SECTION 2704 PROPOSED REGULATIONS UNDER DRAMATIC REVIEW
The White House orders an unprecedented review of burdensome tax regulations, and Treasury puts section 2704 proposed regulations on the menu.
Dear Readers Who Follow Washington Developments:
The drama that defines Washington politics these days has implicated a closely-watched estate and gift tax guidance project in an unprecedented review. The regulations on valuation discounts under section 2704, proposed a year ago, are one of eight regulation projects selected for reexamination in response to an Executive Order to identify unduly burdensome or complex regulations issued since the beginning of 2016. The IRS asked for public comments, and many organizations, including ACTEC, vigorously responded.
PROPOSED REGULATIONS UNDER SECTION 2704
The Proposed Regulations were released on August 2, 2016, and published in the Federal Register on August 4. They were instantly controversial. They produced severe contention, not only between estate planning professionals and the IRS, but among estate planning professionals themselves, who have not reached a consensus on what effect the Proposed Regulations would have if finalized or what the Proposed Regulations even mean. The IRS reportedly received over 28,000 comments from members of the public, many very cursory and clichéd of course, but many deeper and broader and sometimes bitter. There were 36 speakers at the all-day public hearing on December 1. ACTEC submitted Comments on October 27 that, in ACTEC’s tradition, were thoughtful, professional, and evenhanded, and Stephanie Loomis-Price ably spoke on ACTEC’s behalf at the hearing.
This Capital Letter will describe the latest round of attention to the Proposed Regulations spurred by the Executive Order. Unless unforeseen developments intervene, Capital Letter Number 41 will look in more depth at the Proposed Regulations themselves, particularly at the factors that created so much contention. Capital Letter Number 42 will take a broader look at the current political and rhetorical climate and its implications for tax guidance.
EXECUTIVE ORDER 13789
Executive Order 13789 was issued on April 21, 2017, and published in the Federal Register on April 26. It directed the Treasury Department to identify tax regulations issued on or after January 1, 2016, “that (i) impose an undue financial burden on United States taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service.” It directed that such regulations be identified in an interim report to the President within 60 days, or by June 20, 2017.
Notice 2017-38, 2017-30 I.R.B. 147, was the initial response of Treasury and the IRS to the Executive Order. It was issued on July 7, about two and a half weeks after its due date (although it may have been submitted to the President earlier). It identified eight regulations, including the section 2704 Proposed Regulations, that it said “meet at least one of the first two criteria specified by … Executive Order 13789” – that is, undue financial burden or undue complexity. The Notice included this about the section 2704 Proposed Regulations:
Commenters expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens. Commenters were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious.
Understandably, the IRS did not concede that any of its regulations met the third criterion in the Executive Order because they “exceed the statutory authority of the Internal Revenue Service.” But it would be at least noteworthy, if not surprising, that the IRS would admit that the Proposed Regulations impose “undue” financial burden or add “undue” complexity to the tax laws. That would beg the question of why the IRS ever issued the Proposed Regulations in the first place. But, to be fair, an IRS response that “we don’t think anything we have done was undue” would not really have captured the spirit of the Executive Order. One way to read Notice 2017-38 is merely as an acknowledgment that if any regulations potentially create undue burdens or complexity, then the eight regulations identified in the Notice are the most likely candidates. Another way to read the Notice is that it simply measures undue burden by the intensity of the public reaction, which, in the case of the section 2704 Proposed Regulations, is reflected in the Notice’s focus on what “commenters” have said.
The Notice asked for comments from the public by August 7. ACTEC responded with a Letter on August 1.
THE MOST SERIOUS PROBLEMS WITH THE PROPOSED REGULATIONS
Many features of the Proposed Regulations have been severely criticized, in professional meetings, in the press, in communications to Congress, and in the tsunami of over 28,000 public comments, including ACTEC’s October 27, 2016, Comments. ACTEC’s August 1 Letter selected six of those troublesome features as the most conspicuous sources of the kind of undue burdens and complexity the Executive Order seems to be aimed at.
1. Blurring the Standard of Transfer Tax Value
The Proposed Regulations would make many changes affecting the tax treatment of transfers of interests in family-owned entities. The most prominent, and perhaps the most controversial, is to add a new category of “disregarded restrictions” that would be, as the name implies, disregarded under section 2704(b) in valuing such an interest for transfer tax purposes if the restriction lapses after the transfer or the transferor’s family has the ability to remove it. A restriction is a “disregarded restriction” if it has the effect of limiting the ability of the holder of the interest to compel liquidation or redemption of the interest on no more than six months’ notice for cash or property equal to at least what the proposed regulations call “minimum value.” “Minimum value” is defined as the pro rata share of the net fair market value of the assets of the entity – that is, the fair market value of those assets reduced by the debts of the entity, multiplied by the share of the entity represented by that interest.
