ANTICIPATED VALUATION DISCOUNT REGULATIONS
Proposed regulations under section 2704(b)(4) are reported to be close to publication.
Dear Readers Who Follow Washington Developments:
After years of suspense and speculation, many of us have heard reports that proposed regulations on restrictions to be disregarded in the valuation of interests in entities may be published this summer or early fall. Pursuant to statutory authority conferred in 1990 and a guidance project pending since 2003, these regulations apparently were drafted by 2009, but the drafters then stepped back and sought additional legislative cover. In 2013 the legislative gambit was abandoned, but the administrative guidance project has gone forward anyway. Now we may be close to finding out what that draft contains. But for those who cannot wait, this Capital Letter (which is based on a presentation I made at the meeting of the Estate and Gift Tax Committee in Quebec last month) will explore some possibilities.
The Chapter 14 Statutory Structure
When chapter 14 was added to the Internal Revenue Code in 1990, section 2704(b) provided that certain restrictions, called “applicable restrictions,” would be disregarded for estate, gift, and GST tax purposes in valuing interests in corporations or partnerships transferred to family members. Section 2704(b)(2) defines an “applicable restriction” as “any restriction (A) which effectively limits the ability of the corporation or partnership to liquidate, and (B) with respect to which either … (i) [t]he restriction lapses, in whole or in part, after the transfer … [or] (ii) [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.” Section 2704(b)(3) provides exceptions for “(A) any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either, or (B) any restriction imposed, or required to be imposed, by any Federal or State law.”
Notably, section 2704(b)(4) provides:
(4) Other restrictions. The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or 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.
One might say that this is exactly what estate planners do.
Regulatory and Judicial Elaboration
With regard to the exception in section 2704(b)(3)(B) for “any restriction imposed, or required to be imposed, by any Federal or State law,” Reg. §25.2704-2(b) states that “[a]n 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.” In Kerr v. Commissioner, 113 T.C. 449, 472-74 (1999), aff’d, 292 F.3d 490 (5th Cir. 2002), the Tax Court viewed the regulation “as an expansion of the exception contained in section 2704(b)(3)(B)” and held that provisions in limited partnership agreements that the partnerships generally could be dissolved within 50 years only “by agreement of all the partners” were not “applicable restrictions,” because the applicable Texas limited partnership statute generally required the consent of all partners to dissolution in the absence of the occurrence of other events specified in the partnership agreement to cause dissolution. In other words, default state law, which could be overridden by the partnership agreement, had become the standard for measuring “any restriction imposed, or required to be imposed, by … State law.” Needless to say, in the wake of the enactment of section 2704 many state default partnership laws were amended to require unanimous consent to dissolution as a default rule.
When it affirmed the Tax Court’s holding, the Court of Appeals for the Fifth Circuit declined to analyze that issue, but held only that the restriction on dissolution was not an “applicable restriction” because the presence of the University of Texas as a limited partner prevented the removal of that restriction by the Kerr family.
The 2003-2004 Treasury-IRS Priority Guidance Plan, released on July 24, 2003 (12 years ago this week), added a new project entitled “Guidance under section 2704 regarding the liquidation of an interest.” It has been in every Priority Guidance Plan since. The 2005-2006 Plan, released August 8, 2005, elaborated the description as “Guidance under section 2704 regarding restrictions on the liquidation of an interest in a corporation or partnership.” The 2011-2012 Plan, released on September 2, 2011, changed the description to “Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships,” which continues in the 2014-2015 Plan. Although the reference to “regulations” did not appear until 2011, it has seemed likely since 2003 that the project contemplated regulations regarding “other restrictions” as authorized in section 2704(b)(4).
Treasury’s Proposals to Strengthen the Statutory Structure
The Obama Administration’s first four “General Explanations of the Administration’s … Revenue Proposals” (popularly called the “Greenbook”), called upon Congress to give the Treasury Department greater regulatory authority to create more durable rules for disregarding restrictions under section 2704(b). See “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals” at 121-22 (May 11, 2009), “General Explanations of the Administration’s Fiscal Year 2011 Revenue Proposals” at 124-25 (February 1, 2010), “General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals” at 127 (February 14, 2011), and “General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals” at 79 (February 13, 2012).
