The IRS has issued proposed regulations governing limiting the use of certain liquidation restrictions in reducing the value of property for gift and estate purposes in REG-163113-02.  These regulations attempt to breathe life back into IRC §2704 that was part of the “Chapter 14” provisions Congress added in 1990s.

The “Chapter 14” provisions were Congress’s attempt in 1990 to eliminate the use of what they viewed as “artificial” valuation discounts by taxpayers in estate planning—effectively looking at items such as family limited partnerships.  However the law and the implementing regulations proved rather ineffective in practice, as planners, taxpayers and state legislatures combined to make the provisions effectively toothless.

IRC Section 2704 is the focus of these regulations, which looks at “applicable restrictions” which will be effectively ignored for valuation purposes.  IRC §2704(b)(2) provides:

(2) Applicable restriction.  For purposes of this subsection, the term “applicable restriction” means any restriction—

(A) which effectively limits the ability of the corporation or partnership to liquidate, and

(B) with respect to which either of the following applies:

(i) The restriction lapses, in whole or in part, after the transfer referred to in paragraph (1).

(ii) 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.

In Reg. §1.2704-2(b) the IRS defined an “applicable restriction” as follows:

(b) Applicable restriction defined.

     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. A restriction is an applicable restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or the transferor (or the transferor's estate) and any members of the transferor's family can remove the restriction immediately after the transfer. Ability to remove the restriction is determined by reference to the State law that would apply but for a more restrictive rule in the governing instruments of the entity. See section 25.2704-1(c)(1)(B) for a discussion of the term "State law." An applicable restriction does not include a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity's trade or business operations whether in the form of debt or equity. An unrelated person is any person whose relationship to the transferor, the transferee, or any member of the family of either is not described in section 267(b) of the Internal Revenue Code, provided that for purposes of this section the term "fiduciary of a trust" as used in section 267(b) does not include a bank as defined in section 581 of the Internal Revenue Code. A restriction imposed or required to be imposed by Federal or State law is not an applicable restriction. An option, right to use property, or agreement that is subject to section 2703 is not an applicable restriction.

One of the IRS’s key losses occurred in the case of Kerr v. Commissioner, 113 TC No. 30 (1999), aff'd, 292 F.3rd 490 (5th Cir. 2002) where the estate escaped the impact of IRC §2704 and the regulation based on the following:

• The rule only applies to the ability to liquidate the entire entity and not an individual equity holder’s ability to force a redemption of his/her interest by the entity;
• The rule, as provided for in an exception found only in the regulation, only applies to a restriction that is more onerous than applies under state law (in Kerr the Court found the IRS wasn’t looking to the correct state law provision in running this test);
• The application of default state law meant that a transfer to an assignee rather than to a partner is tested under the limitations a law imposes on an assignee; and
• The inclusion of a nonfamily member (a charity in the case of Kerr) meant that the family acting alone could not remove the restriction.

These regulations seek to reverse the Kerr holding in its entirety.  The IRS, after 17 years, seems to have taken up the Tax Court on the invitation it gave towards the end of the Kerr decision where the Court noted:

We are mindful that the Secretary has been vested with broad regulatory authority under section 2704(b)(4). However, the regulations in place do not support a conclusion that the disputed provisions in the KFLP and KILP partnership agreements constitute applicable restrictions.

Normally we don’t spend much time on proposed regulations that are not issued simultaneously as temporary regulation or contain a provision allowing taxpayers to rely on the regulations prior to their issuance as final regulations.  But since these regulations affect estate planning which, by its nature, will be greatly impacted by any changes these proposed regulations deserve some study.

In this case, the proposed effective date would have these regulations apply to the lapse of any right created on or after October 8, 1990 that occurs on or after the date these rules are published as final in the Federal Register.  Thus, a family limited partnership created today would have these apply when they are issued as final—and the nature of the planning in this area could mean it would be very difficult or even impossible to revise the plan to take these rules into account.