If a “disregarded restriction” encompasses anything that restricts or prevents an interest-holder’s realization of “minimum value” on six months’ notice, then the Proposed Regulations would require the valuation of that interest to assume that nothing restricts or prevents such realization. If everything that prevented such realization were removed, then such realization would be permitted. The form of the entity, the management of the entity, the activities of the entity, the market or other economic environment in which the entity functioned – all would then be ignored. The holder of an interest in the entity would then be treated as the direct owner of a pro rata share of the net fair market value of the entity, valued as such, with perhaps only a discount for the time value of money over a deferral period of six months. The entity, in effect, would be disregarded. And, assuming that the use of such entities to depress transfer tax values is what the Proposed Regulations must be aimed at, then the objectives of the IRS would be served. Some described that element of the Proposed Regulations as the valuation of an interest in a family-owned entity as if the holder could put the interest to the entity (or other owners) for its “minimum value” – in other words a “deemed put.” And the “deemed put” label caught on.
At the public hearing on the Proposed Regulations on December 1, 2016, the first speaker, speaking on behalf of the AICPA, referred repeatedly to that “put right” (as did many other speakers). After that first speaker’s comments, ACTEC Fellow and Treasury Department attorney-adviser Cathy Hughes, a member of the government panel at the hearing, stated that “to put your mind at rest, as we have said publicly before, there is no intended put right, and we will absolutely make that clear in the final regulations.” The view of Capital Letters, similarly, is that the Proposed Regulations do not impose a “deemed put right” or “minimum value” as a standard of transfer tax value; there will be more about that in Capital Letter Number 41. But the logic in the preceding paragraph, standing alone, is hard to refute. And if an appraiser must assume that liquidation value is the standard and that liquidation can always occur within six months, no matter how impractical that is, then the result could only be a host of artificially inflated, sometimes grossly inflated, values.
It is appropriate for Notice 2017-38 to state that “Commenters expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens.” Likewise, the Notice does well to state that “Commenters were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious.” A new “minimum value” standard, supplanting the time-honored “fair market value” standard, would seriously disrupt valuations and baffle the appraisal community. And, besides being “arbitrary and capricious,” imposition of such a new standard of value would transgress the third criterion of Executive Order 13789, which Notice 2017-38 does not mention, by exceeding the statutory authority in section 2704(b)(4) only to “provide that other restrictions shall be disregarded … 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.” Congress did not authorize regulations to disregard real restrictions that really reduce value and certainly did not authorize the affirmative prescription of new substituted standards of value.
Finally, while assurances about the intention to fix these problems in the final regulations are welcome, they have not alleviated the burdens of public frustration and fear these regulations, even in proposed form, have created. For that reason, in light of Executive Order 13789 and the invitation in Notice 2017-38, ACTEC responded to the extraordinary uncertainties, frustrations, and fears with the extraordinary conclusion that there is no redemption for these Proposed Regulations other than to immediately withdraw them, and to re-propose them for further public scrutiny and comment only if and when these problems have been fixed. Under the circumstances, it is hard to argue with that.
2. Ignoring Nonfamily Members of an Entity
In enacting section 2704(b), Congress chose to limit the disregarding of what it called “applicable restrictions” to restrictions that lapse after a transfer or can be removed by the transferor’s family. In prescribing “other” restrictions under section 2704(b)(4) in Proposed Reg. §25.2704-3(b)(1), the IRS has taken the same prudent approach. But this prudence is made illusory by the requirement in Proposed Reg. §25.2704-3(b)(4) that interests of nonfamily members – not just “restrictions,” but interests of nonfamily members – must also be disregarded unless
(A) the interest has been held for at least three years;
(B) the interest constitutes at least 10 percent of the value of all equity interests;
(C) the interests of all nonfamily members in the aggregate constitute at least 20 percent of the value of all equity interests; and
(D) every nonfamily member who holds an interest in the entity has, unbelievably, a “put right” for “minimum value” within six months – not the put right apparently meant to be hypothetical when used to define a “disregarded restriction,” but a real put right here.