The Greenbooks recalled that sections 2701-2704 (chapter 14) were enacted to curb the use of “estate freezes” and other techniques designed to reduce transfer tax values without reducing the economic benefit to the beneficiaries. Specifically, the Greenbooks pointed out that section 2704(b) provides that certain “applicable restrictions” that would otherwise justify valuation discounts are ignored in intra-family transfers of interests in family-controlled corporations and partnerships. But the Greenbooks lamented that “[j]udicial decisions and the enactment of new statutes in most states, in effect, have made section 2704(b) inapplicable in many situations” and added that “the Internal Revenue Service has identified other arrangements designed to circumvent the application of section 2704.”
The Greenbook proposals would have created a more durable category of “disregarded restrictions,” which “would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations” – that is, not measured against either default state law or mandatory state law.
The 10-year revenue estimates for this proposal were $19.038 billion in the 2009 Greenbook, $18.667 billion in the 2010 Greenbook, $18.166 billion in the 2011 Greenbook, and $18.079 billion in the 2012 Greenbook. Thus the estimates were rounded to the nearest $1 million, representing fine-tuning to the nearest $100,000 per year. Another way of looking at this is that, at a 40 percent transfer tax rate, these estimates are fine-tuned to the nearest $250,000 of disallowed discounts per year. In contrast, on June 11, 2009, shortly after the proposal first appeared, a set of Joint Committee on Taxation revenue estimates related to the Administration’s budget proposals skipped this proposal, because of its lack of specificity that made it impossible to tell what it would accomplish and therefore what revenue effect it would have. But the revenue estimators at Treasury obviously had no such handicap, and the annual fine-tuning suggested that they knew exactly what the contemplated regulations would provide. That in turn supported the hypothesis that by the time the 2009 Greenbook was published the regulations had already been drafted, or at least the substance of the proposed regulations had been very specifically outlined.
Return to a Focus on the Regulatory Process
Then in “General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals” (April 10, 2013), the proposal for additional legislation was dropped, and it has not reappeared. It was hard to believe that Treasury and the IRS had abandoned the idea of such regulations, and, indeed, when the 2013-2014 Priority Guidance Plan was released on August 9, 2013, it included without change the reference to “Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships.” That meant that the IRS and Treasury had decided to go ahead with the regulations without the additional statutory cover the 2009, 2010, 2011, and 2012 Greenbooks had sought. And with the revenue estimates suggesting that the proposed regulations had already been substantially drafted, it was reasonable to expect the polishing and necessary review of the draft to take no longer than, say, a couple years.
As winter gave way to spring in 2015, assessment of the progress of other projects on the Priority Guidance Plan and of the abatement of recent “emergencies” (mandatory and then elective carryover basis for 2010, portability beginning in 2011, and the treatment of same-sex married couples after 2013) suggested to this writer that the section 2704 regulation train might emerge from the tunnel around Labor Day. Then, later this spring, informal suggestions from government personnel at professional meetings confirmed that the proposed regulations should be expected by September.
ANTICIPATING THE CONTENT OF THE PROPOSED REGULATIONS
The Greenbooks as Predictors
Although there have been no significant informal clues about the content of the contemplated regulations, it stands to reason that the descriptions in the Greenbooks of what Treasury asked Congress to bless by legislation provide an outline of what Treasury has intended to do by regulation. But at least two caveats come to mind.