The proposed regulations would create three categories of entities that would be tested for application of “state law” restrictions.  As the preamble notes:

As a result, for purposes of the test to determine control of an entity and to determine whether a restriction is imposed under state law, the proposed regulations would provide that in the case of any business entity or arrangement that is not a corporation, the form of the entity or arrangement would be determined under local law, regardless of how it is classified for other federal tax purposes, and regardless of whether it is disregarded as an entity separate from its owner for other federal tax purposes. For this purpose, local law is the law of the jurisdiction, whether domestic or foreign, under which the entity or arrangement is created or organized. Thus, in applying these two tests, there would be three types of entities: corporations, partnerships (including limited partnerships), and other business entities (which would include LLCs that are not S corporations) as determined under local law.

For purposes of “control” tests the proposed regulations provide:

The proposed regulations would clarify, in § 25.2701-2, that control of an LLC or of any other entity or arrangement that is not a corporation, partnership, or limited partnership would constitute the holding of at least 50 percent of either the capital or profits interests of the entity or arrangement, or the holding of any equity interest with the ability to cause the full or partial liquidation of the entity or arrangement. Cf. section 2701(b)(2)(B)(ii) (defining control of a limited partnership as including the holding of any interest as a general partner). Further, for purposes of determining control, under the attribution rules of existing § 25.2701-6, an individual, the individual's estate, and members of the individual's family are treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.

The current Reg §1.2704-1(c)(1) provides a special rule that applies if the transfer of the interest results in the lapse of a liquidation right.  For instance, the transferor may have held a sufficient interest in the entity prior to the gift to unilaterally have forced liquidation, but the gift might serve to reduce the transferor’s interest below that magic level.  Thus the regulation as currently written provides:

Except as otherwise provided, 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.

The IRS now wants to impose a “three year” rule on the relief—that is, if the transferor doesn’t survive the gift date by three years, the exception would no longer apply.  The revised regulation would add the following language:

The lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor's death is treated as a lapse occurring on the transferor's date of death, includible in the gross estate pursuant to section 2704(a).

The regulations also greatly modify the “local law” exception, effectively removing the current rule.  Proposed Reg. §1.2704-2(b) would be revised to add the following at §1.2704-2(b)(2):

(2) Source of limitation. An applicable restriction includes a restriction that is imposed under the terms of the governing documents (for example, the corporation's by-laws, the partnership agreement, or other governing documents), a buy-sell agreement, a redemption agreement, or an assignment or deed of gift, or any other document, agreement, or arrangement; and a restriction imposed under local law regardless of whether that restriction may be superseded by or pursuant to the governing documents or otherwise. For this purpose, local law is the law of the jurisdiction, whether domestic or foreign, that governs the applicability of the restriction. For an exception for restrictions imposed or required to be imposed by federal or state law, see paragraph (b)(4)(ii) of this section.

Reg. §1.2704-2(b)(4)(ii) provides a new, more nuanced, provision with regard to a restriction imposed under local law.

It retains a general local law rule, as Proposed Reg. §1.2704-2(b)(4)(ii) begins:

(ii) Imposed by federal or state law. An applicable restriction does not include a restriction imposed or required to be imposed by federal or state law. For this purpose, federal or state law means the laws of the United States, of any state thereof, or of the District of Columbia, but does not include the laws of any other jurisdiction. A provision of law that applies only in the absence of a contrary provision in the governing documents or that may be superseded with regard to a particular entity (whether by the shareholders, partners, members and/or managers of the entity or otherwise) is not a restriction that is imposed or required to be imposed by federal or state law.

All well and good so far—but the regulation goes on to then remove certain restrictions that the IRS appears to believe are created solely by state legislatures to enable estate tax reductions.  The proposed regulation continues:

A law that is limited in its application to certain narrow classes of entities, particularly those types of entities (such as family-controlled entities) most likely to be subject to transfers described in section 2704, is not a restriction that is imposed or required to be imposed by federal or state law. For example, a law requiring a restriction that may not be removed or superseded and that applies only to family-controlled entities that otherwise would be subject to the rules of section 2704 is an applicable restriction. In addition, a restriction is not imposed or required to be imposed by federal or state law if that law also provides (either at the time the entity was organized or at some subsequent time) an optional provision that does not include the restriction or that allows it to be removed or overridden, or that provides a different statute for the creation and governance of that same type of entity that does not mandate the restriction, makes the restriction optional, or permits the restriction to be superseded, whether by the entity's governing documents or otherwise. For purposes of determining the type of entity, there are only three types of entities, specifically, the three categories of entities described in § 25.2701-2(b)(5): corporations; partnerships (including limited partnerships); and other business entities.