ACTEC Fellow Mickey Davis has perceptively noted that this combination of four traits is simply not observed in the real world of either family-owned or widely-held entities. He likens the family member the Proposed Regulations would respect to the mythological gryphon (or griffin or griffon), which has the body and hind legs of a lion and the head and wings of an eagle. Everyone knows what lions and eagles look like, but no one has ever seen a gryphon. While the Preamble to the Proposed Regulations purports to target “nominal” interests held by nonfamily members like the interests given to the University of Texas in Kerr v. Commissioner, 113 T.C. 449 (1999), aff’d, 292 F.3d 490 (5th Cir. 2002), the unrealistic constraints on respecting nonfamily owners mean that all nonfamily owners would be ignored in all or almost all cases. ACTEC’s August 1 Letter observes:
To avoid the harsh application of the Proposed Regulations in settings where there is no reason for them to apply, a transferor, for example, would have to wait three years after forming an entity or welcoming nonfamily owners to the entity before transferring interests to members of the transferor’s family. ACTEC views that restraint on transfer as an undue burden on the involvement of family members, especially younger-generation family members, in the stewardship and benefits of the family wealth. Moreover, the entity would have to give all of its nonfamily owners a redemption right that could favor nonfamily owners over the family that nurtured that wealth and created that entity, which ACTEC also regards as an undue burden on that family.
3. Frightening Owners of Operating Businesses
There is no reason for the Proposed Regulations to apply to family-owned operating businesses. In the case of an operating business, discounts from net asset values, or from values derived from comparisons with interests in comparable publicly-traded entities, are driven by the commercial and capital markets in which the business operates. Lack of marketability is real. Partially liquidating a synergetic combination of real estate, equipment, inventory, working capital, personnel, management, governance, intellectual property, and business opportunities to accommodate a substantial cash buy-out is an absurd notion. Artificial restrictions in governing documents add little or nothing. Operating businesses thus have little or nothing to fear from limitations on such artificial restrictions, in light of the restrictions already inherent in economic realities. That is especially true if the “deemed put” alarm is an overreaction and those economic realities are not also disregarded (as Capital Letter Number 41 will discuss).
Yet there is no question that owners of family operating businesses have been severely frightened by the harm that the Proposed Regulations supposedly threaten. Indeed, as ACTEC’s August 1 Letter states, “the outcry has evidently reached the ears of Congress, where, for example, bills to prevent the finalization of the Proposed Regulations have been titled the ‘Protect Family Farms and Businesses Act’ (H.R. 6100 and S. 3436 in the 114th Congress and H.R. 308 and S. 47 in the current 115th Congress).”
If family-owned operating businesses really are not the target of the Proposed Regulations, and especially if they would suffer little or no impact under the Proposed Regulations anyway, then, as ACTEC’s Letter goes on to say, “there will be nothing of substance to be lost – and very much calming of public outcry to be gained – by simply making an exception for family-owned operating businesses explicit.” Indeed, Cathy Hughes was reported as saying at the ABA Section of Taxation midyear meeting in Orlando on January 20, 2017, that such an explicit exception for businesses “would make most of the objections to these proposed regs go away.… We considered piggybacking on the 6166 definition of a closely held business” but decided against it “because 6166 is a mess.” (Allyson Versprille, “Final Estate Tax Rule May Add Closely Held Business Exclusion,” Bloomberg BNA Daily Tax Report®, Jan. 24, 2017, at G-1.)
One reason why section 6166, especially the patchwork of definitions and special rules in section 6166(b), is a “mess” is that it is so difficult to amend section 6166 in a thoughtful, intentional way. That is true in large part because congressional revenue estimating rules often treat a deferral of tax beyond the applicable “budget window” – currently ten years – as a loss of revenue, even though the deferred tax will eventually be paid with interest. But Treasury and the IRS should not feel so constrained in crafting an operating business exception for purposes of the Proposed Regulations. Proposed Reg. §25.2704-3(b)(1)(iv) itself already has an “active trade or business” exception from the payment-within-six-months element of the definition of a “disregarded restriction.” And in the same year that the IRS published the Proposed Regulations, Treasury’s “Greenbook” of tax legislative proposals included a proposed tax on unrealized appreciation at death, but contemplated an operating business exception, stating that “payment of tax on the appreciation of certain small family-owned and family-operated businesses would not be due until the business is sold or ceases to be family-owned and operated.” Department of the Treasury, “General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals” at 156 (Feb. 9, 2016).