First, if statutory language has been drafted to implement the Greenbook proposal, it is not known to have found its way into an introduced bill or otherwise to have been made public. On June 25 Senator Bernie Sanders (I-VT) introduced the “Responsible Estate Tax Act” (S. 1677), which, among other things would raise the top estate tax rate to 55 percent over $50 million and 65 percent over $500 million. (A companion bill, H.R. 2907, was introduced in the House of Representatives by Rep. Janice Schakowsky (D-IL).) Section 6 of S. 1677 is entitled “Valuation rules for certain transfers of nonbusiness assets; limitation on minority discounts” and thus has fueled speculation that there was some connection with the abandoned Obama Administration Greenbook proposal. That is unlikely. Like bills entitled the “Responsible Estate Tax Act” Senator Sanders had introduced in 2010 (S. 3533) and 2014 (S. 2899), section 6 is about the same as the valuation provisions in previous bills, including, for example, bills introduced by Ways and Means Committee Members Rep. Charles Rangel (D-NY) in 2001 and Rep. Earl Pomeroy (D-ND) in 2002, 2005, 2007, and 2009, which in fact sought to implement a different approach to valuation proposed in the 1999, 2000, and 2001 Greenbooks of the Clinton Administration.
The second caveat is to recall that regulations providing “that other restrictions shall be disregarded” are already authorized by section 2704(b)(4). Thus it is possible that the proposed regulations will elaborate section 2704(b) or even change Reg. §25.2704-2(b) in ways not revealed in the barely-500-word descriptions in the Greenbooks. But it is likely that the most important features of the proposed regulations have been reflected in the Greenbooks, and that the core proposal of “disregarded restrictions” measured against the regulations, not state law, is the best place to start when thinking about what the proposed regulations might provide.
Limitations of Legislative History
While it is common to study legislative history – in this case the legislative history of section 2704 – to discover hints for what to expect in the implementing regulations, at least two caveats come to mind in this context as well. First, the legislative history is a quarter-century old, and the new regulations, as the Greenbooks said, will be informed by intervening experience. Second, again, section 2704(b)(4) contemplates “other restrictions” that are not necessarily addressed by the legislative history.
For example, much has been said and written about the disclaimer in the 1990 House-Senate conference report that “[t]hese rules do not affect minority discounts or other discounts available under present law.” H.R. Rep. No. 101-964, 101st Cong., 2d Sess. 1137 (1990) (Conference Report). Consistently with the stated focus of section 2704(b)(2) on “applicable restrictions” defined as “any restriction … which effectively limits the ability of the corporation or partnership to liquidate,” this disclaimer is cited – understandably! – for the proposition that only restrictions on liquidation can be disregarded under section 2704(b). But the authorization in section 2704(b)(4) to add “other restrictions” by regulations appears to override that proposition. And the Greenbooks stated only that the contemplated “disregarded restrictions” will “include” certain limitations on liquidation, not necessarily exclusively.
A SUGGESTION FOR PREDICTING THE “DISREGARDED RESTRICTIONS”
Inasmuch as no one outside of Treasury and the IRS knows what features of a closely-held entity will make the list of “disregarded restrictions,” I suggest a less reliable but perhaps more interesting approach. Most of us have seen features of entities that look natural and common and justifications for valuation discounts based on those features that therefore look reasonable or even compelling. But many of us have also seen justifications for discounts that just seem too aggressive, maybe even to the point of being unbelievable. Even those of us who like every discount we have ever seen might still be able to summon up the resolve to tell which justifications for discounts are the most aggressive and therefore perhaps closest to the line. So, with some such continuum in mind, let us ask ourselves what restrictions we would disregard if it were up to us. And here are eight markers or factors to help us do that:
First, Eliminate $4.5 Billion of Discounts Per Year
Our starting outline of restrictions to disregard must support discounts of, say, $4.5 billion per year. Recall the 10-year revenue estimates in the 2009-2012 Greenbooks – $19.038 billion, $18.667 billion, $18.166 billion, and $18.079 billion – trending downward to, say, $18 billion. That represents a revenue gain of $1.8 per year. At today’s 40 percent estate and gift tax rate, an annual recovery of $4.5 billion of value otherwise lost to discounts would raise $1.8 billion per year. This is a grossly simplified model that ignores income tax effects, opportunity costs, and doubtless a host of other factors that Treasury’s revenue estimators use. But it is all we have.
