The following article was written by Steven A. Horowitz, a tax attorney that Avenue M Advisors, Inc. works with and we found the article to be very compelling
about the new proposed regulation changes under IRC §2704(b).
The Background To Chapter 14 of the Code
When I was a very young, neophyte lawyer, the United States Congress undertook to create a set of rules to eliminate the use of what were then called “Recap Freeze transactions”. In essence their mission was to eliminate certain types of transactions that were being used by various tax and estate planning practitioners to minimize the estates of their wealthy clients without the imposition of a gift tax in the process. The goal of the practitioner was to “freeze” the value of an enterprise (be it a family business enterprise, or a family real estate holding company) in the hands of the senior generation family member-owners at its then current fair market value, and shift the appreciation into the hands of the next generation (or generations beyond) by recapitalizing the entity into preferred and common interests. In a nutshell, the claim was that the preferred stock or partnership interests would have all of the appraised equity value retained unto it by virtue of certain liquidation preferences, a preferred coupon, and a “put right” retained by the senior generation, which the appraiser would certify was equal to one hundred percent (100%) or more of the current fair market value of the business being operated, or of the real estate then held by the entity; and the common class of interests would have an initial value of zero (0) but was entitled to one hundred percent (100%) of the growth in value of the business above the current value or the “put right value.”
There were many such Recap Freeze Transactions undertaken and implemented between 1960 and up through December of 1986 (the effective date of Section 2036(c). Some practitioners even continued to engage in making these transactions for their clients after 1987, because they realized that 2036 (c) was more likely than not unconstitutional and the call for its repeal was then appearing in all of the major tax and estate planning journals, resonating within the walls of the Treasury Department, and even echoing through the hallowed halls of the two houses of Congress. Truth be told, the mission of Congress in enacting 2036(c) to stop the abuses of the Recap Freeze, was both a noble and essential one. They just went about it the wrong way, and stepped on the Constitution and the realities of the Transfer tax system in the process. By 1985/86, it was readily apparent that the “envelope” was being pushed and stretched in far too many directions with regard to the Recap Freeze. The operational economics and business realities were such that the Senior Generation holders of the “Preferred Interests” were actually helping to build the value of the “Common Interests” at their own expense. They did so via conducting the business and decreasing their compensation, in failing to pay the annual coupon, which they had retained, and by failing to make that Preferred Coupon cumulative.
The net effect of all of these things was the creeping accretion in value of the Common Interests via the swelling of the retained earnings accounts, which were then adding to the value of the Common Interest held by the Junior Generation. Essentially, the creative design of the generation of tax and estate planners who were engaging in these transactions during that time was clearly a form of envelope pushing very much like the Grantor retained income trust which used discounts based upon the ten percent (10%) Treasury Tables set forth in the pre-Section 7520 Treasury Regulations under Regulations Section 25.2512-5, whereby a ten percent (10%) interest factor was used to discount assets producing near zero current cash flow to present value and thereby artificially serve to reduce the value of gifts and provide a significant benefit for the Trusts’ remainder beneficiaries.
In essence, very much like the FLP of the 1990s and 2000s, the GRIT and the Recap Freeze had been designed by practitioner engineering to artificially destroy the economic underpinnings of the techniques, and save their clients millions of dollars of transfer tax while parting with nothing of real value. As such, both the Recap Freeze transaction and the Common Law GRIT were deserving of some degree of curtailment, but Section 2036 (c) was a swinging of the pendulum, which was ill-conceived, misplaced, overly broad and unconstitutional and was repealed retroactively in October of 1990, via the enactment of Chapter 14 and Sections 2701 through 2704 of the Code. The effective date for the GRIT replacement by the GRAT in Section 2702, was September 10, 1990. Chapter 14 was designed to clean up the mess of 2036 (c), curtail the pre-adoption abuses, give both the Internal Revenue Service (the “IRS” or “Service”) a set of rules to live by, a workable statutory and regulatory framework which would limit the amount of revenue loss of the public fisc, etc., while enabling the smooth transition of family business enterprises and family real estate holding and other family wealth from one generation to the next without too much depletion for transfer taxes. This was especially important in the early nineties, when high interest rates dominated the business environment and therefore, Section 6166 deferral was not really a workable solution for most companies because of the burden that it put on the business cash flow.
