis, Tim and Jeff own an LLC worth $12 million. They are

• unrelated. Their 1/3 share should still be valued under the old “fair

market value” principles for gift/estate tax – perhaps a 20-40% discount- perhaps $ 3 million value. However, if a funded buy-sell agreement formula mandates the buyout

• f a deceased owner for a pro rata value of $4 million (not uncommon

for unrelated parties), it would be valued at $4 million regardless. Beware: if Jeff retires or dies and Francis and Tim buy him out (regardless of whether it is for $3 million or $4 million), 2704 may now be triggered because they own 50% (again, the remaining “discount” after §25.2704-3 application is unclear, but the three year rule application could still be quite impactful)

Contrasting Effect - Related and Unrelated Parties

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Contrast, if Francis, Tim and Jeff in our prior hypothetical were brothers, each of their interests may be valued closer to $4 million for estate tax purposes under the proposed regulations, even if there is no buy sell agreement, even if they hate each other and always litigate, even if the widow/estate of owner is later bought out for $3 million! (again, this effect is debated) In most families, siblings control each other as much as we control the wind, moon and tides, yet the IRS may attribute collusion regardless. Similarly, 50% ownership of a company is hardly control, yet the regulations force higher valuation, especially if three year rule to apply (e.g. if 51% owner gifts 2% and retains 49%).

Contrasting Discount - Related and Unrelated Parties

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Example: Francis, Tim and Jeff are brothers and own real estate or artwork as tenants-in-common worth $12 million. Their 1/3 interest should still be valued under the old “fair market value” principles for gift/estate tax – perhaps a 15-30% discount (less “discount” typically than an LLC/LP)- perhaps $ 3.2 million value, unaffected by the proposed regulations. The new regulations only affect entities. However, except for the rare case of siblings inheriting property from a parent, most people will co-own real estate through a limited liability entity for superior ease of transfer and asset protection. But, consider, what about Francis, Tim and Jeff contributing their 1/3 tenancy in common to their own three separate LLCs? Potential IRS attack: depending on the level of cooperation and coordination, the IRS might find such joint ventures/TICs to be de facto partnerships for tax purposes. See Rev. Proc. 2002-22 for discussion. While tenancy in common agreements are recommended, a restriction on partition may be disregarded. IRC §2703

Contrasting Discount for Non-Entities, Tenancies in Common

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Effective Dates

• Some of the regulations become effective upon immediately after the

regulations are published as final, but the most substantial and far- reaching rules will not take effect until 30 days after that. Prop. Reg. §25.2704-4 (page 49-50 of pdf). They could be made final in December, January, or likely months later (it could take years). The important point is that we have time to plan.

• There is a strong possibility that regulations may be modified or even
• verturned (more likely if the “strong” 6 month put right interpretation

applies), but it may take years – safest to plan for the worst.

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Proposed 2704 Regulations Exceed IRS’ Authority

James G. Blase, CPA, JD, LLM Blase & Associates, LLC

• St. Louis, MO

314-909-6565 jimblase@blaselaw.com

Proposed Section 2704 Regulations Exceed IRS’ Authority

 Note bills in both House and Senate along the same lines.

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“And/or” Change

 The IRS has attempted to add regulations that change the law so that no longer must the control of the entity immediately before the lapse or transfer be in the hands of the transferor and members of their family, as required by both Internal Revenue Code Section 2704(a) and 2704(b), but instead control immediately before the transfer need only be in “the transferor and/or members of the transferor’s family.”

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“And/or” Change

 The Conference Committee Report that accompanied the passage of IRC Section 2704 in 1990 was very specific in including the requirement that control of the corporation or partnership immediately before the lapse or transfer be in “the transferor and family members,” and included this concurrent arrangement in all three of its examples illustrating the application of IRC Section 2704(a) and 2704(b).

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“And/or” Change

 The Internal Revenue Service has clearly exceeded its regulatory authority by changing the Congressionally-imposed “and” to an IRS-imposed “and/or.”

 Congress gave the IRS authority to disregard

• ther restrictions, which the IRS clearly has

done by proposing new Treasury Regulations Section 25.2704-3, but Congress didn’t grant the IRS authority to make other unilateral changes to the IRC, which it clearly has also done by changing the key concurrent word “and” to the concurrent or disjunctive phrase “and/or.”

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“And/or” Change

 Evidence that Congress knew how to employ the concurrent and disjunctive “and/or” concept can be found in the separate IRC Section 2704(b)(2)(B)(ii), which deals with the situation after the transfer: “The transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.”

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“And/or” Change

 The IRS itself has also demonstrated that it understands the difference between the “immediately before” and “after” sections and the use of the word “and” versus the phrase “and/or,” by choosing to employ the following language in proposed regulation Section 25.2704-2(b)(1): “. . . if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor’s estate, and/or any member of the transferor’s family, either alone or collectively.”