Second, Consider the Composition of the Assets
Perhaps the most obvious badge of aggressive discount planning is the justification of those discounts only by features of the entity holding the assets, not features of the assets themselves. Isn’t it obvious that the entity holding cash or publicly-traded securities is the easiest target?
Third, Forget Those “Nontax Reasons”
The application of a “legitimate and significant nontax reason” test to family entities in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005) (reviewed by the Court), was welcomed by some as a relaxation or at least a clarification of a narrower “business purpose” test. Indeed, Judge Laro, joined by Judge Marvel, wrote a concurring opinion stating: “I disagree with the use of the majority’s ‘legitimate and significant nontax reason’ test. … I would apply the longstanding and well-known business purpose test of Gregory v. Helvering, 293 U.S. 465 (1935).” Ironically, the underlying assets in Bongard were an operating business, and even Judges Laro and Marvel concurred in the result. Judge Halpern found “a legitimate and significant nontax reason” to be “an inappropriate motive test” and dissented in part, while Judges Chiechi, Wells, and Foley, citing United State v. Byrum, 408 U.S. 125 (1972), questioned the need for “any significant nontax reason” and would have gone even farther in the taxpayer’s favor than the majority. The Bongard test is used in applying the “bona fide sale for an adequate and full consideration in money or money’s worth” exception of sections 2036(a) and 2038(a)(1), not for determining the effect on value of an entity-level restriction as such, but it has been applied in 20-some cases and has become a staple of the family entity planning vocabulary.
But don’t count on a nontax reason exception from the disregarded restrictions in the proposed regulations. The regulations might conclude that if holding assets in a family entity like a limited partnership or LLC has nontax benefits such as keeping legacy investments in the family, permitting centralized and more efficient investing, facilitating transfers of interests in real estate, and protecting assets from claimants and spendthrifts, those benefits may actually enhance value for the family, as section 2704(b)(4) contemplates, which is an odd justification for reducing the transfer tax value through discounts. This will be an uncomfortable notion for many, but it is hard to deny the economics.
Fourth, Leave Operating Businesses Alone
In contrast, the operation of a genuine business, such as the business at the core of the Bongard case, would be a very poor target for these regulations. The valuation of an operating business is complicated. A net asset value method of valuation, which “courts are overwhelmingly inclined to use … for holding companies whose assets are marketable securities” (Estate of Richmond v. Commissioner, T.C. Memo 2014-26), is rarely as useful for valuing an interest in an operating business, and, even when it is used, it is normally attended by many adjustments to the otherwise unhelpful concept of “book value.” Business valuation entails judgments in selecting and weighting valuation approaches, judgments in selecting and weighting comparable businesses, judgments in making adjustments to financial statements, judgments about the economic context and outlook, judgments about the specific opportunities and risks of the business in question, judgments about the relevant interest rates and similar data to be used, and countless other judgments trained and experienced appraisers make, not just judgments about various discounts applied after the appropriate base of value has been determined but still inseparable from the unique overall process of business valuation. Applying any mechanical constraints on that last part of a unified process would be an imprudent and unworkable idea.
In addition, applying the contemplated “disregarded restrictions” rules to operating businesses would unnecessarily burden a category of entities – small businesses and family-owned businesses – that transfer tax law has historically, even if somewhat haltingly, sought to aid, evidenced in policy judgments at least since the Small Business Tax Revision Act of 1958 added section 6166 to the Code. (Subchapter S was added at the same time.)