The proposed regulations will add a list of specifically disregarded restrictions .  The preamble describes these as follows:

Under § 25.2704-3 of the proposed regulations, in the case of a family-controlled entity, any restriction described below on a shareholder's, partner's, member's, or other owner's right to liquidate his or her interest in the entity will be disregarded if the restriction will lapse at any time after the transfer, or if the transferor, or the transferor and family members, without regard to certain interests held by nonfamily members, may remove or override the restriction. Under the proposed regulations, such a disregarded restriction includes one that: (a) limits the ability of the holder of the interest to liquidate the interest; (b) limits the liquidation proceeds to an amount that is less than a minimum value; (c) defers the payment of the liquidation proceeds for more than six months; or (d) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.

The preamble discusses the definition of “minimum value” as follows:

“Minimum value” is the interest's share of the net value of the entity on the date of liquidation or redemption. The net value of the entity is the fair market value, as determined under section 2031 or 2512 and the applicable regulations, of the property held by the entity, reduced by the outstanding obligations of the entity. Solely for purposes of determining minimum value, the only outstanding obligations of the entity that may be taken into account are those that would be allowable (if paid) as deductions under section 2053 if those obligations instead were claims against an estate. For example, and subject to the foregoing limitation on outstanding obligations, if the entity holds an operating business, the rules of § 20.2031-2(f)(2) or 20.2031-3 apply in the case of a testamentary transfer and the rules of § 25.2512-2(f)(2) or 25.2512-3 apply in the case of an inter vivos transfer. The minimum value of the interest is the net value of the entity multiplied by the interest's share of the entity. For this purpose, the interest's share is determined by taking into account any capital, profits, and other rights inherent in the interest in the entity.

The preamble goes on to discuss additional disregarded restrictions, noting:

A disregarded restriction includes limitations on the time and manner of payment of the liquidation proceeds. Such limitations include provisions permitting deferral of full payment beyond six months or permitting payment in any manner other than in cash or property.

The proposed rules provide special provisions related to notes, as the preamble continues:

An exception is made for the note of an entity engaged in an active trade or business to the extent that (a) the liquidation proceeds are not attributable to passive assets within the meaning of section 6166(b)(9)(B), and (b) the note is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value (when discounted to present value) equal to the liquidation proceeds. A fair market value determination assumes a cash sale. See Section 2 of Rev. Rul. 59-60, 1959-1 C.B. 237 (defining fair market value and stating that "[c]ourt decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing to trade . . ."). Thus, in the absence of immediate payment of the liquidation proceeds, the fair market value of any note falling within this exception must equal the fair market value of the liquidation proceeds on the date of liquidation or redemption.

Generally a “passive asset” under IRC §6166(b)(9)(B) is “any asset other than an asset used in carrying on a trade or business.”

The proposed regulations note that exceptions to “applicable restrictions” apply to the new disregarded restrictions.  The preamble notes:

One of the exceptions applicable to the definition of a disregarded restriction applies if (a) each holder of an interest in the entity has an enforceable "put" right to receive, on liquidation or redemption of the holder's interest, cash and/or other property with a value that is at least equal to the minimum value previously described, (b) the full amount of such cash and other property must be paid within six months after the holder gives notice to the entity of the holder's intent to liquidate any part or all of the holder's interest and/or withdraw from the entity, and (c) such other property does not include a note or other obligation issued directly or indirectly by the entity, by one or more holders of interests in the entity, or by a person related either to the entity or to any holder of an interest in the entity.

The preamble goes on to note a special rule for operating entities in this case:

However, in the case of an entity engaged in an active trade or business, at least 60 percent of whose value consists of the non-passive assets of that trade or business, and to the extent that the liquidation proceeds are not attributable to passive assets within the meaning of section 6166(b)(9)(B), such proceeds may include a note or other obligation if such note is adequately secured, requires periodic payments on a non-deferred basis, is issued at market interest rates, and has a fair market value on the date of the liquidation or redemption equal to the liquidation proceeds. A similar exception is made to the definition of an applicable restriction in proposed § 25.2704-2(b)(4).