Of course Treasury and the IRS will be concerned about an explicit exception that could be abused, for example by stuffing investment assets into an operating business or by otherwise structuring an investment entity to fit within whatever technical definition of an “operating” business is crafted. For that reason, the relief for operating businesses might not be an explicit exception, but could perhaps be something like a series of sharply focused Examples with typical operating business fact patterns, which could be just as reassuring to everyone but those seeking to find loopholes for investment entities. And if the Proposed Regulations are withdrawn in the meantime, all taxpayers and their advisers would be reassured that they will not be finalized until the proposed relief has been subjected to another round of public scrutiny and comment.
4. Burdening Donees or Legatees Who Never Had Control
The Proposed Regulations appear to apply to any family member who transfers a non-controlling interest in a family-owned entity, even if the family member never had control and never avoided the transfer tax the Proposed Regulations are presumably designed to protect. Suppose, for example, that Founder creates Entity with restrictions on transfers and gives or bequeaths a one-fourth interest in Entity to each of Founder’s four Children. Presumably, whatever final rules emerge from the Proposed Regulations would apply to those transfers if they occur after the Proposed Regulations take effect. If, later, one Child gives or bequeaths a one-twelfth interest in Entity to each of three Grandchildren (Child’s children), or even gives or bequeaths the one-fourth interest to a single Grandchild, there seems to be no good reason to apply the Proposed Regulations at the Entity level to those transfers. (They might still apply at the level of any additional entities or arrangements Child creates, such as entities to hold the one-fourth interest in Entity that Child received.) Child should likewise be exempt from the Proposed Regulations if the transfers from Founder occurred in the past, before the Proposed Regulations had become final.
Besides the obvious considerations of fairness that should reject the taxation of Child on something Child never owned, a “one and done” rule among generations would generally limit the application of the Proposed Regulations to the temporary artificial restriction contemplated by section 2704(b)(4) that “reduc[es] the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”
Again it might be necessary for such a modification of the Proposed Regulations to include special rules, such as for a case where more than one family member, not just a single “Founder,” maybe even family members in different generations, have joined together to create an entity and create artificial restrictions on transfers of interests in that entity. But permitting the Proposed Regulations to impose a higher tax burden on someone who never had control seems to be an incontestable case of imposing an “undue” burden.
5. Creating a Harsh Three-Year Rule
The guidance project that produced the Proposed Regulations was described in the most recent Treasury-IRS Priority Guidance Plan as “Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships” – in other words, focused on section 2704(b). In a surprise proposed amendment of the current regulations under section 2704(a), the Proposed Regulations would impose a claw-back rule if a transferor who divests control of an entity in a transfer now exempt under those current regulations dies within three years of that exempt transfer. The August 1 ACTEC Letter points out that, as a result, “any transferor who complies with all the known rules under section 2704 would still have the unfair burden of anxiety that the rules might retroactively change if the transferor dies within three years, no matter how unexpected that death is or how unrelated the transfer was to the timing of the transferor’s death.” The unfairness of that result and the common sense of substituting a proven regulatory mortality test like that in the section 7520 regulations (which ACTEC recommended) are obvious.
6. Bifurcating the Effective Date
The new “disregarded restriction” rules in Proposed Reg. §25.2704-3 would not take effect until 30 days after the date the regulations are published as final regulations in the Federal Register. That is the general rule of the Administrative Procedure Act (5 U.S.C. §553(d)) applicable to “substantive” regulations. The surprise amendments to the section 2704(a) regulations, and other amendments that update the types of covered entities, would take effect when they are finalized, without a 30-day deferral. ACTEC has proposed using the 30-day deferral for everything in the Proposed Regulations, to eliminate the need to keep track of two separate sets of rules and to avoid litigation over what should have been viewed as “substantive.”
Section 2704 was enacted on November 5, 1990. That is 321 months ago. Can another month really matter?
SOMETHING TO LOOK FORWARD TO
Executive Order 13789 also directed the Treasury Department to “prepare and submit a report to the President that recommends specific actions to mitigate the burden imposed by the regulations identified in the interim report.” It directed that this second report be submitted within 150 days of the Executive Order, or by September 18, 2017.
Many critics of the Proposed Regulations have called for – or at least hoped for – some formal announcement from the IRS that it has heard the cries for relief and will ensure that the final regulations will provide it, perhaps addressing the issues raised in ACTEC’s October 27, 2016, Comments (the most serious of which are recapitulated in ACTEC’s August 1 Letter and in this Capital Letter). So far those pleas have not been answered.
But the Executive Order does ask for a report by September 18. That may be interesting.