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“And/or” Change

 The preamble to the proposed regulations likewise illustrates that the IRS recognizes that Congress intended the word “and” to mean concurrent ownership only:

 The legislative history of section 2704 states that the provision is intended, in part, to prevent results similar to that in Estate of Harrison v. Commissioner, T.C. Memo. 1987-8 . . . In Harrison, the decedent and two of his children each held a general partner interest in a partnership immediately before the decedent’s

• death. . . .

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“And/or” Change

 Finally, note that the IRS’ current “immediately before” regulations do not employ the proposed “and/or” wording, but rather track the Code’s “and” wording. Thus, for whatever the reasons, the decision was apparently made to change the concurrent word “and” to the concurrent and disjunctive phrase “and/or.”

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“And/or” Change

 Relevance

 An owner owing 100% of an entity may have his or her minority, etc. discounts severely reduced when making lifetime gifts of the entity to his or her children, as the restrictions on liquidation and lack

• f voting control could be ignored.

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“And/or” Change

 Relevance

 A possible planning technique around Section 2704 completely would be to transfer the 100% interest in the entity to an “incomplete gift” irrevocable trust where the transferor retains no interest

• ther than the ability to allocate the

entity among family members.

 But this technique fails when the “and/or” change is read into the law.

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Deemed Lapse at Death

 If a transfer of an interest “results in” a lapse of a voting of liquidation right within three years of the transferor’s death, the Service will deem that the lapse occurred at death.

 Again, there is no authority in the Internal Revenue Code which would allow the IRS to change the law in this fashion.

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Deemed Lapse at Death

 Relevance

 If the deemed lapse at death is invalid, and no attempt is made by the IRS to tax resulting lapses for federal gift tax purposes, then the only valuation argument remaining on the typical minority interest lifetime transfer is the Section 2704(b) applicable restriction argument, which again fails if the “and/or” change fails.

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Disregarded Restrictions

 The entire proposed regulation (PR) Section 25.2704-3 on disregarded restrictions misses a vital requirement of the enabling Internal Revenue Code Section 2704(b)(4). That section includes the prerequisite that the disregarded restriction “not ultimately reduce the value of such interest to the transferee.”

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Disregarded Restrictions

 In each of the four situations described in PR subparagraphs (i) through (iv) of Section 25.2704-3(b)(1) involving various limitations on the ability to redeem or liquidate an interest in any entity, however, the value of the interest in the transferee is ultimately reduced. Therefore, all of the “disregarded restrictions” listed in PR Section 25.2704-3 are invalid.

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Removal of Restrictions

 The PRs incorrectly extend the attribution rules (including the trust attribution rules) referenced at Section 2704(c)(3) to the requirement that the restrictions must be removable after the transfer by the transferor and/or members of the transferor’s family.

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Removal of Restrictions

 Section 2704(c)(3) provides that “[t]he [attribution] rule of section 2701(e)(3) shall apply for purposes of determining the interests held by any individual.” The “interests held by any individual” language is referenced in the IRC Sections 2704(a)(1)(B) and (b)(1)(B) prerequisites that the transferor and members of the transferor’s family “hold” control of the entity, and in the Section 2704(a)(2) determination of the value of the lapsed voting or liquidation right.

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Removal of Restrictions

 This same “held” language isn’t employed as part of the Section 2704(b)(2)(B)(ii) requirement that “[t]he transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.”

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Removal of Restrictions

 Thus, for example, if the limited entity interest is transferred, either during lifetime

• r at death, to an irrevocable trust that

includes an independent trustee or co- trustee, how can it be said that: “[t]he transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.”

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Removal of Restrictions

 To remove the restriction, the family members would need the consent of the independent trustee or co-

• trustee. There’s nothing in the IRC

that authorizes a “deemed” or “attributed” consent concept in the right to remove the restriction context.

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Disregarded Restrictions Held by Non-Family Members

 Although the IRS arguably has the authority to disregard de minimis or nominal ownership interests generally, the question is whether the proposed regulations have exceeded this authority.

 The three-year, 10 percent, 20 percent and put right requirements add up to a very significant interest indeed, far exceeding what’s generally thought to be a de minimis or nominal interest.

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Planning Opportunities and Strategies

Ed Morrow Director, Family Wealth Consulting Group Key Private Bank Topic Presented by Entire Panel

• Short Term GRATs often use non-family entities for funding

anyway (because distributing in kind with a discount going

• ut as necessary for 2-3 year GRAT removes most benefit
• f discount anyway) - these will not be affected
• Even if the proposed regulations are made final (and the

more stringent “deemed 6 month put” interpretation valid), many gifting strategies will still be highly effective and continue to be used, especially over the longer term, because grantor trust status permits tax-free gift by paying the tax, and growth is still outside of estate. Over time, these two factors dwarf the value of the discount.

• Volatile assets may be well suited to GRATs, whereas

more stable ones to IGTs, since GRATs do not waste any seed gift if the value of the asset decreases. GRATs can adapt to increased valuation uncertainty!