The preamble goes on to describe the new test to be applied to determine if a non-family member equity holder will actually be considered as removing the family’s ability to unilaterally remove a restriction, something that Kerr had allowed for a relatively minor interest held by a charity:

In determining whether the transferor and/or the transferor's family has the ability to remove a restriction included in this new class of disregarded restrictions, any interest in the entity held by a person who is not a member of the transferor's family is disregarded if, at the time of the transfer, the interest: (a) has been held by such person for less than three years; (b) constitutes less than 10 percent of the value of all of the equity interests in a corporation, or constitutes less than 10 percent of the capital and profits interests in a business entity described in § 301.7701-2(a) other than a corporation (for example, less than a 10-percent interest in the capital and profits of a partnership); (c) when combined with the interests of all other persons who are not members of the transferor's family, constitutes less than 20 percent of the value of all of the equity interests in a corporation, or constitutes less than 20 percent of the capital and profits interests in a business entity other than a corporation (for example, less than a 20-percent interest in the capital and profits of a partnership); or (d) any such person, as the owner of an interest, does not have an enforceable right to receive in exchange for such interest, on no more than six months' prior notice, the minimum value referred to in the definition of a disregarded restriction. If an interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.

The regulation goes on to note that “disregarded restrictions” are ignored for purposes of determining the fair market value of the asset, noting:

Finally, if a restriction is disregarded under proposed § 25.2704-3, the fair market value of the interest in the entity is determined assuming that the disregarded restriction did not exist, either in the governing documents or applicable law. Fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums, subject to the assumptions described in this paragraph.

The proposed regulations also note an issue regarding a different treatment for the value of assets subject to IRC §2704 for purposes of a charitable or marital deduction.  The preamble notes:

Section 2704(b) applies to intra-family transfers for all purposes of subtitle B relating to estate, gift and GST taxes. Therefore, to the extent that an interest qualifies for the gift or estate tax marital deduction and must be valued by taking into account the special valuation assumptions of section 2704(b), the same value generally will apply in computing the marital deduction attributable to that interest. The value of the estate tax marital deduction may be further affected, however, by other factors justifying a different value, such as the application of a control premium. See, e.g., Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987).

Section 2704(b) does not apply to transfers to nonfamily members and thus has no application in valuing an interest passing to charity or to a person other than a family member. If part of an entity interest includible in the gross estate passes to family members and part of that interest passes to nonfamily members, and if (taking into account the proposed rules regarding the treatment of certain interests held by nonfamily members) the part passing to the decedent's family members is valued under section 2704(b), then the proposed regulations provide that the part passing to the family members is treated as a property interest separate from the part passing to nonfamily members. The fair market value of the part passing to the family members is determined taking into account the special valuation assumptions of section 2704(b), as well as any other relevant factors, such as those supporting a control premium. The fair market value of the part passing to the nonfamily member(s) is determined in a similar manner, but without the special valuation assumptions of section 2704(b).

Or, to put more directly, the preamble continues:

Thus, if the sole nonfamily member receiving an interest is a charity, the interest generally will have the same value for both estate tax inclusion and deduction purposes. If the interest passing to nonfamily members, however, is divided between charities and other nonfamily members, additional considerations (not prescribed by section 2704) may apply, resulting in a different value for charitable deduction purposes. See, e.g., Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981).

As was noted earlier, the IRS wishes to apply these regulations to all transfers of property subject to restrictions that took place after the original effective date of IRC §2704 where the lapse takes place after the date the regulations are published as final in the Federal Register.  Thus, unless the IRS were to add a “grandfathering” exception in the final regulations (something that would be risky to count on happening), these regulations impact all existing arrangements and certainly must be considered when undertaking any new estate or gift planning for a taxpayer.

Be aware that these are proposed regulations—for now they do not affect any current lapses of restrictions and they have to be adopted as final regulations to ever have such an effect.  The IRS could modify the regulations before they go final—which seems likely since these regulations are likely to draw numerous comments from the estate planning community—or they could be withdrawn and never become final.