It is understandable that those in the IRS and Treasury who are charged with interpreting and administering transfer tax laws may find it frustrating when a family limited partnership, for example, claims nontax purposes or the right to be valued like a “business,” especially when value seems to disappear for transfer tax purposes but reappear in the hands of the transferees, as section 2704(b)(4) contemplates. But it is also frustrating to tax professionals when tax enforcement seems to overreact by treating real operating businesses like FLPs. These regulations should not make that mistake. Admittedly, that would probably require measures to prevent circumvention of the rules by “stuffing” nonbusiness assets, especially liquid assets, into family-owned businesses beyond the reasonable needs of the business for working capital. But that is already true in other contexts, including section 6166. And while the treatment of that issue in section 6166 is not necessarily pretty, some thoughtful effort to that end is necessary and could reap a dividend in public acceptance that these regulations are likely to need.
Fifth, Consider Who Created the Restriction
Again in the interest of public acceptance, the proposed regulations must consider the origin of any targeted restriction. A transferor who self-creates and self-imposes a restriction should be the target. The holder who receives a restricted noncontrolling interest from others (including ancestors) and who never had a meaningful opportunity to remove those restrictions should not be a target. If that seems arbitrary or sounds like a “loophole,” consider that the most flagrant scenario that fuels this regulation project may be the scenario in which the family finds a way to remove, mitigate, or ignore a restriction shortly after the estate tax statute of limitations has run on a valuation that was substantially depressed by that restriction. Exempting ancestral restrictions not created by the transferor would not ordinarily permit that scenario. Attribution among family members, except between spouses, would have no place.
The Greenbooks provided that “[r]egulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met.” No details were given. As an aside, it is odd that a proposal to limit opportunities to “circumvent” section 2704 would contemplate that section 2704 could be avoided simply by the way governing documents are drafted. But perhaps this authority would be used in the proposed regulations to protect actual family operating businesses or to protect the holder of a restricted noncontrolling interest received from others. In other words, there may be room within the Greenbooks’ offer of regulatory safe harbors to support and confirm these fourth and fifth factors.
Sixth, Consider Who Can Remove the Restriction
The Greenbooks stated that “[f]or purposes of determining whether a restriction may be removed by member(s) of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family.” Presumably, for example, the relatively small interest held by the University of Texas in Kerr would be treated as held by the Kerr family under this provision, despite the Fifth Circuit’s ruling that it was enough to prevent section 2704(b) from applying. Whether viewed as a de minimis rule or something else, this is another element to expect in the proposed regulations.
Under the Greenbooks, disregarded restrictions would also include limitations on a transferee’s ability to be admitted as a full partner or other holder of an equity interest, thus apparently denying the opportunity to value a transferred interest as a “mere” “assignee” interest. Although it is not clear that that makes much practical difference, such a rule should be expected in the proposed regulations.
Seventh, Expect a More Holistic Approach Than Case Law Can Provide
The Greenbooks promised to “make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions.” This could override the harsh “reverse-Chenoweth” result seen in Technical Advice Memoranda 9050004 (Aug. 31, 1990) and 9403005 (Oct. 14, 1993) (all stock owned by the decedent valued as a control block in the gross estate, but the marital bequest valued separately for purposes of the marital deduction), relying on Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987) (estate of a decedent who owned all the stock of a corporation entitled to prove a control premium for a 51-percent block bequeathed to the surviving spouse for purposes of the marital deduction), and Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981). Put another way, it could ensure that a large estate left in three equal shares to three public charities would be entitled to charitable deductions that equaled the whole gross estate, rather than three charitable deductions calculated as minority interests that left a portion of the value of the estate subject to tax. Such a result in the proposed regulations would also reinforce the fairness of the proposal and promote public acceptance. Because judges are limited to the cases before them, case law could never achieve such a holistic result.
Eighth, Without Statutory Cover, Walk It Back a Bit
That completes Capital Letters’ list of items to look for in the proposed regulations this summer or fall. But it is based largely on the summaries in the Greenbooks of the statutory cover Treasury believed would be desirable to support the regulations it contemplated. Assuming that Treasury was right in desiring strengthened statutory authority, it is reasonable to assume that in the absence of such statutory authority it might, in caution, back off some of its original expectations. Maybe that would result in dropping the attribution to the family of small interests held by charity or other non-family members. Maybe it would cause reconsideration of the treatment of “assignee” interests. Maybe something else. There really is no way to tell.