The Response from the Practitioner Community and the Business Community: Everything from “What’s all the Hoopla About?” to “These Regulations Are In-Line with the Treasury Green book Proposed Budget of President Barack Obama”.
An article (David Pratt, Dana Foley & Daniel Hatten on the Recently Proposed Section 2704 Regulations: What’s All the Hoopla About? Leimberg’s Estate Planning Newsletter August 10, 2016) that was written by three very knowledgeable and well respected estate and tax planning attorneys asks “what the hoopla is about” and decries the fact that these proposed regulations are in line with the budget proposals of the President of the United States. The hoopla is about four words: REAL WORLD ECONOMIC REALITY, and the factors, which govern and guide business valuation in the commercial marketplace of mergers and acquisitions on a daily basis. The Treasury Department doesn’t have the mandate to wipe those things away and play let’s pretend they don’t exist for estate and gift tax purposes. As a result of this fact, the proposed regulations of 2704(b) not only violate the statutory enabling language of Chapter 14, Section 2704, they are not constitutionally valid under the Due Process Clause as an improper taking of the property and property rights of an individual. Likewise, these proposed regulations are both over-reaching and an evisceration of the doctrine of economic reality principles of both state property law rights and their governance of the treatment of assets for transfer tax purposes. Moreover, they decry the principles of economic reality used in business valuation set forth in Rev. Rul. 59-60 (1959-1 C.B. 237), the mother of all business valuation rulings and the deciding point of every business valuation case from the Estate of Daniel Harrison, (T.C. Memo 1987-8), to Estate of Mandelbaum, (T.C. Memo 1995-255) to the Estate of Paul Mitchell, (T.C. Memo 1997-461) to Rev. Rul. 93-12 (1993 C.B. 202).
IRS Aims To Stop Undervaluation Of Transferred Interests
The IRS proposed new rules on August 3, 2016, which are intended to prevent the undervaluation of transferred interests in corporations and partnerships for estate, gift and generation-skipping transfer tax purposes. The proposed regulations, affecting the transfer tax liability of individuals who transfer an interest in certain closely held entities but not the entities themselves, address deathbed transfers that result in the lapse of a liquidation right, clarify how transfers creating an assignee interest will be treated, and add a new section to address restrictions on the liquidation of an individual interest in an entity.
Under the new rules, which the IRS is seeking comments on before finalization, the form of an entity would be determined under local law, regardless of how the entity is classified for other federal tax purposes and regardless of whether it is disregarded as an entity separate from its owner under federal tax laws. A transfer which results in the restriction or elimination of any of the rights associated with the transferred interest is treated as a lapse, and the proposed rules will narrow the exception to the definition of a lapse of a liquidation right to transfers occurring at least three years before the transferor’s death. This three year no-lapse restriction provision which would otherwise result in the asset being deemed to lapse solely for transfer tax purposes should actually be more aptly placed, if at all, in the provisions of IRC Section 2035, an action which would require an act of Congress.
Under the new Section 25.2704-3 for family-controlled entities, the IRS said, restrictions on a shareholder’s or partner’s right to liquidate his or her interest in an entity will be disregarded if the restriction lapses after the transfer. These restrictions include those that limit the ability of an interest holder to liquidate that interest, limit the liquidation proceeds to an amount that is less than a minimum value, and defer the payment of the liquidation proceeds for more than six months.
The proposed regulations also introduce a new class of “disregarded restrictions” that include limitations on the time and manner of the payment of liquidation proceeds such as the deferral of full payment beyond six months. Exceptions that apply to existing restrictions would also apply to the new class of disregarded restrictions, the IRS said. The IRS said that the new rules are needed since existing regulations have been largely rendered ineffective by changes in state laws and court rulings.
For example, courts have concluded that the current regulations apply only to restrictions on the ability to liquidate an entire entity and not a transferred interest in that entity, the revenue agency said. The IRS is giving the public three months to submit comments on the proposals, and a public hearing is scheduled for Dec. 1 in Washington, D.C.
The Internal Revenue Service’s recent attempt to value transferred interests in partnerships and corporations for estate tax purposes more fairly could backfire under court scrutiny, according to experts who say the agency may have exceeded its regulatory powers by artificially inflating the market value of these transfers. The IRS, seeking comment from the public, on Tuesday proposed new regulations meant to prevent the undervaluation of transferred interests in corporations and partnerships for estate, gift and generation-skipping transfer tax purposes. The agency said it plans on disregarding restrictions on a shareholder’s or partner’s right to liquidate interest in an entity if the restriction lapses after the transfer, and the rules also introduce a new class of “disregarded restrictions” that include limitations on the time and manner of the payment of liquidation proceeds, such as the deferral of full payment beyond six months.