Planning Opportunities that Will Remain Effective

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• If the estate tax value increases due to §2704, is the buy-sell

agreement buyout tied to that number in any way?

• If it is not, should it be (if so, when)? Phantom estate value occurs

if $X is in estate, but estate receives $.64X (non-family buy-sells usually do not discount).

• There is no obvious answer, it depends on the situation, but

parties should make sure they agree on result - the three year rule may create the nastiest valuation difference

• The difference between estate tax value and “fair market value”

could be significant and may lead to expensive non-tax litigation!

• Buy-sells where other family members are or may become
• wners should be reexamined. Buy-sells with non-related parties

are not as likely to be affected, but verify.

Old Buy-Sell Agreements – a Ticking Time Bomb?

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• The election – Secretary Clinton has proposed estate/gift

tax changes that would decrease the estate/gift tax exclusion from $5.45 million (current) to $3.5 million, and increase the gift/estate tax rates from 40% to 45%, with 50% rate > $10 million, 55% rate >$55 million, 65% rate bracket for estates > $500 million

• Current historically low applicable federal rates – August

2016 is only 0.56% (short term), 1.18% (mid-term) and 1.9% (long-term) – 7520 rate only 1.4% - these favor techniques that include loans

• Many taxpayers made large gifts in 2012 before the “cliff”

and the statute of limitations on the gift tax return has safely passed, giving them more comfort level to make additional gifts

Other Factors Impacting the Decision to Plan in 2016

79

• Tom Clancy’s estate just had a nasty estate tax

apportionment battle causing years of litigation (see short article posted on LinkedIn by Ed Morrow)

• The “phantom inclusion” of §2704, especially more

likely for gifts within three years of death, could cause nasty tax apportionment battles – if I get stock worth $X, but the estate has to pay combined state and federal tax of 50% on a higher value of $1.5X, who pays the additional tax cost? If there is only one residuary beneficiary, that’s easy, but many estates with business interests will have specific bequests and blended families. Tax Apportionment Traps; Adapting to Three Year Rule

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Discount Planning in Light of the Proposed 2704 Regulations

James G. Blase, CPA, JD, LLM Blase & Associates, LLC

• St. Louis, MO

314-909-6565 jimblase@blaselaw.com

Potential Action Steps Before the Proposed Regulations Become Final

 Obviously individuals who are concerned about future valuation discounts will want to consider making transfers, either by gift or by sale, before the proposed regulations become final, which could be as early as January.

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Potential Action Steps Before the Proposed Regulations Become Final

 This planning generally should also involve making sure no gift taxes are paid, and minimizing income taxes on sales, potentially through the sale to an intentionally defective trust technique.

 In some situations it may actually be advisable to intentionally pay gift taxes. For example, if Secretary Clinton is elected President, there is a Democratic majority in the House and Senate, and the client is

• lder but is expected to live at least three

years.

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Incomplete Gift Trust

 This concept attempts to avoid Section 2704 in its entirety.

 The entity is transferred to an irrevocable trust which qualifies as an incomplete gift but which is also not a grantor trust.  The grantor/transferor retains no interest in the trust other than the ability to direct gifts out of the same to his or her descendants (i.e., not a spouse).

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Incomplete Gift Trust

 Minority interest gifts are then made from the trust to descendants, but of course only after considering the step transaction doctrine.  Section 2704 theoretically should not apply to the gifts, since immediately before the same the client “and” members of his or her family did not control the entity.

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Incomplete Gift Trust

 If at the transferor’s death, only a minority interest is owned by the incomplete gift trust, it too should not be subject to Section 2704.  The plan does not work under the IRS’ proposed 2704 regulations, however, because of the IRS’ change

• f the Code “and” language to

“and/or” language.

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The Future of Discount Planning

 Per the proposed regulations, “[i]f a restriction is disregarded under this section, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the disregarded restriction does not exist in the governing documents, local law, or

• therwise.”

87

The Future of Discount Planning

 What this basically means is that the transferor could have liquidated his or her interest and received a pro rata value of the entity’s underlying assets.  The proposed regulations then make clear that minority and other discounts may apply to this value.

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The Future of Discount Planning

 Thus, for example, as a 20% shareholder I may be deemed to have received a 20% interest in a photocopy machine. But as a minority owner of the machine, what can I really do with it?

 Nothing in the proposed regulations says that we are to deem the machine sold by the entity, and the transferor received 20% of the net (i.e., after tax) proceeds.

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The Future of Discount Planning

 Similarly, and in most cases to an even greater extent, when an

• perating entity is deemed liquidated,

the value of its underlying assets can become largely irrelevant, so minority interests remain largely unaffected by the proposed regulations.

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Contact Information for Panelists:

• edwin_p_morrow@keybank.com or edwin.morrow3@gmail.com
• jimblase@blaselaw.com
• switkin@BlankRome.com

Thank You

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