That leaves the intriguing question of the effective date of the new rules. The proposal in the Greenbooks would have applied to transfers – gifts and deaths – after the date of enactment. Consistent with section 2704 itself, the proposal would not have applied to restrictions created on or before October 8, 1990. Under section 7805(b)(2), regulations issued within 18 months of the date of enactment could have been retroactive to the date of enactment. (That is how the portability regulations finalized last month could be retroactive to the date of enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, as explained in Capital Letter No. 37.)
Thus there are two elements of the effective date – when? and what? The date the regulations are proposed and the date they are finalized are the likely possibilities for when. But perhaps an even more significant factor is what event is measured against the effective date. If that event is the creation of a restriction, as in section 2704 itself, then post-enactment transfers from an entity already created and funded would not be subject to the new rules. But if the critical event is the transfer of restricted interests, then it is not enough to have the entity in place before the effective date. The necessary transfers, presumably to younger generations or trusts for their benefit, must have been completed. For some that possibility could encourage an acceleration of taxable gifts, rather than waiting until death.
Somehow effectiveness of the new rules immediately upon their publication in proposed form, especially if they are applicable to all transfers even of interests in entities already formed subject to restrictions already imposed, seems ambitious for regulations under a 25-year-old statute and a 12-year-old Priority Guidance Plan project. Perhaps such an aggressive effective date is the main reason Treasury sought statutory cover from Congress for four years. If so, then we should expect that either the application of the proposed rules is postponed until they are finalized, or they are proposed to be immediately effective but that goal is eventually watered down or abandoned in the face of the intense and voluminous public criticism that is bound to come.
Even so, while it might be wrong to push to completion an entity-based estate planning transaction that has no compelling “nontax reason,” the pending regulations do encourage us to get off our desks whatever projects are sitting there, if feasible. Of course readers will remember that they have been hearing these “urgent” warnings for 12 years now.
And the same informal indications that the proposed section 2704 regulations might be coming out soon have suggested that two other projects are expected to be completed ahead of them – first, finalization of the proposed regulations published on January 17, 2014, dealing with the basis of property in a charitable remainder trust that is the subject of a coordinated sale of the income and remainder interests to the same buyer, and second, the publication of guidance under section 2801 on the new succession tax on the receipt of certain gifts and bequests from someone who expatriated on or after June 17, 2008. Such suggestions are not guarantees, but they will still give some procrastinators their doomsday timetable.
The notion that for transfer tax purposes “fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” is itself a creation of regulations (Reg. §20.2031-1(b)) that, it would seem, could be changed by regulations. On the other hand, it could credibly be noted that Congress has amended statutes that rely on this decades-old definition so many times that the definition itself has gained a type of statutory dignity or at least congressional ratification. But the relatively open-ended regulatory authority of section 2704(b)(4) gives Treasury and the IRS a lot of room to embroider on time-honored entity-based valuation discount planning techniques. And by this fall we might see it happen.
Would $4.5 billion (or less) of disallowed discounts per year be the end of the world? Or even the end of all discounts? As discounts go, is this a large number? Or a modest number? Again, the revenue estimators in the Treasury Department have the data to permit answers to those questions; Capital Letters does not. From observing cases that are known to the public and from working with and listening to practitioners and appraisers around the country, however, I find (that is, I guess) $4.5 billion to be a moderate number – neither so trivial as to be ignored nor so large as to spell the end of all discounts.
As suggested above, the reaction to the proposed regulations is likely to be intense, as many will try to criticize, challenge, or circumvent the new rules. Final resolution, if it is possible at all, may take several years. But for others, increased objectivity and certainty and a holistic application to deductions may be seen as an improvement over the current ad hoc case law that is necessarily driven by the facts of the litigated cases. Some may even read the new rules in the proposed regulations and find them worth it.