While the revenue agency does have the statutory right to disregard restrictions on liquidation rights for family-controlled businesses, it can only do so if these restrictions don’t affect the market value of the interests being transferred. However, as any business valuation professional and any investment banker will tell you, as well, the rights and restrictions imposed by state law and by agreement of the parties, are the very stuff of which all determination of the value of business interests are made. The proposed regulations basically assume a 10 percent interest holder has the right to liquidate the company or to withdraw 10 percent of the value of the company, and that’s simply not true as a matter of corporate or limited liability company law. They’re treating an individual as if he or she can do this because they, together with other family members control it, but in reality there is no such ability to mandate that any such actions and liquidation take place. The Treasury Department is once again trying to impose a theory of family attribution (an income tax provision codified by Congress in a multitude of income tax provisions such as Section 318, 267, etc.) onto the transfer tax. This simply does not exist and the Service lost nearly one dozen cases before the U.S. Tax Court in which that argument, originally promulgated in Rev. Rul. 81-253 (1981-2 C.B. 187) and specifically revoked after the Berg case (Estate of Berg v. Commissioner, 976 F.2d 1163) in Rev. Rul. 93-12 (1993-1 C.B. 202). For both gift tax, estate tax and GST Tax purposes there is a basic realization, that one who owns an interest in a business entity or real estate entity is not going to be able to force his or her siblings to sell just because he or she wants them to, or because he or she has to pay a tax bill. Likewise, there is a realization that the economics of the situation from a hard and fast standpoint are such that the owner of such a minority interest is going to be offered significantly less in the real world by a third party willing buyer.
The rules introduced by the IRS will ultimately raise estate taxes by making people report a much higher value for their company than they would under current law. The agency said the rules were needed because existing regulations have been largely rendered ineffective by changes in state laws and court rulings, and it wanted to stop family-owned businesses from being able to make transfers with discounts and restrictions that it deemed unreasonable. Experts say the proposed regulations are complex and will require more time to parse through to truly understand their full scope, but their early analyses suggest the rules are overly broad, fail to provide clarity and may instead be adding confusion to the tax treatment of these transfers. The immediate impact of the rules is that they put family-owned businesses under a great deal of pressure to complete affected transactions before the end of the year when the rules may get finalized, experts say. A public hearing on the proposals is scheduled for Dec. 1.
There are professionals who have explained the obvious, to wit: that the agency is really trying to do away with the practice of senior generations restructuring a business while allowing the future value to go to the younger generation in the family while escaping estate and gift taxes. For people who try to use various restrictive and entity based techniques such as FLPs and FLLCs in an attempt to discount their assets so they can get more out of their estates, the IRS is clearly, and without appropriate authority, trying via these proposed regulations to reduce or eliminate the ability to do so. If you’re unable to get as much value out of your estate by doing this kind of planning, then you would have more value left in your estate that is subject to estate tax. The proposed regulations also disregard provisions that individual states allow, contrary to what the Internal Revenue Code provides, and as such the rules are both unenforceable and likely unconstitutional, if enacted in their current form.
I have often suggested that when a tax lawyer argues that a provision in the Code or the Treasury Regulations is unconstitutional, that he or she must be either desperate or out of his or her mind. However, these Proposed Regulations are so overly defiant of the realities of the economics of business and so devoid of the consideration of state law property rights and its control over the valuation of property/ assets for gift and estate tax purposes, that the maxim holds no water in this situation. While the Secretary of the Treasury may be empowered under the Statute to promulgate regulations in the context of Chapter 14, they MUST, nevertheless be consistent with the intention of the statute. The intention of Congress in enacting Section 2704(b) in 1990 was not to change state law property rights and create a regime whereby fantasy once again overwhelms the transfer tax system. After all, that was why they repealed Section 2036(c) and replaced it with Chapter 14 twenty-six years ago, in the first place. Economic reality and state law property rights must be more appropriately represented in any set of regulations that the Treasury Department is going to put forward.
By: Steven A. Horowitz
Partner, Horowitz and Rubenstein, LLC